World Economy Counts the Cost of Euro Zone Dithering

By | November 23, 2011

From credit bottlenecks in Eastern Europe to slower growth in China, delays in tackling the euro zone’s debt crisis are causing ever-greater economic and financial damage well beyond the borders of the 17-nation bloc.

As politicians dither over how to share the costs of cleaning up the mess and preventing a recurrence, concern is mounting among policy advisers and academics that Europe could be condemned to several years of sluggish growth as excess debts are gradually worked off.

And wrangling over how to pay for decades of debt accumulation is not limited to Europe.

As Francesco Garzarelli of Goldman Sachs has noted, the political stalemate over how to reduce the U.S. budget deficit is another example of the difficulties advanced economies face in reforming the ‘social contract’ against a background of repairs to overstretched private sector balance sheets.

“We’re in for a very slow growth period in the world. This is going to define the next 15 to 20 years,” said one international official who was critical of the “intoxicating” monetary and fiscal policies that turbocharged growth and enabled the West to live well beyond its means until the bubble burst in 2007.

Figures on Wednesday underlined how difficult it is to shed debt, or deleverage, without throwing a spanner in the wheels of the economy. The euro zone’s private sector is likely to shrink in November for the third month in a row, according to a survey of corporate purchasing managers, pointing to economic contraction this quarter.

A companion survey in China showed an even sharper deterioration in business sentiment, and economists were quick to make the connection with Europe, which buys about 20 percent of China’s exports.

“We see downside risks to our below-consensus forecast of 8.4 percent GDP growth (in China) for 2012, mainly from the deterioration in the euro area growth outlook (a mild recession looks increasing likely) and the ongoing and widespread property market correction in China,” analysts at Barclays Capital in Hong Kong said in a note.

Evidence is also piling up of contagion from the euro zone through financial channels, not least because banks are complying with orders from regulators to strengthen their capital ratios, expressed as a percentage of their risk weighted-assets, by rapidly reducing exposure to non-core markets.

Eastern Europe is in the firing line, but so are countries as far afield as Chile, where Spanish bank Santander plans to sell a $1 billion stake in its local unit to raise cash.

Asian currencies are also a casualty. The Indian rupee plumbed a record low on Tuesday and analysts are more bearish on the currency than at any time in more than three years.

“As the exchange rate will continue to be driven by global capital flows to emerging economies, and the euro zone crisis looks set to drag on into 2012, the rupee could weaken further as portfolio investment is withdrawn,” Andrew Kenningham with Capital Economics, a London consultancy, told clients.

There is no shortage of technically feasible remedies to the euro zone’s malaise, including a strengthened financial rescue fund, massive secondary-market bond purchases by the European Central Bank and jointly issued bonds.

What is lacking, however, is a broad political compact between euro zone surplus and deficit countries on how to put the bloc on a more solid footing.

Will the first group have to guarantee, one way or another, the debts of weaker deficit countries? Will the latter, as a quid pro quo, accept outsiders second-guessing their budgets submitted to democratically elected parliaments? How will underlying economic imbalances be corrected?

Fear that Germany, the European Union’s traditional paymaster, will ultimately have to foot the bill was one of the factors at play in a rare failed auction of German government bonds on Wednesday.

The Bundesbank had to buy almost half of the €6 billion ($8 billion)of bonds on sale as investors went on strike.

ECB Vice-President Vitor Constancio played down what one analyst called a “disastrous” auction. “Markets often overshoot from time to time,” he told an audience in London. “We have to keep our nerve.”

But Constancio acknowledged that the architects of the euro had never envisaged the day that buyers for the long-term debt of a euro zone member might suddenly vanish. Apart from Greece, Ireland and Portugal have also been locked out of the bond market. Spain, Italy and now Belgium are paying punitive rates.

What was needed, Constancio said, was deeper fiscal integration and a workable financial rescue mechanism. The details might take a year to implement, but markets would settle down if they saw that politicians were in agreement on the deep reforms required.

“What’s important is that the final goals are very clearly explained and are strong and credible,” Constancio said.

Not only is a blueprint to prevent new crises still elusive, but banks and governments have yet to agree with Greece how to share the burden of writing off a chunk of Athens’s old debts.

But Larry Hatheway, chief economist for UBS’s investment bank based in London, said the proposal to wipe out half of the face value of the debt was progress.

Governments had long resisted the principle of a write down, fearing it could be the thin end of a very long wedge that banks under their jurisdiction could not cope with.

“Now there’s an acknowledgement among creditor governments that financial institutions will have to accept a loss on the exposure to certain sovereigns. That’s a step forward,” he said.

Yet even as crumbling confidence in policymakers drains life from the euro zone economy, demanding immediate action, the history of debt workouts suggests many more steps will be needed before creditors and debtors strike a compromise.

Patrick Butler, a board member of Austria’s Raiffeisen International bank, complained about weak political leadership and said the proposed 50 percent haircut for Greece was unlikely to be the end of the story. As recently as July, governments had blessed a proposal to write down just 21 percent of the net present value of the Greek bonds owned by jettisoned within weeks and actions taken in flat contradiction to the wordsprivate sector banks.

“It is clearly difficult for any investor to have the confidence to put his money at risk when unequivocal statements made by heads of state, finance ministers and central bank governors are jettisoned within weeks and actions taken in flat contradiction to the words,” Butler told a financial conference in Moscow.

(Additional reporting by Douglas Busvine in Moscow; Editing by Ruth Pitchford)

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