SERIOUS MONEY:THE SECOND phase of the financial upheaval that began during the autumn of 2007 is under way. History illustrates that banking crises are typically followed by sovereign debt crises and the current episode is proving no exception, with Greece being singled out as the weakest link among fiscally stretched developed nations, writes CHARLIE FELL
The €45 billion EU/International Monetary Fund (IMF) debt contingency accord at concessionary rates of interest, coupled with the European Central Bank’s (ECB) decision to relax its rules on what is deemed as acceptable collateral, provided the Greeks with only temporary respite.
Sounder minds prevailed. Investors appreciated that while the measures taken may reduce short-term liquidity risk, they do nothing to alleviate medium-term solvency concerns. This would almost certainly result in lower recovery values for private debt-holders, because EU sovereign loans are likely to receive higher priority.
Inevitably, the improvement in market interest rates proved temporary and 10-year government bond yields have since climbed to more than 7.8 per cent, or almost 475 basis points (4.75 percentage points) above their German equivalents. The Greek fiscal situation is simply unmanageable at current market rates, and a debt restructuring or credit event is almost certain to be triggered. It is highly improbable however, that Greece will elect to leave the European Monetary Union, and they cannot be compelled to do so. Greece cannot conceivably leave the euro zone because, as Barry Eichengreen at Berkeley points out, the decision would precipitate the mother of all financial crises. First, the decision to leave could not be taken overnight; it would require extended preparations and would have to go through some democratic process. A run on the banking system would ensue, as domestic depositors attempt to secure the value of their funds and shift them elsewhere in the EU.
The exiting country could not block the capital outflows by decree, since there is unrestricted capital movement in the EU. Thus, only an exorbitant rise in interest rates could prevent a banking system collapse.
Second, the seceding country could not conceivably re-denominate its outstanding stock of euro-denominated debt in the new currency, as access to international financial markets would close and foreign investment would collapse. Furthermore, borrowing costs would soar, as investors demanded a sizeable inflation and liquidity risk premium. Thus, the real value of the debt-to-GDP ratio would rise, and real interest rates would remain punitive.
Finally, the improvement in the seceding country’s competitive position as a result of the large drop in the external purchasing power of the new currency would, in all likelihood, not persist for long because labour would be unwilling to accept a drop in real living standards. Thus, the drop in the external value of the new currency would be quickly followed by an equally sharp decline in its internal value. The economy would become increasingly prone to periodic bouts of high inflation, economic volatility would rise, and foreign investment would leave.
There is no incentive for a fiscally challenged country to leave the euro zone but actions taken by the EU and the ECB in response to Greek distress have served to undermine the credibility of the euro as a hard currency, and have increased the chances of an eventual break-up nevertheless. This is because the EU/IMF debt contingency accord at below market interest rates, combined with the ECB’s softer collateral stance, has erased the credibility of any threat that a recalcitrant fiscally challenged euro zone member will be allowed to default.
The removal of this threat introduces serious moral hazard concerns.
Fiscally stretched countries are now aware that the EU will climb down should market rates push borrowing costs to unacceptable levels. Furthermore, ailing euro zone members are also aware that the ECB will accept their debt as collateral so long as at least one of the three rating agencies has not downgraded their securities to below investment-grade status. The need for aggressive action to turn around public finances has become less urgent, and it has become increasingly likely that the euro zone will succumb to fiscal profligacy and higher inflationary pressures over time.
It is unlikely that stronger countries, such as Germany, will accept such increased price instability, and the accompanying degeneration of the euro into a soft currency. Playing the role of “bailer-of-last-resort” is already deeply unpopular, and a jump in long-term inflation expectations combined with currency weakness could ultimately motivate the stronger countries to leave the euro zone. The crisis in Europe has only begun.
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