Eurozone Crisis- United we fall

Posted in Finance Articles, Total Reads: 3984 , Published on 17 October 2011
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In the century of globalization and free market capitalism; tightly knit clusters of nations have generally dominated world markets. OPEC and OECD, with oil being their greatest tool, have rewritten rules of world trade. The recently formed cluster of nations – European Union – has climbed the bandwagon, but with an unusual start.

European Union (EU) made up of 27 European nations is witnessing perhaps its biggest challenge after its formation. The Eurozone crisis which initiated as currency crisis has roots of possible banking crisis. Let us first understand the Eurozone crisis, its consequences and Lessons from the Political, Economic and Global perspective.

 

Political perspective:

Current crisis will likely shift the political nature and workings of the EU. It further weakens already weak ties which exist between its member nations, as member nations face a trade-off between the responsibility to deal with the crisis and their political motives.

Eurozone politicians have enough tools in hand to tackle this crisis. However, the primary hindrance to act seems to be the lack of will to implement these tools. Since the state power is at stake, it becomes difficult for so called (politically motivated) “leaders” to ask private sector to share a slightly larger chunk of the sovereign debt pie. The bail out which was given to Greece was mainly with the motive to avoid the possibility of complete default. However, practically speaking, some form of default may indeed be necessary. This was also acknowledged at the recent EU conference.

“Europe's decline is not just economic — it's a crisis in leadership,” says Damon Wilson, vice president of the Atlantic Council. [1] Unwillingness of leaders of member nations to act upon the crisis and their laggard behaviour has hampered EU as a whole.

The following figure depicts the state of EU member nations. We can clearly see which countries are highly susceptible for further setback.

The Figure Shows Current Public Debt as a percentage of GDP. [3]

In addition, many changes will be inevitable on the political front as the crisis unfolds. Political parties in Portugal and Ireland have been thrown out of power this year. Spain will probably follow the suit as well, while leaders in Italy, France and Greece may be in line.

As southern European nations struggle, Germany can definitely take a huge advantage of the situation and become the most dynamic economy of the world.

Since the beginning of Euro crisis,politically, the role of European commission has been minimal and big guns (i.e. Germany and France) have controlled the overall direction of talks. France is at a relatively larger risk in terms of financial stability. It is possible that it may lose its competitive advantage with the further spread of crisis, and thus pass on all the controlling knobs in the hands of Germany.

Other smaller countries which have intertwined themselves in debt traps, will find it difficult to match the level of these nations. This may give rise to further austerity measures, spending cuts and further introvert behaviour at economical as well as political level. This spread of Euro crisis within Europe can also result in smaller nations turning their backs on Euro, as scares will spread in already fragile economies.

European countries may also lose their frontrunner tag on global scenario, especially when it comes to participating in the global systems for the purposes of global welfare as well as defence schemes such as NATO operations. If their influence and participation is reduced in such operations, it will be difficult for them to maintain their political superiority on a global level.

If EU is to survive in the global political systems of nations, a strong Euro commission is a must. EU must promote joint decision-making, and should not allow concentration of power in single hand.

Stronger coalition and inclusive nature of commission will ensure quicker and stern actions. Disparities which exist in EU members, on the economic and political front, should not be directly translated into the proportionate dominance at commission.

Economic Perspective:

Economically, the crisis has been more damaging than currently presumed by the rest of the world. Few of the economic highlights of the crisis must be scrutinized carefully for further learning.

One of the major learning has been the limitation of a single currency system. It lacks the central Treasury mechanism which can control the inherent trade imbalances which result in huge budget deficits, much like the gold standard era.

Another major reason why Europe is engulfed in this turmoil is the single currency system applied to the divergent economies. This hampers the interest rates and eliminates the possibility of crawling your way out of such situation through the devaluation of currency.

With abandonment of the euro, countries such as Spain, Italy, and Greece etc. can use an exports route for recovery by devaluation. However, Abandoning Euro itself is not a plausible solution at the moment.

Consider the example of Greece. At present it owes more than 400 Billion Euros (about 200% of its GDP) to other EU countries. If it abandons Euro, its Nominal GDP will become more than half; raising its debt in tremendous manner (twice the current) in nominal terms, which will not be repaid resulting in its default.

Similar conditions exist in other countries such as Portugal and Ireland. Moody’s recently downgraded both these countries. Soon to follow is Greece, and some fear that France might be in queue, too.

Britain is relatively safe as it is a non-Eurozone country. At any moment it can choose to devalue its currency and use exports to come back in shape. However it’s not as easy as it seems. Devaluation of currency has several implications. One of the major implications is the loss of at least some credibility in terms of a nations’ political and economic superiority.

Devaluation of currency causes drop in monitory value of the external debt. For example; if Britain owes 100 Pounds (GBP) to India which is equivalent to approx. 8500 INR at the moment. If Britain devalues its currency to 75 INR per GBP; then in it has to pay only 7500 INR to India, causing a loss of 1000 INR to India.

Another thing that goes against Britain is that it sells almost half of its current total exports to EU countries. Thus, recovery through devaluation has major hindrances.

When whole of the Europe is literally engrossed in brainstorming, USA is sitting on the boiling pot. Although many American money market funds are not directly exposed to “Junk” bonds of indebted nations, they still hold a large portfolio consisting of European bank debt; which in turn hold the abovementioned “Junk” portfolios. This exposure effectively amounts to trillions of dollars. Thus, if domino effect starts in Europe, we know be certain about where its end will be. It’s certainly no good news for the already embattled American economy. Deposits in the US banks can also surge when money market funds redirect themselves. With huge piles of cash in hand and no takers for loans, American banks may be caught in unyielding money trap. [2]

Solutions could be many. Imposing a greater fiscal integration of member states is one of them. With greater integration, responsibilities will be well managed. Unlike Greece, where there is still doubt about its accounting procedures.

Another tangible solution could be, issuing jointly guaranteed bonds. It reduces the overall risk for the investor by principle of diversification, and thus they will be eager to pick them up.

In immediate term such issue could halt the crisis, but on strategic level better integration of EU and inclusive nature of commission is the only way out in longer run.

Global Perspective:

Repercussions of EU crisis will not be limited to Eurozone. Its ripples will be felt even in the developing economies, some of which may be positive but at large most of them will be negative.

The debt crisis and reduced role in word politics of European countries could create a golden opportunity for China to bolster its position strategically. As the political influence of US and Europe diminishes; China is at the vantage point. It has already been using state controlled capitalism and multiple resource ownership strategy across the globe to spread its wings. With presence in most of Africa (which are viewed as next big markets and are resource rich), China could tighten its grips on world economy.

However economically, some of the Chinese imports may see a hit as it exports large chunk to European nations.

For other countries, multiple revenue streams may get hit. Exports for example, could be one of the first to get hit. As feared by the Chinese, further deterioration of the EU zone countries will reduce exports. It is also predicted, that the Euro may be devalued with respect to dollar, if crisis moves unprecedented. In such scenario, incentives to export to EU will reduce. Developing countries which export autos, agricultural produce (such as India, Indonesia) and textile exporting countries (such as Bangladesh) could see an immediate effect.

Tourism and travel may be hampered. This is bound to happen across the globe as the purchasing power and willingness of European tourists drop. Globally, tourism is in dire state after ’08-’09 crisis. Many companies like Thomas cook are already suffering due to lack of sustainable business.

Capital flows may be redirected for longer terms, from Europe into other markets. European markets would be seen as “risky” in short run and “sluggish” in the long run. Since in the long run, interest rates will be lower, reducing incentives for capital inflows.

This in turn is opportunity as well as threat for Emerging markets. In the short run, it will improve their inflows, providing vital capital for businesses and building rapid growth in markets, propelling economies forward. However greater risk exists in the long run, as asset bubbles and inflation could grow out of proportion.

Confidence in the banking system may further reduce in the short run as all the global banks have exposure to European sovereign debt. This retaliation is already seen in banking stocks bear rally.

To address these issues, certain policy changes may have to take place in emerging nations. They may have to rely on domestic trade as well as exports in upcoming years. Further they need to strengthen their trade relations with similarly positioned nations, creating bilateral ties for better portfolio diversification.

Better monitoring of capital inflows will be required to manage inflation and bubble situations. At the same time maintaining a greater control on banking system will be cautious approach required to avoid further implications.

Conclusion:

Greater changes are bound to happen politically and economically on a global platform. The magnitude of these changes will be defined by the way in which crisis unfolds.

If the crisis is curtailed in its early stages; many of these implications will be halted. However, considering the lack of political will in EU nations, crisis may lead to major structural adjustments. Especially in emerging nations repercussions are greater and policy changes might be in the cards.

What is left to be seen is the way in which series of events take place. A dramatic change at political level can certainly shift the balance towards better recovery and less damage.

 

This article has been authored by Neeraj Patki from SCMHRD


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