The downward pressure on world stock markets, that began some months ago, continues to grow in intensity, as rising recession risks across the Western world can no longer be ignored. The source of the turmoil has moved back-and-forth across the Atlantic Ocean in recent months, as a lame economic recovery in the US has collided with a debt crisis in the eurozone. Indeed, the focal point for the latest bout of turbulence centers on Greece and its government’s inability to meet the ambitious targets as prescribed under the EU/IMF adjustment program.
Unfortunately, the focus on Athens has seen most commentators, investors and, even policymakers view the eurozone’s problems through the narrow prism of sovereign debt. Viewed in this light, profligate government spending precipitated the build-up of sovereign debt to unsustainable levels and, as a consequence, many analysts seem to believe that successful fiscal consolidation in the troubled nations of Greece, Ireland and Portugal, will bring the crisis to an end.
Such a belief however, is extraordinarily naïve as the crisis should be seen, not as a sovereign debt crisis, but more appropriately as a balance of payments and external debt crisis. The availability of low-priced credit from banks in the eurozone’s core following the launch of the single currency more than a decade ago, allowed the periphery to run large and persistent external deficits that sparked a disturbing increase in the level of foreign debt, both public and private.
The dependence on foreign debt made each of the peripheral nations vulnerable to a sudden reversal in capital flows. A reassessment of risk premiums, as the ‘Great Recession’ took hold, led to a stunning increase in interest rates and one-by-one, the governments of the peripheral nations had no option, but to seek assistance.
However, while fiscal consolidation as prescribed by the EU/IMF adjustment programs may well be desirable and necessary, the reversal of primary budget deficits alone will not be sufficient to bring the crisis to an end. The large current account deficits still present in Greece and Portugal in particular, must be eliminated if foreign debt loads are to stabilize but, in the absence of currency devaluation, that task looks nigh on impossible.
Foreign lenders in their search for yield in a low-return world, lent freely to the peripheral countries in the years leading up to the crisis. Current account deficits were allowed to grow to alarming levels with little, if any, consideration for the true nature of the risks involved.
The Greek external deficit relative to GDP expanded by more than eight percentage points to almost fifteen per cent from 2003 to 2008; the Portuguese deficit widened by more than six percentage points to 12.6 per cent over the same period, while the Irish external position went from near-balance to a deficit of 5.6 per cent over the five-year period.
External imbalances were to be expected following the launch of the single currency, as relatively poorer countries played catch-up with their wealthier brethren. However, borrowed funds were used primarily to finance current consumption, rather than productive capital investment designed to boost export potential, such that a significant proportion of the foreign lending may never be repaid.
The focus on sovereign debt is understandable in the case of Greece, since it was its unsustainable public debt position that sparked the confidence crisis. Nevertheless, the country’s non-financial private sector debt ratios still managed to jump from 52 to almost 90 per cent of GDP between 2002 and 2009, as underleveraged Greek households and businesses caught the borrowing bug.
The Portuguese private sector partied that bit harder and the comparable debt ratio surged by more than 50 percentage points to 178 per cent over the same period, while the non-financial private sector in Ireland outdid everyone with the ratio increasing by more than 100 percentage points to almost 200 per cent.
An external financing crisis duly erupted in each country, as the borrowing capacity of both private and public sectors reached exhaustion with net external debt approaching 100 per cent of GDP. Focus on such disturbing external imbalances was bound to happen sooner or later, irrespective of what happened elsewhere, though the meltdown in America’s mortgage market brought matters to a head sooner than might otherwise have been the case.
The fall-out was severe though hope springs eternal, as the Irish situation has since stabilised. A large trade surplus has allowed the current account to move into positive territory and, not surprisingly, yields on Irish debt have decoupled from their troubled brethren. Be that as it may, a successful conclusion to the Irish problem hinges on events elsewhere.
Unfortunately, the news from both Greece and Portugal remains grim. Chronic trade deficits persist in both countries, while foreign debt and interest payments abroad continue to grow. A large double-digit percentage point reversal in the trade account as a share of GDP is required to stabilise the level of foreign debt in both cases. Such a development is highly unlikely given the low value-added and uncompetitive nature of the respective export sectors, not to mention the slowdown in external growth.
Absent a herculean reversal in the export sector’s fortunes, the necessary external adjustment could only take place through a depression-like collapse in domestic demand, which would throw fiscal consolidation off course and result in no fall in aggregate debt levels.
Both Greece and Portugal are stuck in a debt-deflation trap and the harsh reality cannot be disguised – both countries are insolvent. Eventual euro-exit should not be dismissed lightly.
Originally posted on www.charliefell.com
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