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Thursday, 26 January 2012

The eurozone: still reasons to be fearful; The widespread adoption of fiscal austerity will keep hobbling the region

Vikram Khanna

(SINGAPORE) In town last week was Klaus Regling, CEO of the European Financial Stability Facility (EFSF), which is the eurozone's main bailout fund for troubled sovereign debtors.

Part of his mission, it appeared, was to reassure the growing tribe of eurosceptics that the eurozone was well in control of its crisis, which is the stuff of headlines these days.

Candid and straightforward, he made a strong case for the durability of the eurozone and left no questions unanswered. But for all that, it was still a less than fully convincing effort.

Mr Regling, whom The Economist magazine has dubbed the eurozone's 'Chief Bailout Officer', arrived at a slightly awkward moment; on Jan 16, ratings agency Standard and Poor's (S&P) had downgraded the EFSF (from AAA to AA+), after having three days earlier cut the ratings of nine eurozone sovereigns (including France, Italy and Austria).

He pointed out that the cut in the EFSF's ratings (which came from only one credit rating agency) would make little difference to its lending capacity or to confidence in the institution. On this, he was probably right; there was certainly no discernible negative reaction from the markets. The EFSF will live on and might even thrive.

However, the rest of Mr Regling's presentation to the media here was not as reassuring as he perhaps wanted it to be.

He began with a slide titled: 'Don't underestimate Europe!' He pointed out that the European Union, which comprises 27 member states, is the largest economic area in the world, accounting for about 20 per cent of the world's GDP.

He claimed that Europe's economic performance 'has been better than perceived', noting that growth in per capita GDP has been 'identical with the US in the last 20 years'; it is only because of its poorer demographics (basically lower birth rates) that Europe's absolute GDP growth has been lower.

While Europe is indeed a major engine of growth, from the perspective of its trading partners, its absolute growth rate (as well as import intensity) matters more than its per capita growth rate. Moreover, in the midst of the eurozone crisis, past growth is less important than present and future growth.

And here, the projections for the eurozone are troubling. In its September 2011 World Economic Outlook, the International Monetary Fund (IMF) forecast euro area growth for 2012 at 1.1 per cent, compared to 1.6 per cent for the United States. The OECD Economic Outlook of November 2011 is even more pessimistic for the euro area, projecting growth of just 0.2 per cent, versus 2 per cent for the US this year and 1.4 per cent (versus 2.5 per cent for the US) in 2013.

One of the reasons the eurozone is poised for slow growth, if not recession, in 2012 and 2013 is the widespread adoption of fiscal austerity. This has been enshrined in a so-called 'fiscal compact' championed by Germany and agreed by European leaders last December.

Under this compact, countries will aim to keep their fiscal deficits to no more than 3 per cent of GDP and national debt to 60 per cent. Leaving aside the fact that these targets are far away from where troubled debtors are today, they are the same targets that were agreed under the eurozone's 'stability and growth pact' in 1997. Several countries breached the targets then.

Mr Regling maintained that the difference this time is that enforcement will be stronger; the fiscal and debt targets will be written into countries' national laws. Those who breach them can be taken to the EU's highest court, the European Court of Justice, and face sanctions.

The credibility of these 'enforcement mechanisms' is doubtful, however. At the national level, legal limits on budget deficit levels have had a mixed record. More often than not, political pressure to maintain or increase expenditures prevails over legalisms, or governments tend to find creative 'off-budget' ways to spend what they need to spend.

At the European level, if breaches of deficit and debt levels are exceptions to the rule, it is possible that the violators will be taken to court and sanctioned. But whether that will happen when breaches are more the rule than the exception - as happened with the old stability and growth pact, when even France and Germany were in breach - is moot.

The eurozone also suffers from the fact that, unlike the United States, it lacks a system of easy fiscal transfers. Labour mobility is lower as well, even though it is (in theory) a unified labour market.

Mr Regling explained the measures taken by individual countries, describing Ireland as a 'success story', Portugal as being 'on track' and Spain as 'taking swift action'.

While the accuracy of these descriptions can be disputed, there is no denying that eurozone governments have taken many tough decisions, especially on the fiscal side. The question is whether those were the right decisions. Many economists think not; pursuing fiscal austerity is not what countries should be doing when faced with ballooning deficits and debts in a recessionary environment, and where no easy mechanisms for cross-border fiscal transfers exist.

Mr Regling, in tune with many German officials, urged that investors look more at the medium term - that is, three or more years out. He complained that Anglo-Saxon investors especially (though not Asian investors) were very short- term in their focus and did not pay enough attention to medium-term issues.

To underline the importance of the medium-term view, he drew a parallel with the Asian crisis of 1997/98, pointing out that, at the time, the IMF was much criticised for the tough monetary and fiscal policies imposed on the crisis-hit countries of South Korea, Thailand and Indonesia. But subsequently, these countries emerged stronger. So will it be with Europe, he suggested; the austerity being imposed now will show up in better performance later.

These arguments are problematic. First, on the issue of investors being 'too short-term focused': the fact is that many eurozone debtors do not have the luxury of time. They are faced with having to make bond repayments (or do bond issues) within weeks, and the success of these efforts have frequently been in doubt. In that sense, many of them - most dramatically Greece, but not just Greece - have urgent short-term problems too.

Short-termism therefore comes not from investors' faulty mindsets but from the very nature of the problems of the eurozone. Indeed, any investor accused of excessive short-termism might well respond: when your house is burning, you don't think of the medium term.

The parallel Mr Regling draws with the Asian crisis is also invidious. One of the critical measures that enabled South Korea, Thailand and Indonesia (and Malaysia as well) to restore their competitiveness and recover from the crisis was sharp devaluations in their exchange rates. This option is not available to the eurozone's beleaguered sovereign debtors. Stuck with the straitjacket of the euro, they are forced to engineer sharp 'internal' devaluations - that is, cuts in domestic prices and wages, in some cases of the order of 30 per cent in a single year. Even if this were economically wise (which it isn't), it is politically unworkable, and the fact that few countries have come even close to achieving it is no surprise.

There was, however, one particular area where Mr Regling did have a point. That slide was titled: 'The ECB has taken significant measures.'

After having dithered for the better part of two years, the European Central Bank, under its new president Mario Draghi, has indeed acted decisively and imaginatively. It has cut interest rates (something it should have done back in 2010, if not earlier); continued buying sovereign bonds from the secondary market; and liberalised its requirements for collateral from banks. Most significantly, on Dec 21 last year, it launched a 489 billion euro (S$804 billion) long- term refinancing operation (LTRO) under which it has provided eurozone banks with three-year financing at an interest rate of one per cent.

This facility has helped improve liquidity across the eurozone and enabled banks to shore up their capital as well as reduce their holdings of sovereign debt, which they can park with the ECB as collateral. Some banks have also used the cheap funding to buy sovereign debt, earning a nice spread. The ECB has indicated it will launch yet another LTRO facility in February - which might be even larger than the last.

The ECB's actions have probably prevented a financial meltdown in the eurozone. They are the main reason for the decline in bond yields and the equity market rally we have seen since the start of this year. Indeed, if the zone gets through the sovereign debt crisis in one piece, it would be due in no small part to Mario Draghi's creativity.

However, this creativity does not resolve the fundamental problems of the eurozone, which are essentially too much debt, too few resources to service it, and too few ways to obtain those resources - even from other parts of the eurozone.

So, especially as long as fiscal austerity remains the centrepiece of Europe's strategy to deal with its crisis and policies to promote economic growth remain off the agenda, there remain reasons to be fearful - including about the break- up of the eurozone itself.

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