German student Caroline Duong has won the 2011 Threadneedle Investment Award for an essay on the debt crisis in Europe and the investment implications of a Eurozone break-up.
“…Europe exemplifies a situation unfavourable to a common currency. It is composed of separate nations, speaking different languages, with different customs, and having citizens feeling far greater loyalty and attachment to their own country than to a common market or to the idea of Europe.”
Professor Milton Friedman, The Times, 19 November 1997
The current EU sovereign debt crisis surfaced in the wake of 2008, as governments and central banks across the developed world undertook drastic measures to shore up financial markets on the brink of collapse.
The result was a transfer of debt burdens from private to public balance sheets, resulting in a surge of debt-to-GDP ratios and public sector deficits, still ongoing.
The EMU shares an unsavoury commonality with the gold standard – a deflationary bias.
The Euro forces adjustment in real prices and wages as opposed to exchange rates; therefore the burden of adjustment falls on weak currency / deficit nations.
Whereas this burden was carried more easily by some, it caused unsustainable debt levels among those in worse economic shape, notably the Eurozone periphery.
Furthermore economic convergence between stronger northern EMU members and their southern counterparts expected as a result of Euro membership has failed to materialise over the past decade.
PIIGS have benefited from converging costs of borrowing by joining the EMU, yet labour costs rose by 30%-40% since 2001 (Cliffe, 2010). With low growth, ongoing deficits and rising cost of borrowing, Greece and Portugal are unlikely to be able to service their debt.
Spain, which has a lower debt level, suffers from high unemployment and its banks are
threatened by a substantial amount of non-performing loans from the Spanish housing bubble. France, Britain and Germany hold about €572 billion of Spain’s debt making it the biggest concern among core economies (Nugee, 2010).
Although peripheral countries lack the economic and fiscal discipline in operating sustainable fiscal policy, they were able to continue financing their deficit whilst bond prices reflected European credit risk rather than that of individual countries.
As their financial and economic health became increasingly precarious borrowing costs soared, exacerbating already unstable debt levels.
Along with bail-out packages for Ireland and Greece, the EU and IMF have imposed strict austerity measures. Further fundamental structural changes, ranging from competitiveness to tax collection rates are vital for peripheral countries to be able to “grow” out of their debt.
However fiscal tightening is accompanied by relatively tight monetary policy resulting in deflationary pressure and economic contraction.
In order to prevent a break up scenario, EU authorities will have to deal with the transition to more sustainable debt levels in the near future, as well as enforce structural changes in periphery countries and the EMU as a whole.
The rescue package made available to Greece by the EFSF / IMF has failed to allay investor concerns, with the focus of investor concern ultimately questioning Greek solvency.
Greece’s debt-to-GDP ratio is expected to peak at 159% in 2012 and GDP growth is forecast to remain in negative territory until 2011(Nedjalkov et al., 2011).
Consequently, Greek three year bond rates have risen to 21%, further undermining any chance of debt stabilization (Anastasi, 2011). Extending maturity on Greek debt would merely delay the problem as Greece has a solvency, not a liquidity problem (Economist 2011a).
Citi argues that a 42% haircut now and in combination with austerity and privatisation measures would bring down Greece’s debt-to-GDP ratio below 90% in 2013 (Nedialkov et al., 2011). Though, if delayed for longer haircuts to achieve a credible debt level would be significantly larger (ibid).