EU's Financial Woes 

Sovereign debt crisis to derail world growth?

THE sovereign debt crisis contagion is spreading in Southern Europe (see charts), from Greece to Portugal, Spain and Italy, where government debts and budget deficits are high.

Investors have sold government bonds in those countries as perceived default risks have risen.

This has resulted in the rise in the yields of government bonds resulting in higher borrowing costs for the government and private sector as loans are often tied to the risk free rate of government bonds.

Countries that faced sovereign debt crisis earlier, like Iceland, Ireland, Hungary and Latvia, had to reduce their budget deficits by raising taxes and cutting government spending, resulting in economies going into recessions.
For example, austerity measures in Ireland have resulted in the economy shrinking by almost 12% in the last two years.

Unfortunately, those countries in the eurozone cannot print money like the US, UK and Japan to finance their deficits through the monetisation of debt as they have given up control of their monetary policies to the European Central Bank.

Leaving the eurozone and devaluing their currencies will likely lead to an Argentinian-style loss in confidence and massive fund outflows.

Large budget deficits were the cause of the problems faced by these European countries but still they are likely to resist ceding control over matters like government spending and taxation to the European Union authorities.

As the European monetary union is facing tremendous stress, can the currency union survive where there is no fiscal union or discipline?

Austerity measures are being forced on these Southern European countries at a time when economic conditions are terrible.

For example, following the collapse of the Spanish property bubble which decimated the construction and real estate industry, Spanish unemployment has exceeded four million, representing an unemployment rate of close to 20%.

Cutting Spanish government spending to reduce its 11.4% budget deficit as a percentage of gross domestic product can only worsen unemployment.

The downgrading of the sovereign debts of Southern European countries is also fuelling the contagion and capital flight.

The sovereign rating of Japan, with an extremely high debt to GDP of close to 200%, is at risk with S&P placing a negative outlook on Japan’s double A sovereign credit rating.

Strangely, these agencies have continued to maintain the triple A ratings of the US and UK, even though their budget deficits are very high, estimated at US$1.6 trillion of 10.6% of GDP for the US.

This is despite the fact that the US unlike Japan cannot rely on domestic savings to fund its borrowings. But then, these were the same agencies that maintained AIG’s triple A rating even when it was guaranteeing large amounts of risky subprime loans.

Even the US is facing constraints on the size of its budget deficits as a popular revolt against large deficits are being organised and the loss of the 60-vote Democratic majority in the Senate means that Republicans can now block spending bills.

The world is depending on fiscal stimulus to sustain growth as highly geared Western consumers are still deleveraging and are reluctant to borrow more despite low interest rates.

If enough countries withdraw fiscal stimulus because of the sovereign debt contagion, world growth will stall, plunging the world into a double dip recession.

This possibility cannot be fully discounted as the GDP of all the Southern and Eastern European countries combined is estimated by the International Monetary Fund (IMF) at US$9.1 trillion in 2008, more than twice the size of the Chinese economy.

Already, it would appear that government spending cuts and loss in confidence in the euro has permanently damaged European growth for the next two years.

The EU’s economy, with an estimated GDP of US$18.4 trillion in 2008 is larger than the US economy at US$14.4 trillion.

US and Chinese manufacturing will also be adversely impacted as demand from Europe will decline and a weaker Euro makes US and Chinese exports less competitive.

To prevent this contagion from spreading, the European central bank would have to guarantee the sovereign debt of these affected countries.

Excessive speculation should be curbed to prevent a downward spiral like what happened during the Asian crisis.

Speculative attacks during the Asian crisis ended when speculators who short sold were killed off by the superior buying power of the Chinese and Hong Kong authorities which also changed rules on short selling.

Presumably, Germany and France with the support of other major powers (US, China and the UK) could do the same. That of course would be premised on Greece cutting its budget deficit; probably a foregone conclusion as funding problems will curb spending.

Sounds familiar? The similarities to the Asian financial crisis are as follows: austerity measures were imposed when the economy was hurting and the flight of short-term funds resulted in higher interest rates.

Like Tun Mahathir Mohamad, the Greek prime minister is already blaming unscrupulous hedge funds and speculators for its predicament.

A withdrawal of fiscal stimulus would slow world growth and increase the chance of a double dip recession.

Corporate earnings and the stock market are likely to be adversely impacted. On the flipside, a weak economy will allow interest rates to remain low for a longer time.

The inability to fund fiscal stimulus through government debt may also increase the temptation to print money to finance the deficits, especially if deflationary pressures arise from a slower growth (exacerbated by lower commodity prices and excess capacity).

If such a downturn is moderate, it could lead to better fiscal discipline and a more rapid private sector adjustment; Asian countries hit by the Asian financial crisis (including Malaysia) have weathered the current downturn better as their financial systems are more stable now, budget deficits can be funded by domestic savings, asset bubbles have been better contained and borrowings are funded mainly by domestic sources.

In an environment of weak growth and low interest rates, stick to defensive sectors with steady demand like healthcare (rubber glove companies), utilities, tobacco and telecommunications.

A high dividend yield should also be welcomed as interest rates are likely to remain low due to slower growth and deflationary pressure.

Source: Starbiz ● Choong Khuat Hock, head of research at Kumpulan Sentiasa Cemerlang Sdn Bhd.