European Debt Crisis Going Global

by Ioannis Michaletos

The ongoing European debt crisis that began in Greece, entered Portugal and Ireland, and seems to be moving uncontrollably into Italy and France, is the single most important economic and political development globally, as it may potentially lead to another word market crash if it is not resolved soon. A deal on Greek debt reached this morning—which includes an agreement for banks to accept a 50 percent loss on Greek debt—may have created some breathing room and boosted investor confidence, but the deal merely makes the problem a little less enormous.

France

France wants first of all to secure its banks, which are significantly exposed to Greek and Italian debt. France is being cautious in the plans regarding a haircut in the Greek bonds, which may lead to a precedent that could eventually lead to significant losses for French banks and cause Paris to lose its AAA credibility regarding its ability to borrow capital from world markets and issue reliable bonds. Moreover, France wants the European Financial Stability Facility (EFSF), which is a mechanism directed at stabilizing countries in need, to become a sort of supreme banking institution that would be able to borrow capital directly from the European Central Bank (ECB) and provide to the ECB state bonds as collateral. Nevertheless, this has been adamantly refused by the ECB and the German government, both of which are fearful of an eventual sharp depreciation of the euro and further destabilization of the European Union.

Germany

Germany is the strong man at the negotiation table, having the largest and most competitive economy in Europe. The terms laid out by Berlin include modifying the newly established EFSF into a flexible mechanism that would be able to buy state debt directly after a proper notification by the European Working Group, a bureaucratic body within the European commission in Brussels. The EFSF would be able to sell bonds in the secondary market, keep the bonds until they expire or sell them back to the country that issued them. Furthermore, Berlin wants EFSF to be able to use bonds as collateral in order to acquire liquidity under repurchase agreements with commercial banks. In short, according to Germany’s point of view, a new mechanism potentially global in nature such as EFSF will be formed, which will override to an extent the traditional role of the ECB.

World banking system

The world banking system, which is heavily involved in the crisis, and especially Deutsche Bank, whose CEO Josef Ackermann is also the head of the Institute of International Finance and plays a leading role in the negotiations, are content with a moderate haircut of the Greek bonds of no more than 35 percent (for private debt, excluding IMF and E.U. loans). Many speculate that this is not enough to solve the issue and that eventually Greece will default, thus spreading the crisis further into other European countries that are struggling to reduce their public debts. On the other hand, the world banks claim that this will be viewed as a “credit event,” thus activating the credit default swaps being made over previous years, an event that will cost dearly in terms of capital to mostly U.S. banks that have issued the vast majority of those to E.U. banks.

U.S. banks

Citigroup, in its report on Oct. 20, noted that the European Union’s council of the heads of state does not seem to have the capability of overcoming all the differences. Nevertheless, it is likely that some decisions will be made in order to avert for the time being the problem spreading to Italy and Spain. Moreover, Citi believes that the European banking system should be recapitalized by at least 300 billion euros in order to withstand increasing market pressure. Other factors that will play a role are better governance in the European Union and the ability of EFSF to leverage itself. All in all, if there are multiple defaults in the Eurozone, no amount of capital will be sufficient to cover the losses.

German Bundsbank

The central German bank, according to its board member Andreas Dombret, is against the capability of EFSF to leverage itself because that will increase the danger to European taxpayers. Thus this represents another concern that an eventual series of defaults in the Eurozone may potential break up the EFSF and the losses will be diverted by the European Union to the taxpayers, who already cope with the refinance of the banks, austerity measures and sluggish economic growth.

Possible scenarios

On Oct. 20 authorities in Netherlands announced a significant rise in unemployment along with a decrease in consumer confidence in the country. The Netherlands is considered the main export-import region and commercial gateway for Germany, Switzerland and as far as Central Europe. Therefore it is an excellent indicator of the wider economic climate in the European Union. For the fifth consecutive month consumer confidence has been decreasing in the whole of the European Union, and at the same time Japan and the United States seem unable to restart their economic growth. The possibility of a double-dip recession is not off the table, and a possible default of debt in a European country may well ignite a renewed round of world market instability and GDP decline.

The G-20 will discuss the issue in Cannes-France in the first week of November. As noted above, there are quite a few signs that global growth is declining, judging also by the non-expansion of sea trade that carries 90 percent of the world’s commodities and the lack of interest for mergers and acquisitions and expansion by major multinationals. A double-dip recession followed by a global crash cannot be excluded as a possibility.

Another possibility would be for the major world markets to agree on a simultaneous erase of debt between them, both private and state. This move is a rather complicated one, but there are several historical examples of how to “clean the house” when all are in debt to each other.

There are still many undetermined variables at work, such as the pace of the coming recession in the European Union and the United States; public opposition to austerity measures; and strategic moves by the emerging markets of Russia, China, India and Brazil. These factors, taken together with the changing geopolitical landscape in the Middle East, will likely lead to a new balance in world affairs.

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