During the past six months, the European economy has been embroiled in a sovereign debt crisis. South African policymakers would be making the gravest of errors were they to underestimate the seriousness of this crisis.
For there is every reason to expect that, within the next 12 months, the eurozone’s crisis could lead to the sort of global financial market turmoil that followed Lehman’s collapse in September 2008.
At the heart of the eurozone crisis is the parlous state of the Greek economy, which is now paying the price for years of public-sector profligacy. By 2009, Greece’s budget deficit had swollen to around 14% of GDP while its public debt had increased to 115% of GDP.
This fiscal recklessness spawned consistently higher wage and price inflation in Greece than in the rest of the eurozone. As a result, by 2009 Greece had lost a cumulative 20% in international competitiveness, which has contributed to a ballooning in its external current account deficit.
The essence of Greece’s present economic predicament is that, being stuck within the eurozone, it cannot resort to currency devaluation to restore international competitiveness.
Nor can Greece devalue its currency to boost exports as a cushion to offset the highly negative impact on its economy from the major fiscal retrenchment that the country now needs.
In an exercise bordering on economic lunacy, the recently agreed-on $140?billion International Monetary Fund-European Union programme for Greece requires that the country aims to reduce its budget deficit to below 3% of GDP by 2012. To that end, the IMF has demanded that, for 2010 alone, Greece should adopt tax increases and public expenditure cuts totalling a staggering 10 percentage points of GDP.
And Greece is to do so in the context of acute pressure on its banking system and sharply higher domestic interest rates.
If the experience of Latvia and Ireland, two countries that have recently been engaged in savage budget retrenchment within a fixed exchange rate system, is any guide, Greece could very well see its GDP contracting by 15% over the next three years. Such a slump would only aggravate Greece’s public debt problem and could cause its public debt-to-GDP ratio to rise to 175%.
It is little wonder then that, despite the large IMF-EU bailout support package, markets are presently assigning a 75% probability of a major Greek sovereign debt restructuring within the next few years. A Greek debt default would almost certainly result in intense contagion to Spain, Portugal and Ireland. For, as in the Greek case, all of these countries have highly compromised public finances and severely eroded international competitiveness positions.
In addition, their eurozone membership precludes them from using exchange rate devaluation as a means to address these two problems. This predicament would appear to be particularly acute for Spain, which now has to effect serious budget retrenchment at a time when it is in the throes of a massive housing market bust and when its unemployment rate stands at over 20%.
A sovereign default in Europe’s peripheral economies would have a profoundly negative impact on the rest of the European economy. After all, the European banks are the largest holders of the peripheral countries’ sovereign bonds.
In this context, it is worthwhile recalling that the total sovereign debt of Greece, Spain, Portugal and Ireland exceeds $2?trillion. It is also good to recall that a country like France has had its banks lending as much as 37% of the country’s GDP to those peripheral countries.
An eventual write-down of the peripheral countries’ sovereign debt by even 20% to 30% would constitute as large a shock to the European banking system as that which it experienced in 2008.
If there is one thing that South African policymakers should have learned from the 2008 Lehman crisis, it is how interconnected the global economy has become and how important it is to go into a global crisis with a sound economic position.
Were Europe indeed to experience a full-blown sovereign debt crisis down the road, one must expect that the South African economy would be severely impacted.
Not only would a European banking crisis lead to an abrupt slowing of the economy of South Africa’s main trade partner, and to a decline in global commodity prices, it would also lead to a heightening in global risk aversion and to a drying up of capital flows to the emerging market economies in general, and to South Africa in particular.
On the eve of a possible European economic crisis, one has to be concerned about South Africa’s large public-sector borrowing requirement and about the renewed opening up of a sizeable external current account deficit in the country at a time when international commodity prices remain high.
One also has to be concerned about the acceleration in domestic wage settlements that go beyond levels that the country can afford. These developments would appear to make South Africa particularly vulnerable to any sudden stopping of international capital flows.
In anticipation of the real possibility of renewed international financial market turbulence, one also has to question the appropriateness of the Reserve Bank’s stubborn adherence to a policy of non-intervention in the foreign exchange market.
One would have thought that, by now, the Reserve Bank would have seen the benefits that almost every other major emerging market economy derives from preventing its currency from getting too strong in the good times and from preventing its currency from becoming a one-way-bet and excessively depreciated in the bad times.
At present there is a massive financial effort by the EU, the IMF and the European Central Bank to keep Europe’s peripheral economies afloat. However, judging by the German public’s growing opposition to indefinite bail-outs and by the peripheral countries’ serious solvency issues, South African policymakers would be making a serious mistake to count on this financial support lasting indefinitely. It would seem that they would do well to take advantage of the narrow window that this financial support offers to better prepare the country for the onset of an all-too-probable full-blown eurozone crisis.
Desmond Lachman is a resident fellow at the American Enterprise Institute