Is there an Asian crisis type financial tsunami beginning to ripple in the European Union region? Stock and bond markets over the last week have become increasingly nervous about a possible new financial crisis which centres on sovereign debt positions of a number of European countries. A possible contagion affect could see problems in one country quickly spill over to other sovereigns with vulnerable debt positions. The odds still suggest that a domino sovereign crisis with a number of countries hit is unlikely but the odds are nevertheless shortening.
Three large and important EU countries are under the immediate spotlight. Greece, Spain and Portugal are facing significant challenges as external markets focus on their precarious fiscal positions. All three are burdened by large debt together with high fiscal deficits. Greece remains very vulnerable due to its very high debt to GDP at around 120 per cent and the weak state of the economy. Its deficit to GDP is also worryingly high at more than 12 per cent.
Both Spain and Portugal have similar debt and structural problems. Spain's debt to GDP is around 66 per cent, not excessive by itself but its budget deficit is a very high 9.7 per cent. Portugal has more structural problems with debt to GDP at 90 per cent and a deficit of 9.3 per cent.
Ratings under scrutiny
All three countries face further ratings pressure. The big issue is the collective problem of three important members of the euro zone and the challenge it provides to not only the European Central Bank but to other member countries. The likelihood of default for, say, Greece, is remote as the European Central Bank would likely arrange a support package. However, risk would rise exponentially as other highly indebted countries would be caught up in the financial turbulence. This would require a quick and concerted financial rescue plan by the ECB in order to shore up the financial toxin. It would be no easy feat and any faint impression of hesitation or uncertainty of success would quickly cause a crisis for the euro zone as other countries would be caught up in the storm. In these circumstances, the euro would stand on the edge of a precipice. So far the European Union has not said they will provide help to those member countries facing debt problems.
Other issues thrown into the equation also create questions. Quantitative easing programmes from major economies appear to have run their course. Banks have deleveraged and corporates may have passed the worst.
But economic growth remains weak and consumer confidence is still fragile. Moreover, debt levels for the private and commercial sectors remain high. If there are sovereign debt problems going forward then this could create a new financial crisis. Moreover, with quantitative easing programmes finished, any sovereign debt problems is likely to cause a rise in interest rates. This could see a rise in defaults from both the consumer and commercial sectors.
High levels of debt for a country creates downward pressure on economic growth, particularly if debt exceeds 90 per cent of GDP. Investment house PIMCO believe that banking crises are followed by a deleveraging of the private sector. This is accompanied by a substitution and escalation of government debt, which in turn slows economic growth. PIMCO also believe that countries with debt to GDP over 90 per cent and budget deficits over six per cent are particularly vulnerable. Countries in what PIMCO title their ring of fire include Spain, Greece and Portugal but also the UK and the US.
McKinsey's research shows that in about 50 per cent of cases of country deleveraging results in a prolonged period of belt-tightening. This then exerts a significant drag on GDP growth. In the remainder, deleveraging results in a base case of outright corporate and sovereign defaults or accelerating inflation.
Those countries facing the most problems are the advanced industrialised countries. Some with large debt mountains and low growth prospects will see downward value pressure on their currencies. The same could be the course for the euro, especially if some euro zone countries have debt problems.
In contrast, most emerging markets are in stronger shape with lower debt profiles and more capacity for growth over the next few years.
The UAE falls in this camp. Its debt to GDP is reasonable at around 60 per cent but also has a low budget deficit of approximately two per cent.
This base will help it to generate growth going forward. The larger emerging markets are also generally in better debt positions and will record growth considerably above say the G7 average. It looks like a number of the industrialised countries face both debt and growth hurdles going forward.
- The writer is US-based commentator on business issues
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