Give the Game Changer a chance

December 15, 2011

Two weeks ago, I posted a piece in my blog where I posited that the European nations are about to move aggressively to solve their sovereign debt problem (here). I thought we had finally seen a game-changing moment in the Euro zone debt crisis. I took some risk in calling the Game Changer. As you may know, Game Changers are hard to come by. They are easier to identify after the event or crisis. This is understandable because when you are in the midst of a crisis - one with far-reaching consequences (think the next depression or the collapse of the global financial system) - you tend not to see the wood from the trees.

When the U.S. Fed announced in March 2009 that it would pump more than USD1 trillion into the U.S. economy, I thought that was a game-changing move (here). The U.S. sub-prime crisis in 2008 was extremely difficult, as it gave rise to many serious questions (such as the question of moral hazard) which constrained the response from the U.S. government. The timid response was always behind the curve; either inadequate or a bit too late. Once the difficult questions were brushed aside, the U.S. government moved aggressively to save its financial system. That was quite similar to the implementation of capital control by Malaysia in 1999, which put a floor on the then-collapsing economy during the Asian Financial Crisis.

The Euro zone sovereign debt crisis is much more complicated than our Asian Financial Crisis of 1998 or the US Financial Crisis of 2008. There have been many rounds of meeting & many plans announced which failed to contain the problem. Then in early December, Germany & France agreed on a "stability pact", whereby they would lay down strict fiscal rules to prevent overspending and over-indebtedness. The "stability pact" would include changes aimed at increasing fiscal coordination across the Euro zone and the enforcement of rules on deficit & debts levels. Once this new “fiscal compact” has been put in place, the ECB is expected to intervene by buying bonds of troubled euro zone states or cut interest rates. To me, this is the blue print for a comprehensive action plan in solving the problem.

Last weekend, 17 European leaders met to hammer out the finer details of the fiscal compact. After much jawboning, they agreed to the balanced budget amendment which inter alia allows the European Commission to oversee national budgets and impose penalties if a country's debt grows too much. This entails a revision to the Treaty of Rome. U.K. did not agree to the new accord and it may have to leave the European Union (‘EU’).

The market did not rejoice with the outcome for two reasons: firstly, there will be no EU Treasury, no shared debt issuance, no centralized tax collection and most importantly no fiscal transfer to depressed countries. The absence of any agreement in these areas is probably due to the German’s opposition to the idea of fiscal union or even a smaller idea of debt mutualization. Without fiscal transfer as compensation input, the balanced budget rule would call for painful austerity program for some countries and this would lead to slower growth or deeper recession & higher unemployment.

The second disappointment came when ECB President Mario Draghi hinted that ECB might not buy government bonds. Many attribute this backtracking to the Germans’ reluctant for extensive central bank intervention. With this discouraging comment from Draghi, ECB is also not expected to aggressively lower interest rate. Without an accommodative monetary policy from ECB, the affected countries would feel the full blunt of a fiscal policy that complies with the balanced budget rule.

Table: European nations' Debt & Debt to GDP for 2010 (Source: CIA World Factbook)

The Euro zone debt crisis can be very confusing. My direct take on the problem in Europe is as follows:

• Greece is too heavily indebted and requires a debt restructuring. Its lenders (mostly, German & French banks) would have to take a hair cut. This would lead to huge losses among European banks. ECB has however indicated that it is prepared to top up the equity of the affected European banks.
• Spain is not in the same boat as Greece as its debts as a percentage of GDP is much lower. It is feeling the contagion effect which caused her bond yield to skyrocket. ECB should step in and buy Spain bonds in order to lower the yield to a more comfortable level. Italy is somewhere in between Spain & Greece in term of sovereign debt to GDP. ECB should also buy Italian bonds to cap the yield.
• The Euro is too strong for some weaker countries in the Euro zone. ECB should consider devaluing Euro by 10-20%. This would bring growth to the whole Euro zone, especially the weaker countries (such as Greece) which need it more.

Based on the above, I believe that a solution to the Euro zone debt problem is possible. For the Game Changer to work, Germany needs to make more sacrifice.

(This is my latest article in Merdeka Review. For the Chinese version, go here.)