Saturday, November 19, 2011
(Had written this for a friend's magazine about three weeks ago) When an individual borrows beyond his ability to repay, the impact is perhaps limited to the person who lent him the money. If a large number of individuals default to someone, it could set off a chain of defaults, especially if the lender in turn is not able to meet his commitments. So far, we are talking about localised problems. A solution can be found by the local bank regulator. However, what happens when a nation defaults on its sovereign debt? And the buyers of the debt (lenders) are banks and entities spread across the globe? And what if the borrowing nation is a part of the unique set up called “Euro”? Greece has just defaulted. Portugal, Italy, Spain etc are in queue. The lenders have been forced in to a ‘settlement’ where they have to forgo fifty percent of what they ought to collect from Greece. The balance has been ‘rescheduled’ and everyone hopes that Greece will be able to manage. Will Greece manage even this renewed promise? Looks tough, indeed. A nation that has spent money that it does not expect to have and where tax evasion is rampant, will find it difficult to generate any budget surplus. At best, they have bought some more time. If they cut down drastically on public spending or on public sector jobs, it would cost continuance for the existing government. Deficit budgets are addicting. Giving freebies to public, to win votes, looks like an easy option for those in power which is not strong or solid enough. The Euro, as a currency looks very shaky. One of the tenets of the countries joining the Euro was that each member country would have financial discipline ensuring budget deficits within a limit of three percent or so. In a world that is looking down the barrel of a recession, countries like Portugal, Greece, Italy and Spain (Collectively referred to as PIGS) have borrowed beyond their means. Domestic economies were on a bubble of real estate and now are facing problems of inflation, unemployment and very weak economic growth. Under such a situation, it is unlikely that fiscal discipline can be maintained unless public spending is curtailed. It is a Hobson’s choice. If governments spend, then fiscal discipline is shaken and if they curtail spending, domestic economy looks shaky. Presently, Greece has been ‘bailed out’ by other members of the Euro, like Germany and France. It is doubtful whether these countries can continue to support wayward fellow Euro nations. Economic consequences are but one aspect. The other scary fall out is one of return of ethnic boundaries, with the Germans wanting to have nothing to do with the defaulters and the German citizens opposing their government bailing out irresponsible fools who have spent recklessly. If that happens, it could lead to xenophobia, trade boycotts, manned borders etc., And surely it could mean a curtain call for the Euro as a currency. Sure, none of the 17 members want this to happen, but here we are dealing with fragile emotions and not long term thinking. The defaulter would nurse a grouse that he was bailed out at the cost of someone else monitoring his nation’s finances and that bailed out nations have lost their ‘economic independence’ to the Euro. For the nations that bail out their fellow members, the stakes are high. If PIGS default and shrink their economy, where will Germany and France find outlets for their produce? It is a vicious cycle. I produce more and sell to you. You borrow and prosper. When you cannot repay, it is up to me to see that you are still able to have money to buy my goods. Therefore, I have to bail you out, otherwise I also suffer. Wonderful, isn’t it? One big outcome that can happen is a global contraction due to fear of breaching economic discipline. People with money will not take risks. Risk capital will become scarce. If further bail outs are called for and do not happen, there could be a banking collapse. If there is a bail out, then there could be contraction because of forced budget constraints. Neither option looks good. The Euro crisis is far from over. No one knows how it will play out. Side shows could be strengthening of the dollar and gold relative to the Euro. The one ‘X’ factor in this drama could be China. Sitting on a pile of money, they can step in to the aid of the Euro defaulters with stiff trade demands. This would hasten Chinese economic growth. China now faces the problems of the rich. To keep prosperity growing, you got to help the poor so that they can spend it on you. For India, it is not a good development. It would mean shrinkage of availability of risk capital. If global trade shrinks, it could dent the rising export growth. As the Chinese say, we are headed towards ‘interesting’ times.