Open Dissent (18 page)

The market is starting to feel the stresses of bank defaults and sovereign defaults as the volatility index rises. We don't have to look far to see the evolution of the global crisis. Europe is teetering under the weight of sovereign economic challenges in Greece, Spain, Portugal and Italy, while a recent update written by the US Government Accountability Office (GAO) throws light on economic facts that must be considered instructive about the US. According to the GAO, the US's budget deficit was equivalent to 9.9 per cent of GDP in 2009, making it the largest deficit since 1945. The GAO went on to highlight that without significant policy changes the US Government would soon face an ‘unsustainable growth in debt.'
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The report, which was published in January 2010, goes on to state that, using reasonable assumptions, ‘roughly $0.93 of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020.'
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This implies that, in less than ten years, using reasonable assump tions, there will essentially be no money left to
run the US Government, since 93 per cent of all tax revenues the US Government collects will go to pay social security, Medicare, Medicaid and the interest costs on the national debt. This implies that there would be no money left over for defence, homeland security, welfare, unemployment benefits, education or anything else for the normal business of government. As of this moment US Government debt is rated AAA. Niall Ferguson, historian and professor at Harvard University, recently wrote, ‘the US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941.'
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We are forced to reflect on the global situation and to ask the simple question – how can we, as a nation and as individuals, protect ourselves financially for the foreseeable future?

Coming to grips with where Ireland is today economically and financially, we can take some comfort when highly respected international commentators have complimented our Minister for Finance for leading the way among ailing peripheral Eurozone economies in taking the harsh fiscal measures needed to regain investor confidence – slashing public servant salaries and welfare payments. The investor community initially rewarded Ireland with a reduced cost of borrowing in acknowledgement of our sacrifices. An article in the Lex column of the
Financial Times
states:

Ireland is no saint [imagine that]. Like other peripheral economies it became uncompetitive, paying itself too much and producing too little. And unfettered bank lending and limp regulation during its property boom brought deep recession when the bubble burst. The 13 per cent contraction
in Ireland's gross domestic product since the end of 2007 is the eurozone's worst. Output could shrink 1.3 per cent this year. Furthermore, Ireland's budget deficit, at 14 per cent of GDP, is higher than Greece's...But Ireland is not in the same league as Greece: the former Celtic Tiger has a credible recovery plan. Its public debt, now at 65 per cent of output, from 25 per cent pre-crisis, is certainly more manageable than Greece's ruinous 150 per cent...As Athens forces the eurozone to confront the problem of having one currency, one central bank governor, but no single finance minister, investors should not forget that Mr Lenihan's first mover advantage is at least 18 months ahead of his peers.
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We may ask ourselves whether we should just surrender and renege on our debt and go back to basics. Fortunately, for the moment, we don't have to do that, but whatever steps we take as a country, once we remain in Europe, we are all going to have a reduced standard of living. We have earned a reputation over the years for being honourable creditors and trustworthy in our dealings. Even if things got a lot worse, every avenue should be explored before a default should even be considered.

The credit analysis process appears to be the same around the world; the ability and willingness of the customer to repay under any conceivable set of circumstances is paramount. An interesting example of credit management that I experienced as head of Citicorp/Citibank in Norway in 1979–1980 was in Norske Skogindustrier ASA. This was one of Norway's largest forest product companies, which had run into difficult financial circumstances. It was a major employer and was located down the south-western side of the Oslo fjord. If the company closed down there
was little likelihood of alternative employment being found in the area. The company had a mixed shareholding as it had private as well as government owners. A number of banks had extended substantial amounts of credit. These were both domestic and foreign banks, and when the company took a turn for the worse in 1980 the Norwegian Government's solution was to write off the banks' debt in the company.

For a country that prided itself in relation to the reputation it had earned in the international capital markets, the solution being suggested smacked of expropriation. At a very tense meeting of the creditors I suggested to the chairperson, a senior civil servant, that the proposed actions could be interpreted as some form of expropriation. The outraged civil servant asked if I thought I was dealing with a banana republic, to which I responded, ‘I will judge you by your actions.' We had put forward an alternative proposal that would see the creditors being saved through the sale and lease back by Norske Skogindustrier ASA of a major hydro-electric plant. This proposal was duly accepted by the Government, and the financial independence and well-being of the company was secured.

The current problem of sovereign debt in Europe and beyond has in no small part to do with the power of rating agencies. Rating agencies are in the business of offering their opinion about the creditworthiness of bonds that have been issued by various kinds of entities, be they corporations, governments, banks or, most recently, the packagers of mortgages and other debt obligations. These opinions
come in the form of ratings which are expressed in terms of a letter grade. The best known scale is that used by the agency Standard & Poor's, which uses AAA for the highest rated debts and AA, A, BBB and so on for a debt of descending credit quality.

It is not only investors and companies that have placed too much reliance on bond ratings. The rating agencies were first given official status by the Securities and Exchange Commission in 1975 as offering assistance to regulators to assess capital charges for broker dealers. Since then their influence has spread. Bank credit departments dropped their guard and accepted external ratings from the agencies. Slowly but surely, rating agencies extended their grip and lulled investors and institutions into a false sense of security. These agencies enjoy extraordinary protection under US securities law from investor lawsuits relating to securities they rate before they are underwritten. Currently, they are more protected than banks in the US.

Abdicating the responsibility of making your own credit assessment to an outside rating agency must surely be put in question in the future. Having recourse to your own credit analysts in the event of large credit losses must be a preferred route, as through this you can identify where the poor judgment rests. Cost will always be a factor but the responsibility still remains in-house.

The very entities that were major contributors to the subprime debt debacle in the US, with overzealous credit ratings on structured investment vehicles, are now creating a sovereign crisis of greater proportions. During a period
of enormous economic difficulty, the debt-based solutions to sovereign crises are being rubbished by the rating agencies through ratings downgrades of sovereign debt in the middle of negotiations. If a state's debt is downgraded, the perceived risk of no repayment is increased, and there is a corresponding increase in interest rates on the debt. Ultimately, this means spiraling costs for sovereigns. Whether in the US, Europe or Ireland, the consequences of the increased cost of borrowing will have a negative effect on fiscal deficits, which in turn will likely lead to social unrest.

Within Europe, we recently observed the bailout of Greece. This bailout initially started with the Greeks looking for €30 billion to cover the short-term deficit the country was facing in the context of the real possibility of default. The consequences of the default of a European sovereign state had not been entertained by Brussels when the various treaties were being voted on. But in the drive for a union no one could have foreseen one of the states in an economic situation that would result in it defaulting on its foreign debt. However, today we have at least five countries in Europe that are suffering under the weight of enormous debt, and the social and political consequences for each of these countries has been – and will be – seen in demonstrations and unrest on the streets of their cities.

The interesting aspect of Greece's bailout is that it appears like a patchwork solution. Some €110 billion is being provided over two years to ensure there are sufficient funds to cover all maturing debt and interest payments. Clarity on how this massive mountain of debt was created
in the first place has not been provided. It is the right of every sovereign state to borrow funds responsibly in order to balance the national books. However, Greece is a country that has borrowed in the past to satisfy consumption habits it could not afford. How much of the funds went into productive areas that would have associated cash flows to enable repayment of their borrowings? Inept treasury management has created this debacle and the brains in Brussels failed to anticipate it.

At this point Greece is facing increasing interest payments on a growing stock of debt. Athens contends that the stock of public debt will peak at 150 per cent of GDP,
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which is likely to happen at any stage within the next two years. Many observers, including myself, would contend that this is wishful thinking. Greece faces continued economic recession for the immediate future as austerity packages take hold. A possible default by Greece has a genuine influence on the actions taken by Europe, as one has only to look at who are currently the largest creditors to Greece – Germany, France and the Netherlands. See
Table 1
(
Appendix
) for details of the borrowings by Portugal, Italy, Greece and Spain from other European countries.

There are those who think that the IMF should have been called into Greece on a stand-alone basis. If the IMF is called into a country that is in serious economic difficulty, it will have a tried and proven method of turning an economy around. While the likelihood of this may be considered remote for Ireland, so too was the economic crisis
we now face. Economic growth in countries is often dependent on borrowings, but if these funds are not used productively and sensibly the result is a financial crisis, a crisis that can only be addressed through the devaluation of the country's currency. So, first, the IMF would devalue the country's currency and so, by lowering the relative prices within the economy, would increase the competitiveness of the country's export sector and create an export-led recovery. Devaluation is also politically expedient because regaining competitiveness does not require employers to slash employees' wages, as the cost of living adjusts to the devaluations relatively discreetly. This is the hush factor.

Greece, like Ireland, does not have the option of devaluation because both countries are part of the European Monetary Union (EMU). While monetary policy is controlled by the ECB, any European sovereign entity that falls foul of the agreed economic and fiscal disciplines ultimately loses control of its own destiny. The price of loss of control translates into social unrest, be it manageable or unmanageable.

This potential Greek tragedy, while taking place some 1,500 miles from our shores, could have a tsunami affect on Ireland in terms of the precedents it could set for how European sovereign debt will be dealt with by the EU. If, in the deficit countries, the budget deficit has to be reduced to 3 per cent (in line with the Maastricht Treaty), the burden on taxpayers would be enormous, and there would be further loss of jobs and a reduced standard of living. The problems
in each of the deficit European states are variations on a theme, with similar consequences of large budget deficits, rising unemployment and an outraged public. The solution for Spain, Portugal and Italy, which are suffering untold difficulties domestically, will not be achieved unless they can somehow be freed from the manacles of Europe's economic regime. Is there a chance of some form of economic easing for the offending sovereigns at this stage of the cycle? Or, in the words attributed to Marie Antoinette, should they just eat cake?

It is interesting to view the crisis from the perspective of a list of major investor countries who have been lending their surplus funds in order to accommodate fiscal deficits and soaring borrowings in other member states. Aside from Ireland, the four countries in Europe that have borrowed the most are Spain, Greece, Portugal and Italy. These four countries have an aggregate exposure of almost US$1.5 trillion to their European neighbours.
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As we take away the veils of secrecy we find that Germany is at the top of the investor league with regard to European sovereign debt, alongside France and the Netherlands (see
Table 1
,
Appendix
). At this time, Germany has an exposure to this group collectively of some US$440 billion.
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We are looking at this moment at a crisis of enormous economic and social proportions throughout Europe. The political will of the German electorate may be strong enough to face up to this stern economic and financial test. Someone has to pay for the overindulgence of the deficit countries and so we believe, or hope, that Germany
will get the backing from its own electorate to continue bailing out profligate nations whose governments have not been called to account. Germany has gone through twenty years of reunification and the economic and social costs have been enormous, but the prize was worthwhile. If you are fortunate enough to live in a country where a surplus is created, you will definitely wonder what is going on when you're being continuously asked to prop up nations that lack the fiscal fortitude to manage their own finances. The current generation of Germans may not feel that their hard-earned wealth should be used to bail out countries that are in situations they themselves would never find themselves in. One may wonder whether this unbalanced situation can be attributed to the growing pains of a new union or if it is a stumbling block that will see its disintegration.