After two volatile weeks, European bourses are back to the depressed levels recorded
before the approval of an international aid package for Greece. Measures taken by the EU-IMF to rescue the Mediterranean country have failed to reassure investors. Moreworryingly still, the crisis exposed a lack of cohesion among European countries. As more clouds gather on the horizon – such as fears regarding the Spanish banking system – what does the future hold for the Old World? There appear to be growing concerns among economists that Greece will struggle to meet conditions set as part of its rescue package. Observers question how Greece, which has pledged to introduce tightening measures worth 11% of its GDP, will stimulate growth, since it can not resort to currency devaluation. In a stagnant economy, it will be challenging for George Papandreou’s government to implement painful structural reforms required for long-term recovery.
In this context, some believe that Greece will be forced to restructure its debt sooner or later – a measure that the IMF refused to take into consideration. If lenders accepted taking a haircut on their sovereign Greek loans, they would allow Greece to implement less stringent austerity measures, which would be more supportive to the country’s economy and in turn help it repay its debt, advocates of restructuring argue. However, critics object that the negative market impact of a potential Greek default would be too high. ‘The market is currently repricing Europe’s tax policy fundamentals’ says UniCredit’s chief economist, Marco Annunziata. ‘Its reaction to a restructuring could only have been more violent’. On the other hand, advocates of debt restructuring argue that an ‘amicable’ agreement with lenders, guaranteed by international institutions, would not unsettle the market. They cite recent examples of successful restructurings, such as Poland, Mexico,Brazil, and Indonesia.What market observers seem to agree on is that austerity measures alone are unlikely to suffice and Greece will need more help if it is to weather this storm. This will probably involve Greece’s private lenders (mainly French and German banks), which may have to make some form of sacrifice for the sake of economic stability. The relatively small size of the Greek debt, however, is a factor playing in the country’s favour. ‘Greece is a little bit like Bear Sterns [during the 2008 financial crisis]; in one way or the other it will be rescued,’ says Giancarlo Perasso, chief economist at Redux Capital. ‘The real problem now is Europe’s governance and Germany’s unilateral decision [to ban short selling on asset classes] has dented the credibility of joint EU action.’ As the markets were expecting a show of European unity, national leaders sent mixed messages regarding financial regulation. However, the idea of stricter balance sheet rules at an EU level now seems to be gaining momentum, as member countries also pass tightening packages at home. Yet Europe-wide tightening would have side effects.‘An EU rule imposing balance sheet breakeven would not only lack credibility; it would also be wrong as it would undermine social stability in certain countries’ says Paolo Manasse, an economics professor at the Bocconi business school and Bologna University. ‘Instead, countries should be incentivised to generate surpluses in good times and allowed to report deficits in bad times.’Manasse also warns that a ‘race’ among EU counties to impose austerity packages domestically would have heavy repercussions on the union as a whole. Typically,when a single country sees its domestic demand shrink due to tightening measures, it relies on export to support growth. Since EU economies are heavily interdependent, a simultaneous clamp down in all EU countries would see demand contract across the board, with no relief coming from exports. For this reason, while some countries tighten their belts, other should be allowed to invest to support expansion, Manasse argues. While EU leaders decide which course to take, European markets are plagued by uncertainty. What should investors do with their money? Larry Brainard, chief economist at Trusted Sources, believes emerging markets will surface from this crisis as the long-term winners.‘Investors are going to take money out of Europe, into emerging markets’ Brainard told a meeting in London last week. ‘However, this is not the right time to enter BRIC markets, which will be affected by volatility, albeit to a lesser extent.’‘In addition, countries such as Brazil, China and India have just started their tightening cycles and we have to wait and see how they play out. My advice to investors is to sit on the sidelines and wait until Greece and the Eurozone see the light.
(Article by Francesco Canepa for Standard &Poor’s MarketScope, 27 may 2010)