Excessive sovereign debt: hardly an unprecedented situation
In the recent past, emerging countries like Mexico in 1998 and Argentina in 2001 were particularly badly hit but certain industrialised countries like South Korea in 1998 also came under attack. So the sovereign debt issue is hardly unprecedented and the solutions exist even if they take time to implement.
The Euro zone: a special case
The economic stimulus plans that most countries introduced in the aftermath of the financial crisis boosted government debt to levels close to those seen after the Second World War. According to the IMF, the average debt-to-GDP ratio in developed countries was 97% in 2010. In this light, the euro zone is not the worst in the class as its ratio is 85% . And yet, the zone is the focal point of current investor concerns.
When Greece signed up to monetary union, it lost any independence over monetary policy. This limited its margin to manœuvre, which traditionally lie in four areas: fiscal policy, growth, inflation and restructuring. This means Greece cannot resort to monetary stimulus to help it boost its economy by allowing its currency to fall steeply, thereby fuelling exports and creating inflation.
Its only short term option is to make fiscal adjustments which will depress the economy and reduce wages. The resulting surge in social unrest could well lead to a period of serious political instability just when the country needs to make crucial decisions.
Ending the Greek crisis: threats and opportunities
Greece represents less than 2% of the Euro zone's GDP. In this context, its current woes look overdone and the risk is that other financially troubled countries like Portugal, Spain, Ireland and Italy could be dragged down too. As the combined weight of these countries is obviously higher, systemic risk would be probable and these countries wouldn’t have more alternatives than Greece today.
To avoid this situation, the Euro zone must:
- Find some way of restructuring Greece’s debt as imposing a 3-year adjustment plan is simply not realistic.
- Limit the risk of contagion to other countries in the zone. The main political consequence of this crisis will almost certainly be a strong move towards a federal European state at both the monetary and budgetary levels.
If these solutions are not implemented, Greece could be forced to leave the Euro zone and other countries might be obliged to follow suit. That would have dramatic consequences on financial markets.
Extract from the analytical report by Jacques Tebeka, Head of Diversified Multi Management at Edmond de Rothschild Investment Managers.