Entering the danger zone again

All the signs are that the ongoing euro crisis is dragging the world economy into recession, writes Eddie Ford

There appears to be no end to the crisis afflicting the euro zone and Europe as a whole. Greece still threatens to unravel the entire euro project, though ‘hot spots’ like Portugal, Spain and Italy are nor far behind. Increasingly, all the signs are that the continuing saga could help to trigger a global recession.

In Greece, to the surprise of many, the government and its private creditors have not yet done a deal on debt repayment. European finance ministers are putting Greece’s private creditors under intense pressure to accept a lower interest rate than the 4% previously offered - take an even bigger write-down (‘haircut’) on their loans to Athens. Therefore they have rejected, or effectively vetoed, all the offers/arrangements that so far have been put on the table by the respective parties. Various ministers have strongly reiterated that it is absolutely essential for the Greek government and its private creditors to come to a final agreement in order for the European Union, European Central Bank and International Monetary Fund troika to release the next tranche of €130 billion bailout money for Greece - without which Athens will not be able to make €14.5 billion of loan repayments due in March.

Troika officials have called on both parties to reach a deal by the end of the week, which in reality is a demand that Greece’s creditors swallow the bitter pill and accept the fact that they are going to make a substantial loss. The ongoing impasse in Athens raises the dreaded fear of a messy or disorderly default by the Greek government, which in turn could see it crashing out of the euro and unleashing economic chaos across the entire continent - if not the entire world. At the very least, the disagreements on display at Athens could overshadow - even disrupt - the January 30 summit of EU leaders.


The essential bone of contention is that the European finance ministers expect Greece’s creditors to accept a nominal 50% cut in the value of the loans they have made to Greece. However, the Institute of International Finance - which represents Greece’s private sector creditors - are worried that they might have to take even bigger losses, hence the so-called ‘line in the sand’ of a 4% coupon (interest rate) on the loans. The creditors claim if interest rates were cut below that figure, the net present-value losses for bondholders could end up in excess of 70% - possibly a haircut too far for many of the IIF’s clients. Hedge funds and ‘vulture funds’ in particular are holding out in hope that they will be able to cash in on credit default swaps, which pay out when a bond defaults.

However, Jean-Claude Juncker, president of the euro group and prime minister of Luxembourg, has been adamant that the creditors must accept an interest rate below 4% on the new, longer-dated bonds that are expected be issued in exchange for their existing Greek holdings. In his words, European ministers asked their Greek colleagues to “pursue negotiations to bring the interest rates on the new bonds to below 4%” - which implies, apparently, that the interest “comes down to well below 3.5%” (my emphasis). So we read in the financial press, from an unnamed Greek banker close to the negotiations, that the IIF “authorised” its managing director, Charles Dallara, to negotiate a “compromise” at 3.8% - but this was deemed to be still too high by the troika, who have demanded a smaller and “more realistic” rate.

The breakdown in talks was a bit of a personal humiliation for the Greek finance minister, Evangelos Venizelos, who had forthrightly told the Greek parliament - and the world - that the debt reduction plan had to be in place, no ifs or buts, by January 23 to give lenders enough time to draw up the details of the second bailout package before the January 30 summit. The grand aim, if you can call it that, is to shrink Greece’s €100 billion debt from 160% to 120% of GDP by the end of the decade - though it hardly needs to be said that the 2020 goal looks like a semi-fantastic long shot at best. And of course, more to the point, whatever happens it will be at least eight more years of pain and austerity. To earn the money, show that they’re worth it, the Greek government has to “accelerate structural reforms” designed to strengthen the economy - or that is how the story goes - before any future funds will be released. That is, the troika representatives want to impose further public sector lay-offs and revenue cuts - more and more attacks on the Greek working class.

But the battle for Athens continues. As far as the European ministers are concerned, with the Greek government following in tow, any interest that was not significantly below the 4% mark would make the ‘2020 plan’ all but impossible. Raising the stakes - or temperature - Gikas Hardouvelis, who heads the economics team advising Greek prime minister Lucas Papademos, said the EU would be “abdicating its responsibility” if it allowed the banks, insurers, hedge funds and ‘vultures’ to offset a 50% write-down of the country’s debts by charging interest rates of around 4%. Enforcing such rates, he insisted, would be the same as kicking Greece out of the euro. Take that, creditors.

Now it is brinkmanship all round, but who will blink first? Dallara declared on January 22 that if Athens did not accept the outlines of the deal taking shape, then it would have no choice but to default on its debt mountain. In response, Austria’s finance minister, Maria Fekter, retorted that that a crash would be “far more expensive” - for everyone. More aggressively, Jan Kees de Jager, the Dutch finance minister bluntly stated that, whilst a voluntary agreement on debt reduction was the preferable option, it was “not a precondition for us”. In a further display of tensions, Michael Noonan, Ireland’s finance minister, told the German newspaper, Süddeutsche Zeitung, that it had been a “fatal” mistake to involve the private creditors (in the form of the IIF) in the negotiations at all - the subsequent insecurity and volatility had “driven the markets crazy”. He said that markets would only calm when they were convinced that euro zone countries were making “serious efforts” to solve their debt problems.

Meanwhile, Standard and Poor’s rating agency said that it was likely to put Greece into “selective default” once the protracted debt negotiations were concluded - if they ever are. Selective default is one notch above ‘restricted default’, the black mark reserved for when a borrower simply stops repaying their debts. Of course, this is just a repetition of S&P’s position from last summer.

1930s moment

As well as the drama surrounding Greece’s debt restructuring, euro zone ministers have been discussing efforts to enforce stricter budgetary rules for EU states as part of the new “fiscal compact”. They are also debating how to finalise the structure of a permanent euro zone bailout fund in the shape of the European Stability Mechanism, which is due to replace the European Financial Stability Facility in July, and which will have a theoretical lending capacity of €500 billion. Yet the sober reality is, as we all know, that the fund has been seriously depleted by the bailing out of Ireland and Portugal, not to mention the monies used to provide part of a second, €130 billion, rescue for Greece. And that was before the EFSF, along with France and Austria, were downgraded one notch by S&P, thereby further effecting its ability to borrow money on the open market.

Alarmed by the dwindling resources available to the EFSF/ESM, Christine Lagarde, the IMF’s director-general - alongside the Italian technocratic prime minister, Mario ‘not so super’ Monti - have ventured that the bailout ceiling should be raised, possibly up to €1 trillion, so as to ensure it has more than enough capacity to handle any potential problems in major economies such as Spain or Italy. A more than distinct likelihood, of course.

In an not-so implicit rebuff to Angela Merkel, Lagarde delivered a speech in Berlin on January 23 where she told Brussels to drop its opposition to a bigger bailout/insurance fund, in a bid to convince the world money markets that Europe has the necessary fire-power to protect vulnerable - or distressed - countries in the euro zone. The former French finance minister pointedly gave her warning in Berlin, where Merkel’s conservative government has led opposition to providing bigger loans for the EU’s bailout fund. She suggested “folding” the money left in the EFSF, into the new ESM and maintained that the ECB should “provide the necessary liquidity” so as to “stabilise” bank funding and sovereign debt markets.

More controversially, she called on European leaders to complement the “new fiscal compact” they agreed last month with some form of “financial risk-sharing” - like, for instance, a debt redemption fund or “euro zone bonds”. An idea that is currently anathema for both the German government and the ECB. Additionally, she re-emphasised her opinion that “across-the-board, across-the-continent budgetary cuts will only add to recessionary pressures”. Aggressive austerity drives, in other words, are self-defeating folly - strangling the opportunities for economic growth, a vital prerequisite for any government that wants to pay off its debts. Her words are not a little hypocritical though, given that the IMF - as in Greece - has been an enthusiastic champion of ‘balancing the books’ and ‘labour reforms’, all of which have helped to kill the patient.

But the same question keeps resurfacing: where exactly is the money going to come from to make financial institutions like the EFSF/ESM into a real and effective firefighting force? It is obvious to all that a ‘credit event’ of any significant proportion - a major bank collapse, for example, or maybe a second rescue for ailing Portugal - would blow apart the bailout mechanism, and perhaps the euro itself. The Financial Times reported that Merkel was ready to see the ceiling of the combined firewall raised to €750 billion in exchange for agreement on “tighter euro zone budget rules” - but the story was immediately denied by her chief spokesman. Nobody wants to pay the bills. Yet one day somebody has to.


Unfortunately for the dithering Eurocrats, the crisis will not go away. All the indications are that Europe is slipping into recession. Therefore we discover in a report published on January 21 by the accountants, Ernst and Young, that the number of UK firms that had issued profit warnings had leaped by more than 70% in the last three months of 2011. In total, UK listed companies issued 88 warnings in the fourth quarter, up from 51 in the third quarter - marking the highest quarterly jump for a decade. For the whole year, 206 companies issued 278 profit warnings.

Quite predictably, the sectors that saw the most warnings were retail and support services, as cash-strapped customers - suffering an average 8% fall in disposable income - curbed their spending. Hence some 39 retailers issued profit warnings in 2011, more than the whole of 2009 and 2010 combined. Whilst many firms were still “expanding profitably”, explained Ernst and Young, many other “zombie companies” - which “remain moribund by debt” or trapped in “defunct business models” - were simply unable to “build value or gain momentum” in these challenging economic conditions. In conclusion, the accountancy group thought that the rise in profit warnings in the fourth quarter had started “an upward trend that could well continue into 2012”.

Then in its half-yearly health check on the global economy published on January 18, the World Bank cautioned that the world had “entered a very difficult phase characterised by significant downside risks and fragility” - the art of understatement. Meaning that the bank lowered its forecast for global growth in 2012 from 3.4% to 2.5%, but said governments should be preparing for a downturn as bad as that which followed the collapse of Lehman Brothers in 2008 - get your hard hats ready. Furthermore, this time round an “escalation of the crisis would spare no-one” - rich and poor alike, developed and developing country growth rates could fall by as much or more than in 2008-09.

According to the bank, the euro zone was already in recession and was likely to contract by 0.3% this year. High-income countries would grow by 1.4% as a result of a recovery in Japan from a tsunami-affected 2011 and a slight pick-up in activity in the US. Even so, rich countries are expected to grow in 2012 at only half the 2.7% it expected in the last forecast, published in June 2011.

If anything, the IMF was even more hard-hitting or pessimistic in its own study released on January 24, believing that the world economy is “deeply into the danger zone”. Slashing its growth forecasts for most major countries in 2012, it urged governments to adjust the “rhythm” of their austerity measures to avoid derailing economic recovery - stop cutting your own throat. The IMF expects euro zone GDP to fall 0.5% during 2012, a large downgrade from the 1.1% growth it was originally predicting in September. And world growth prospects were downgraded from 4.1% to 3.3%. As for Germany, it is forecast to grow 0.3% in 2012, down from 1.3% - and France is expected to show just 0.2% growth in 2012, down from 1.4%. However - a silver lining? - the IMF stands by its 1.8% growth prediction for the US, based on the “recent strong domestic data” on jobs and manufacturing.

In the overall judgement of the IMF, output in most major economies was “decelerating but not collapsing”. It should be borne in mind, continued its statement, that the predictions and forecasts were the most upbeat available - given that they are “predicated on the assumption that in the euro area policy-makers intensify efforts to address the crisis” - a very big assumption indeed. Not pulling too many punches, the IMF warned that the US and other advanced economies were “susceptible to spill-overs” from a “potential intensification” of the euro zone crisis. Things could get a hell of at lot worse - one far from incredible scenario could see the euro zone plunge by a further 4% and global growth tumble from 3.3% to merely 1.3%.

Naturally, the UK was not let off the hook by the IMF - it is now set to grow by just 0.6%, a sharp fall from the earlier 1.6% estimate. This is similar, of course, to the 0.7% pencilled in by the independent Office of Budget Responsibility last November. But the picture got even less rosy on January 25, when the Office of National Statistics published its latest update on the UK economy. We find out that economic activity shrank by 0.2% in the last three months of last year - a marked decline from the third quarter of 2011, when GDP expanded by 0.6%.

The UK economy - like the European economy - is sluggish and may well grind to a halt, even go into reverse at some stage. What glorious achievements have being produced by ‘book balancing’ and ‘belt tightening’ - steeply rising unemployment, poverty, widening inequality and a government debt of £1 trillion.