Last week, Jim O'Neill was feeling quite sanguine. The chief economist at Goldman Sachs, best known for cheerleading the "Brics" group of emerging markets, was pretty confident that the fallout from the Greek financial crisis would not be enough to derail the global recovery.
But with each day that global equity markets have wobbled, interbank lending rates risen and the euro slid further against the dollar, the more the little local difficulty in southern Europe has threatened global consequences. "Things have been looking scarier, without a doubt," O'Neill says. "This is not just about Greece anymore."
Comparisons between Greece and the collapse of Lehman Brothers investment bank in September 2008 might seem overdone. There is much more clarity about the exact size of the current problem — the sovereign debt stock at risk of default — than there was about Lehman's outstanding contracts.
But a common factor is the deep uncertainty about how rapidly banks can transmit troubles through economies and around the world. As long as that uncertainty exists, it is impossible to rule out the Greek crisis pushing the world back into recession.
It is little surprise that the global financial crisis ended up testing the resilience of sovereign credit. Governments frequently took over the burden of private sector debt — increasing stimulus spending to compensate for deleveraging companies and consumers or nationalising the debts of crisis-racked financial institutions.
But as the creditworthiness of sovereigns such as Greece and Spain has itself come into question, concern has shifted to their private creditors, especially banks in France and Germany, and to the governments in Paris and Berlin that may ultimately have to stand behind them. When it agreed a 110-billion-euro (Dh497 billion) rescue package for Greece, the euro zone was in effect partly bailing out its own banks at one remove.
"It is like a [card] game of Old Maid," says Morris Goldstein of the Peterson Institute for International Economics in Washington. "Everyone is trying to shift the debt on to someone else's balance sheet, from private to public and from one country to another."
The great fear, he says, is that the world may be running out of lenders with shoulders broad enough to support the huge load of debt while it can calmly be unwound. Tongue in cheek, Goldstein casts around for creditworthy sovereigns. "The solution is clear," he says. "Canada and Brazil will have to take on the rest of the world's debt."
In their recent book on the history of financial crises, Carmen Reinhart and Kenneth Rogoff note that banking crises are frequently succeeded by sovereign debt crises, as governments are forced to assume private liabilities to keep their national financial systems afloat. The 1997-98 Asian crisis provides a relatively recent example of how private debts can rapidly become public liabilities if a default threatens the overall economy.
Cause of crisis
In the euro zone, points out Paul De Grauwe of the University of Leuven in Belgium, despite the talk of endemic fiscal profligacy, the huge rise in government debt in the past few years was a consequence as much as a cause of crisis. "While the government debt ratio in the euro zone declined from 72 per cent in 1999 to 67 per cent in 2007 ... financial institutions increased their debt from less than 200 per cent of [gross domestic product] to more than 250 per cent," he wrote in a recent post on the VoxEU economics blog.
Spain, for example, cut government debt, from a level equivalent to 60 per cent of GDP to one of 40 per cent. But its economy rested on an unsustainable housing and consumption boom financed with bank debt, and the response to the crisis merely shifted indebtedness from the private to the public sector. Madrid's decision to inject public money into CajaSur, a regional savings bank, last weekend revived speculation about how far that process may yet have to run. Mohammad Al Erian, chief executive of the giant bond investor Pimco, says: "A small bank in a small economy has indicated to the rest of the world that the whole European banking system is under pressure."
Yet troubles in European banks do not automatically equate to a rerun of the Lehman crisis. This time there are reasons to be more relaxed. The banks' asset holdings are far from transparent but they are much less uncertain than the size and distribution of potential damage to Lehman's counterparties. Banks in general are better capitalised and thus able to absorb writedowns of their assets.
Policymakers are also better prepared to cope with threats to the functioning of financial markets, certainly in the short term. Faced with market volatility, the European Central Bank recently executed an about-turn and started buying government bonds outright, while the Federal Reserve rapidly reinstated the swap lines with other central banks that helped push liquidity through the system during the first phase of the financial crisis.
Though the interbank rates at which banks lend to each other have risen sharply recently relative to official overnight interest rates, an indicator of uncertainty about the health of banks, they remain well below the stratospheric levels reached in the panicked aftermath of the Lehman collapse. "There have been changes of behaviour among policymakers since 2008," says Al Erian. "It is not a question of a global banking crisis, but of how much damage the European banking troubles will do to the global economy."
Immediate answer
The immediate answer appears to be "not much". Estimates of the direct impact of the Greek crisis on the world economy are generally fairly minimal. Greece makes up only 2-3 per cent of euro zone GDP; and in any case the euro zone has not been functioning as a great engine of global demand for several years.
As for the impact of movements in financial and commodity markets on the US, for example, Michael Feroli at JPMorgan Chase in New York says the effects have been "negative but not enough to derail the recovery". He reckons the hit to US household wealth from recent falls in equities could reduce consumer spending by between 0.3-0.6 per cent, with the effect spread over a year - but this would be partly offset by a 0.2 per cent boost from lower energy costs caused by the fall in oil prices. The 3.2 per cent rise in the trade-weighted dollar from its March average could take 0.4-0.5 per cent off growth this year but lower mortgage rates will boost domestic consumption. All in all, a moderate headwind rather than a brick wall.
Nevertheless, if the euro zone crisis is not enough to collapse the global recovery, it could well push the world economy back into a familiar and unwelcome pattern. The global imbalances that built up during the pre-crisis boom, with the attendant risks that they would unwind in a disorderly fashion, are well known. The US ran a large current account deficit as the consumer of last resort, matched by surpluses in much of the emerging world, particularly Asia. The European Union was roughly in balance, the deficits of countries such as the consumption-oriented UK balanced by the surpluses of exporters such as Germany.
Those imbalances diminished during the global crisis, but that owed more to cyclical effects than a shift in the underlying pattern, with weaker consumer demand in the US and lower oil prices reducing America's imports. A permanent shift, most economists think, would require the dollar to remain at a markedly lower level for several years and US savings to rise. The corollary for Asia — and to a lesser extent Europe — would be a shift from exporting to consuming helped by appreciating exchange rates, most particularly in China.
Market participants
But the southern European crisis has halted tentative moves in this direction. Many market participants expected, following careful diplomacy by the US, that Beijing would announce in May or June a resumption of the slow appreciation in the renminbi that it put on hold in 2008. But with the euro falling sharply as a result of the Greek crisis, investors have downgraded such expectations. China has little wish to find its export sector losing competitiveness simultaneously against Europe and the US, its two main markets. With the dollar rising, the US target of doubling exports in five years, which had looked unlikely, now borders on the quixotic.
In the months ahead, policymakers face extremely difficult problems. First, they may have to cope with continued turmoil in financial markets, and opinion on how best to do so varies considerably. While there is general support for both the short-term liquidity provision by central banks and the 750 billion euro bailout fund readied by the eurozone, the ban on naked short-selling by the German authorities has been blamed by many market participants for increasing uncertainty and volatility.
Goldman's O'Neill is concerned at the German announcement and other interventionist moves, such as America's adoption of the Volcker rule restricting banks from trading with their own money. "This might be the kind of thing you would expect someone from an investment bank to say, but could it be that this succession of national plans to control finance is creating concern in the markets?" he says.
The rise in interbank lending rates, while small at the moment, reveals a worrying lack of trust between banks. "The hedge funds will be thinking that a ban on short-selling means that German banks have something to hide," O'Neill says.
The second challenge is what to do if it becomes clear rescue plans are not working and sovereigns such as Greece, Portugal and perhaps Spain are headed for default. If German and French banks find their Greek debt being written down, Paris and Berlin's implicit government support operations will have to become explicit bank recapitalisations to avoid the risk of a succession of failures in major financial institutions. But, as governments have already taken on huge amounts of debt, it is not clear how much room they have to shoulder more.
And if the crisis causes more downgrading of risky sovereign credits, it could force more governments to adopt policies of fiscal retrenchment, removing further impetus from the global economic recovery. Countries such as the UK, for example, have so far been able to err on the side of keeping fiscal policy loose in the short term to maintain domestic demand.
A wave of concern about sovereign debt could tip them into the category of nations that need to tighten policy immediately to restore confidence rather than enjoying the luxury of returning to fiscal balance gradually over a number of years.
So the fact that the financial crisis has moved into a sovereign debt phase may not be particularly surprising. But nervous investors who have fashioned a further cycle of transmission from government debt to the banking sector and back to government debt have created uncertainty that poses perhaps the greatest threat to the global economy since it started to crawl out of recession last year.
O'Neill and his counterparts will be monitoring financial markets anxiously in the days and weeks ahead.
— Financial Times
Spain has fuelled concerns that the bank sector will be the next big problem to hit Europe. The country's central bank was forced to take over CajaSur, a small savings bank, while BBVA, Spain's second biggest bank, was forced to look elsewhere for funding outside of the US commercial paper market because of punitive interest rates.
Closely watched market gauges have also flashed red in recent weeks as tensions in the financial markets have risen, with many banks struggling to finance themselves. London Interbank Offered Rates have risen to their highest levels since last July, reflecting these tensions and the extra costs banks have to pay for their lending because of concerns that they may go bust.
Lending between banks beyond a week has also fallen sharply because of the increasing worries about counter-party risk, or the fear that a bank will fold and not repay its loans.
But all that is far from meaning that continental Europe's banking system is tottering. For a start, eurozone banks are still able to fund themselves through their customers' deposits or through domestic loans — borrowing from other banks in their country.
Facilities are already in place to provide generous fall-back support. As well as government guarantee schemes, the European Central Bank is still offering unlimited loans - a facility of which BBVA is thought to have taken advantage.
The amount outstanding from ECB market operations, by which it pumps funds into the banking system, has crept up this month, sometimes approaching 860 billion euros — higher than seen in the weeks after the failure of Lehman Brothers in September 2008. The ECB has also started intervening in government bond markets.
"A liquidity crisis does not seem possible, but that doesn't mean that the banking system is not facing pressures or that banks have not become more nervous about lending to each other," said Jacques Cailloux, European economist at Royal Bank of Scotland.
One indicator of the fear among banks is the amount they deposit overnight at the ECB, rather than lend to each other. In recent weeks, the sums in the Frankfurt-institution's "deposit facility" have risen to around 300 billion euros — a level not seen since the middle of last year.
Christian Noyer, governor of the Banque de France, says recent events could lead "one to think that direct intervention in the markets had become a general policy for central banks. That is in fact not the case". Still it could be some time before all the extra ECB support is withdrawn.
— Financial Times
