[Martin Khor] Rich economies caught in crisis

There was more bad news about the global economy last week. It looks as if the major developed economies are facing worsening problems that will not go away.

This does not augur well for the developing world, as it is still dependent on the richer economies.

An economic slowdown in the United States was indicated by last week’s data of a rise in unemployment to 9.2 percent and only 18,000 new non-farm jobs created in June.

U.S. President Barack Obama’s ongoing battle with the Republicans to get congressional approval to increase the government’s debt limit and avert a default is also likely to end with an agreement to slash government spending. This will have a depressing effect on the economy.

But if the U.S. has problems, Europe is in the grip of a far worse crisis.

The Greek debt problem with its accompanying political turmoil is its most visible part. However, the Greek tragedy may soon be dwarfed if it spreads through contagion to its bigger neighbors.

Last Wednesday, the rating agency Moody’s in a controversial move downgraded Portugal’s credit standing four notches to junk status.

This had a contagion effect on Spain and Italy; the interest to be paid on their bonds jumped to new highs.

The real fear is that Italy, which has Europe’s third biggest economy, will be drawn into the crisis.

Last Friday, the yield of Italy’s 10-year bond jumped to 5.27 percent with its highest premium over German bonds. This reduction of confidence means the country has to pay more to obtain new loans. Stock prices of Italian banks also fell almost 6 percent in a day.

A spread of the crisis to Italy, after the bailouts needed for Greece, Ireland and Portugal, would magnify the European crisis manifold due to the size of its economy and its debt.

Nearly 3.8 trillion ringgit ($1.30 trillion) of government debt is maturing in the next five years, in a country where debt is equivalent to 120 percent of gross domestic product.

If the yields on Italian bonds keep rising, the cost of servicing them may become intolerably high.

The risk of the European crisis spreading will remain so long as the crisis in Greece is not solved.

There is now a widespread assessment that the country faces a solvency problem and not just a liquidity problem.

A systemic solution is needed such as an orderly debt workout, in which creditors are paid only a part of their outstanding loans to Greece under an arbitration system.

However, major European countries fear that this would result in big losses for their banks that hold Greek loans.

Thus, they seek other ways out such as a “bailout” (new loans from the European governments and European Central Bank and the IMF) to take over from expiring loans, coupled with if possible by private banks and other creditors also giving new credit.

Their objective is to avoid a Greek “default” because that will have problems of its own.

For example, if Greek loans undergo a “credit event” (the new euphemism), this would trigger the need for bond insurers to pay out to holders of credit default insurance.

Unfortunately, it is not only a direct default and a debt restructuring that qualifies as a default in the eyes of the credit rating agencies.

Arrangements by governments to get private creditors to take a “haircut” (partial loss on their loans) are also considered a default.

Even a “voluntary” roll-over of the loans that are maturing or the swapping of their existing loans for new bonds with longer maturity, as had been proposed by France or Germany for their banks holding Greek bonds, is considered by credit rating agencies a selective default which could trigger unwanted consequences.

If the government is unable to get its reforms through, the cry for default will increase. But even if it defaults unilaterally and clears its insolvency problem, Greece still needs new loans to cover its budget deficit.

According to one view, it can attract new credit because its old debts are now cleared.

Another view, more influential at the moment, is that the market having suffered from a default will not give new loans to Greece.

It is unlikely that Greece will declare a default at this stage. But it may be forced to do so sometime in future if there is no alternative financing or if the public opposition to more austerity becomes too strong for any Greek government.

Last week, the uncertainty surrounding the Greek situation reached a new high, especially with conflicting messages from Germany and France, which have been trying to arrange a roll-over or debt swap, and the European Central Bank which opposes any “selective default” or “credit event.”

The inability to get a European act together on Greece has affected confidence in the eurozone and increased the risk of contagion spreading to Spain and Italy.

Thus, neither the United States nor Europe can be expected to boost the global economy.

Instead, their crises may contribute to a weakening of the global economy. As for Japan, it is understandably preoccupied with post tsunami reconstruction.

As the effects of the previous fiscal and monetary stimulus taper off, and nothing equivalent to take its place, it is difficult to be optimistic about the economic prospects of the major developed economies in the next couple of years.

By Martin Khor 

Martin Khor is executive director of the South Centre, a Geneva-based intergovernmental organization of developing countries, and a columnist for the Star, a Malysian daily. ― Ed.

(The Star/Asia News Network)