Europe's west is doomed and its east might not make it

By bne IntelliNews July 30, 2013

Ben Aris in Moscow -

It's not going well. Governments around the world have had six years to make a dent in the huge debts they built up during the 2008 crisis, but in the first half of this year those debt levels have increased and the pace of that growth is accelerating.

The West is doomed to default, devaluation or depression unless their leaders can grasp the nettle and do something about the millstone that's hanging around the neck of the world's leading economies. So far they are failing: at the latest G20 meeting held in Moscow at the end of July, the best they could manage was a protocol calling for "more jobs" and "more stability" in the world. The trouble is they offered almost no details on how to achieve these goals.

The outlook for the global economy is uncertain at best, but the emerging markets are the innocent bystanders and increasingly are being dragged into the mire. Two countries - Ukraine and Belarus - are already on the verge of collapse and the three mainstays of the regional economy - Turkey, Poland and Russia - are also in trouble.

The best anyone has come up with is to throw money at the problem, which doesn't help: In this topsy-turvy world, traders now "buy on the bad news" assuming that poor macroeconomic results - and there have been plenty of those - mean more printing of money by governments, the so-called quantitative easing.

The huge amounts of free money sloshing about have inflated a debt bubble on bond markets that was punctured in July when the chairman of the Federal Reserve, Ben Bernanke, said he would wind down the US' largesse, a process now widely expected to start in the autumn. That will force everyone to look at fundamentals again and the picture is not pretty. "I am very concerned," says Liam Halligan, chief economics columnist at the Daily Telegraph, who warned that the euro crisis is back in a recent editorial. "I am expecting things to get worse and volatility to increase over the summer."

The crux of this crisis is that countries around the world bailed out their almost-failing banking sectors by taking much of the commercial bad debt onto national balance sheets, sending debt/GDP ratios soaring to well over the 60% of GDP maximum stipulated in the Maastricht treaty that governs the euro, and even over the 90% academics say kills growth (although this number is in dispute amongst scholars).

The game since has been to reduce debt to "normal" levels, either by spending in the hope of growing your way out of the debt hole or cutting spending. Which model works best has become the centre of a crucial debate that was highlighted at the last International Monetary Fund (IMF) meeting in Tokyo, where an article by the IMF's chief economists, Olivier Blanchard and Daniel Leigh, argued that everyone is miscalculating the "fiscal multipliers."

What this means is that a very delicate balance needs to be struck between spending and austerity: too much spending and your debt rises faster than your ability to pay it back; too much austerity and your economy slows too much, depressing your tax revenues, and again your debt rises faster than your ability to pay it back. The fiscal multiplier is the number that defines this ratio and we are in unchartered waters here, as no one is sure what this number should be.

Debt mushrooms

At the moment it seems that governments have got the balance wrong. The size of the debt in the 17 countries that use the euro has risen. The debt of Eurozone countries hit 92.2% of their combined GDP at the end of March, up from 90.6% at the end of December, 89.9% at the end of September and 88.2% a year earlier, according to Eurostat. Things are getting worse, not better: neither the spend-to-grow nor the austerity policies tried by most governments are working.

Digging down into the individual country results and the picture becomes even bleaker. "The house of cards of the world economies continues to collapse. The problems of Greece and Cyprus are just the beginning of a global trend. Public debt may soon flatten everything in its path like a huge snowball," the World Organization of Creditors (WOC) said in an alarming report released in July, which concludes that debt is piling up faster than ever.

Out of a total of 27 EU member states, 21 registered an increase in their debt/GDP ratio at the end of the first quarter of 2013 from the fourth quarter of 2012. The highest ratios of government debt were unsurprisingly found in those countries that started all these problems: Greece had a debt/GDP ratio of more than twice the recommended level at 160.5%. Ireland saw the biggest increase in its debt in the period, up 7.7% to 125.1%.

More worryingly, the debt of core European countries is also rising at an alarming rate. Spain is falling further into trouble with its debt rising 4% in the first quarter to 88.2%, Italy's debt topped 130.3% and Portugal's was up by 3.5% to 127.2%, the third highest in Europe. These countries are moving inexorably towards a credit crisis, unless there is a dramatic turnaround in the continent's economy.

Even the UK is floundering, despite the Conservative government's much-publicised public spending cuts: on the face of it, the UK's 89% debt/GDP ratio is just on the edge of the red zone, but like Spain it saw debt levels jump by 10% over the last year as the economy sinks back into recession. "The UK remains in the economic doldrums. Having suffered the deepest slump since the Great Depression, we're staging the slowest recovery in our recorded history. On top of that, and despite the 'austerity' rhetoric, our national debt has doubled since 2008 and, on official estimates, will have more than tripled over eight years by 2016," says Halligan.

Across the pond, the US is in similar trouble, although unlike Europe it went for the spend-to-grow model: the US has the largest absolute debt of all the developed markets at $16.7 trillion, well into the red zone at 103% of GDP as of the end of 2012. And despite the mild economic pick-up, the US' debt continues to grow, reaching 104.8% as of the end of March. It's expected to continue growing.

The situation for the developed world is clearly unsustainable. The WOC concludes that most developed markets are living in a "debt bubble" that will eventually burst. "The countries that are pressured by debt can't find a way to pay their obligations and are being forced to borrow even more money to pay interest on their current loans. For both the majority of developed economies and countries where the debt/GDP ratio exceeds 60-70%, it looks like the point of no return has already been passed," the WOC says in the report. "Sooner or later they will share the fate of Greece and Cyprus. But in this case, there will be no one to borrow the 'rescue' money from."

Indeed, the only major developed market that seems to be coping with the crisis is Germany. The debt/GDP ratio is still high at 83%, but the country saw the growth in its debt last year and turned the corner this year, falling by 0.7% - the only major European country to actually reduce its debt in the last six months.

(The WSJ has created a great interactive chart to compare countries' debt here)

At the beginning of July, the IMF cut its latest updates for global growth again. The IMF said that "centrifugal forces" across the Eurozone remain serious and are pulling down growth everywhere with one or two exceptions. The IMF cut its global real GDP growth forecast from 3.3% to 3.1% and its outlook for next year from 4.0% to 3.8%.

Europe will largely remain in recession this year, but on the face of it the US and the other Organisation for Economic Co-operation and Developmen (OECD) countries are doing better. However, a paper released by GK Research in June concluded: "This is case of GIGO analysis at its most blatant – as in: garbage in, garbage out... Most leading indicator indices are heavily weighted in components that have been manipulated by central banks," Charles Gave, the founder of GK Research, argues.

Stripping away the three dodgy indicators, the remaining indicators show that things are still getting worse in the OECD countries. "The Fed hopes that by manipulating asset prices, it will convince enough people that the economy has stabilized, thus igniting animal spirits. This is a psychological, mystical view of the economy. Of course, there is the possibility that the Fed is right. But if the economy does not do what the Fed expects, then eventually a lot of people are going to lose a lot of money," Gave says.

Better off but still at risk

All these problems are pushing Emerging European countries into the corner. The 2008 crisis showed just how the developed world's problems can hurt the new world too. The problem for emerging markets is that their economies are a lot more fragile than those of the West.

The stars of the region are the plucky little Baltic states. Estonia has the lowest debt/GDP with 10% and Latvia leads the Eurostat league table in terms of debt reduction: Latvia has a debt/GDP ratio of 40.7% at the end of 2012 and saw its debt fall faster in the first half of the year than anyone else, down by 1.5%. Indeed, most of the Emerging European countries have extremely low debt on the order of 30-40% of GDP.

Another way to compare debt levels around the world is to think of the debt in per-capita terms. The outcome is that most developed countries owe the equivalent of a year's average salary per worker, whereas the leading emerging markets owe only one month's salary or less.

Japan has the highest debt on a per-capita basis in the world where the government owes $110,875 for each citizen or about four-times the average annual salary. Ireland has the highest per-capita debt of any country in Europe and its government owes $53,992 per person, or one year's average income. This is slightly ahead of the US with $53,229, or slightly more than the $51,404 average annual salary, but that has been falling by $1,000 a year since the onset of the crisis. Despite the spend-for-growth policy, the average American is now some $4,000 worse off than he or she was before the crisis started. Compare this to Russia's debt of a mere $1,570 per person, which is just twice the average monthly salary.

The story is similar if you look at each country's currency reserves. In general, developed countries have leveraged themselves up to the hilt and keep little cash in reserve, whereas emerging markets tend to save heavily.

Saudi Arabia is the richest country in the world in terms of the amount of cash it has versus its debt with $627bn in the bank, or 1,749% of its foreign debt. Likewise, China has 200% of its foreign debt in cash and Russia 252%, which are also the first and fourth richest countries in terms of absolute reserves. By contrast Japan, the second richest country in the world in terms of the absolute size of its $1.3 trillion of reserves, can only cover 10% of its debt with cash. Germany can cover 8%, Italy 7% and the US only 3%.

Worst behind us?

How will this end? Belarus and Ukraine are already teetering on the edge of the abyss.

Ukraine has only two and half months of hard currency reserves left, while its budget deficit tripled over the first half of this year. It managed to raise some money with a Eurobond issue earlier this year, but since Bernanke's announcement about tapering off the Fed's latest round of quantitative easing, yields on its bonds have jumped to over 10% - a price the government is not willing to pay. With a heavy debt repayment schedule coming up, it is hard to see how the government is going to manage. "Ukraine has financed itself over the past few years, despite weak fundamentals, because of liquid global markets, but it is unclear how much longer this can continue," says Timothy Ash of Standard Bank. Ukraine could be Bernanke's first victim.

Belarus is in similarly dire straits. Exports to its main customers in Europe and Russia have collapsed, and the current account deficit jumped to 17% of GDP over the first six months from nothing last year, bleeding the country of reserves. The population is beginning to panic and the central bank was forced to hike money market rates to 40% at the end of July to head off a banking crisis. What has been President Alexander Lukashenko's response? A massive hike in public wages and pensions to pump up the economy. It was a similar policy that causes the previous crisis in 2010-11, which led to a 60% devaluation of the Belarusian ruble.

On the other hand, some pundits say the worst is passed and that growth will resume in the second half of this year (the IMF's recent downgrade of global growth notwithstanding).

The head of the IMF, Christine Lagarde, told Romanian bankers and journalists at a meeting in July: "Five years after the start of the crisis, the worst is most likely behind you, most countries have returned to positive growth. We expect only two countries of the region to be in recession in 2013 - Croatia and Slovenia - compared to eight last year."

It could be that the Fed does successfully trick Americans into being more optimistic and igniting those "animal spirits," allowing the US to grow out of its quagmire. It could also be that after Angela Merkel is re-elected chancellor in September, and Germany steps in to bail out the southern periphery of the Eurozone. However, both these scenarios look unlikely, and in the meantime the forces for a crisis are building up as government debt continues to grow.

If the politicians don't act, eventually the market will.

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