A Financial Armageddon?

The bad news is the world financial system is possibly at the brink of collapse.

Events in Europe are rapidly unraveling. What started as a containable crisis in Greece, an economy that accounts for only 2.5% of Euro GDP, now threatens all of Euroland.

A run has been defined as a self-fulfilling destruction of confidence. In Europe there is a run on the debt of banks and of nations. Italy and Spain’s 10-year debt is trading at over 7% interest, Portugal’s 14% and Greece’s over 30% (versus the risk-free rate of 2% and the Philippine’s 6.5%), the sign they are in trouble.

These countries overspent and over-borrowed. Unfortunately, they cannot devalue their currency, the euro, to become competitive (just like say California cannot devalue the dollar to help itself). Their only prescription is to cut spending and raise taxes but this is killing their economies in the classic debt trap. The cure is arguably worse than the disease.

The euro problems have global consequences. Banks worldwide have exposure to European banks so if the latter fail so will they. Europe is a major export market so when it tanks so will the rest of the world. Global finances are tied at the hip.

The safe havens in this doomsday scenario are the U.S. dollar, the Japanese yen, and gold. The Swiss franc was a refuge until the country set a ceiling against the euro. Over the long term, even the U.S. and Japan are vulnerable with their own record debt and deficits. In the contagion one can run but one cannot hide.

The good news is that the world financial system is at the brink of collapse.

The consequences are so dire that European leaders are concluding, although not rapidly enough, a “shock-and-awe’ solution is needed to save the system. This means two things: One, in the short term for the European Central Bank, directly or via the IMF, to provide unlimited liquidity by acting as the lender of last resort to banks and Governments. This is termed the “monetary solution”. Two, in the medium term for the Euro nations to adhere to a common standard of good behavior by unifying their tax and budgetary policies. This is called the “fiscal solution”.

In a game of brinksmanship, Germany, Euroland’s financial godfather, has said it will not trigger the monetary solution without agreement on the fiscal. Here is where politics come in. The fiscal solution requires countries sacrificing their sovereignty on spending and taxes which they are reluctant to do. However, to remain in the euro they may have just to accede, effectively handing their economic destiny to Germany, the keeper of the purse. The latter may finally achieve what it failed to do in two world wars.

Stock markets have recently rallied on the premise Europe is too big to fail. A crucial date is Dec. 9 2011 when the 17 Euro nations meet to agree on a panacea. If, as expected, it just results in more waffling, we will move that much closer to the precipice.

What is the impact on the Philippines of a doomsday?

The peso will weaken as investors flee to the dollar. The stock market will collapse.

In the medium term we will see a drop in OFW remittances especially from Europe, weaker exports and a likely recession. A devalued peso will import inflation. Banks will hunker down leading to a contraction in credit particularly to smaller businesses. Unemployment will rise with its social and security implications.

Over the longer term, we may have difficulty refinancing our foreign debt. If investment grade countries like Italy (A) are suffering, the Philippines with its sub-investment grade (BB+) cannot be far behind. This means higher taxes and reduced Government spending, the path of the debt trap. Our projected deficit of P 285 billion will be unsustainable, tempting the Government to print money.

What does a worldwide meltdown look like? It starts with a chain of sovereign defaults. This will bring down banks holding this debt, credit default swaps and other derivatives of mass destruction. Everything comes to a standstill: Unsure of who will fail, banks stop dealing with each other. They cut loans to businesses. Investors dump assets triggering margin calls and further drops. Exchanges stop trading. There is a run on the smaller banks. We are back to barter.

An Armageddon seems inconceivable but I have stopped being surprised. The base scenario is still for more muddling through, increasing volatility and exhausted players heading for the exit; but any spark could trigger the conflagration.

The solution is with Europe’s political leaders who have been behind the curve throughout the crisis.

Maybe the threat of extinction will finally get them to move.

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About Leo Alejandrino

The blog is principally a commentary on Philippine politics and economics.
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One Response to A Financial Armageddon?

  1. thenutbox says:

    Indeed, Greece should just accept the fact that it has to live within its means, and Europe– Germany– should find the resolve to make her realize that. I trust Merkel, arguably one of the most under-rated European leaders in history, knows how high the stakes are, and how firm she should be. It should be shape up or leave the Eurozone for the Greeks and others.

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