Nations, as indeed individuals and corporations, that live beyond their means, tend to have their come-uppance; sooner or later! In recent times, this truism has resonated loud and clear in the public domain.
When the parliaments and / or the press do not get at them, then the financial markets do so with a vengeance; often viciously during the affected nations’ most vulnerable moments. These then galloped into a self-fulfilling phenomenon; what with the credit rating agencies’ quick hammering the last proverbial nail(s)!
This may sound somewhat dramatic and macabre. But President Obama eloquently characterised the imminent US debt default threat as its Armageddon! Berlusconi’s berating of his finance minister in a recent public interview ratcheted-up Italy’s borrowing costs. Both, events (or non-events) had put Portugal, Ireland, Greece and Spain (the PIGS) on tenterhooks. A remaining Damocles sword that hangs over the financial markets in these jittery pre-summer weeks is a potential US default.
First, rewinding back to the EU scene. The prestige and the implicit credit quality conferred by the PIGS’ EU membership is now blown. There will be multi-track economies now with each having a credit rating and a standing in the financial markets, based on whether the investors perceive them to be debt service- worthy. The PIGS submitted themselves to a strict convergence criteria; but have, systematically, diluted the discipline and the financial prudence of the ‘core’ members.
Bloated bureaucracy, national debt overhang, burgeoning budgetary deficits and public sector ownership have been the result of blending socialism, a privileged middle class and an unaffordable welfare state. ‘Free’ financial markets / unfettered trade flows could not support the continuation of this costly mix; funded by unsecured sovereign borrowings. As EU members, they could borrow heavily and easily. Benign interest rates and obliging global banks overlooked the escalating build-up of a debt problem, in the making.
The Euro 109 ‘shoe-box’ cobbled together by the French President and the German Chancellor, as announced, would be scrutinised carefully and the jury is still out.
While this has provided near-term relief for the PIGS, the package outlined does include a secondary market-mopping mechanism to present speculative pressures on the EU PIGS / sick states. The European Financial Stability Facility has Euros 440 billion of war-chest to battle the markets. This deal will immediately pinch private investors, including banks, who will forego some 21% of ‘haircut’ – effectively a club default. The PIGS can derive comfort from the extended tenor of 15-30 years and lower interest rates of about 3.5%.
Now to fast-forward to the US soap opera. A potentially bigger challenge is the perception of the imminent US debt service default. The impasse in the Congress is degenerating into brinkmanship as to who will blink — just in time!. The markets, as yet, believe that wiser counsel will prevail and that an eleventh hour compromise will avert a financial implosion. Threats by either party, as in litigations, are always more effective then executing the threat itself i.e. a fait accompli. When you file cases in the Courts, positions get entrenched and then it is a point of no return. However, if the US were to default by design or even by default (pun unintended), then the rating agencies will move to cut the US Treasuries from AAA – triggering several unintended consequences. These so-called “risk-free rate” bonds will disappear as a mechanism widely used for fixing the US Treasury swap rates etc. and all issuers may start to pay higher interest coupons.
There are some sobering lessons for the GCC and other emerging markets; both from the averted Greek drama and the US soap opera and especially the adverse impact that these make in the markets irretrievably. Dubai, learnt, to its debt service costs that any premature or less than well-prepared communication create global reverberations. Financial pundits should diagnose the underlying factors. These are not crises but chronic maladies a la Tolstoy’s famous novel-opening words “All happy families resemble one another; each unhappy family is unhappy in its own way”.
The US problem is decidedly the result of excessive personal consumption leading to chronic trade deficits. This, along with a lethal combination of unbridled financial markets and government spending, added to the toxic excesses in the financial system. However, more than any other nation, the US has a large economy of scale and size that dwarfs competition with its vibrant productivity, innovation and technological prowess. As a sole surviving superpower, the US leverages its overwhelming military and geo-political supremacy. This resilience enables the US to retrieve from any difficult economic situation to an advantageous position. No country in the world, including its adversary like China, has any qualms about continuing to invest surplus currency reserves in the US governmental paper.
Contrary to this, the EU nations and especially the PIGS pale in comparison. Post the fall of the Berlin Wall, West Germany, grudgingly and yet generously, integrated into the East’s economy. However, this dragged down Germany’s performance for many years, on a combined basis. Therefore, this presents Hobson / Hamlet’s binary choice to Germany to bankroll the debt service (shortfall) of its disparate and desperate fellow EU members on a continuing basis. Such a denouement could well put the EU experiment asunder. But Germany and France did have the compulsions of bailing out their own banking system. Indeed, prior to EU, the Germans had ‘no historic duty’, as Ms. Angela Merkel put it, to bail out their brotherly Greeks. Many Germans, to this date, have vivid memories of life during hyper inflation of pre-World War I and the worthless currency and the authoritarian regime that followed it. Therefore, they are hardly enamoured by the prospect of now spending the fruits of their hard work and prosperity to support the indulgent Greek brothers; as one of them put it. Herein, lies the moral hazard and dilemma of having to fork out their own wealth and tax payers’ money to save the in-disciplined and unequally endowed neighbourhood, every time they are troubled in the markets and it becomes an emotional EU structure’s survival issue.
Essentially, it boils down to the need to go “back to basics”. Simply put, nations, corporations and individuals must, rigorously, and continuously, trim their borrowings.
Sovereign and quasi-sovereign de-leveraging has become an overriding priority to maintain global financial stability. Hopefully, the chastened geopolitical leadership will grasp the net and, in a sensible, sympathetic and, yet, demonstrably rigorous manner, pursue this national objective.
The pendulum has indeed swung widely. Its painful gyrations must soon gravitate to the middle — the golden mean. In a nutshell, these are the lessons to be drawn from each ‘meltdown moments in the markets’ — sometimes subliminally and sometimes tellingly!
Suresh Kumar is the CEO and Board member of Emirates Financial Services (EFS) PSC and the article represents his personal views and not necessarily shared by the organisation that he represents