Over the past six months, the European economy has been embroiled in a sovereign debt crisis. South African policymakers would be making the gravest of errors were they to underestimate the seriousness of this crisis. For there is every reason to expect that within the next twelve months the Eurozone's crisis could lead to the sort of global financial market turmoil that followed Lehman's collapse in September 2008.
At the heart of the Eurozone crisis is the parlous state of the Greek economy, which is now paying the price for years of public sector profligacy. By 2009, Greece's budget deficit had swollen to around 14 percent of GDP while its public debt had increased to 115 percent of GDP. This fiscal recklessness spawned consistently higher wage and price inflation in Greece than in the rest of the Eurozone. As a result, by 2009 Greece had lost a cumulative 20 percent in international competitiveness, which has contributed to a ballooning in Greece's external current account deficit.
The essence of Greece's present economic predicament is that, stuck within the Euro-zone, Greece cannot resort to currency devaluation to restore international competitiveness. Nor can Greece devalue its currency to boost exports as a cushion to offset the highly negative impact on its economy from the major fiscal retrenchment that Greece now needs.
In an exercise bordering on economic lunacy, the recently agreed US$140 billion IMF-EU program for Greece requires that Greece aims to reduce its budget deficit to below 3 percent of GDP by 2012. To that end, the IMF has demanded that for 2010 alone Greece adopt tax increases and public expenditure cuts totaling a staggering 10 percentage points of GDP. And Greece is to do so in the context of acute pressure on its banking system and sharply higher domestic interest rates.
If the experience of Latvia and Ireland, two countries that recently have been engaged in savage budget retrenchment within a fixed exchange rate system, is any guide, Greece could very well see its GDP contracting by 15 percent over the next three years. Such a slump would only aggravate Greece's public debt problem and could cause Greece's public debt to GDP ratio rise to 175 percent. It is little wonder then that, despite the large IMF-EU bailout support package, markets are presently assigning a 75 percent probability of a major Greek sovereign debt restructuring within the next few years.
A Greek debt default would almost certainly result in intense contagion to Spain, Portugal, and Ireland. For as in the Greek case, all of these countries have highly compromised public finances and severely eroded international competitiveness positions. And their Euro-zone membership precludes them as well from using exchange rate devaluation as a means to address these two problems. This predicament would appear to be particularly acute for Spain which now has to effect serious budget retrenchment at a time when it in the throes of a massive housing market bust and when its unemployment rate stands at over 20 percent.
A sovereign default in Europe's peripheral economies would have a profoundly negative impact on the rest of the European economy. After all, the European banks are the largest holders of the peripheral countries' sovereign bonds. In this context, it is well to recall that the total sovereign debt of Greece, Spain, Portugal, and Ireland exceeds US$2 trillion. It is also well to recall that a country like France has had its banks lending as much as 37 percent of France's GDP to those peripheral countries. An eventual write down of the peripheral countries' sovereign debt by even only 20-30 percent would constitute as large a shock to the European banking system as that which it experienced in 2008.
If there is one thing that South African policymakers should have learnt from the 2008 Lehman crisis it is how interconnected the global economy has become and how important it is to go into a global crisis with a sound economic position. Were Europe indeed to experience a full blown sovereign debt crisis down the road, one must expect that the South African economy would be severely impacted. For not only would a European banking crisis lead to an abrupt slowing of the European economy, South Africa's main trade partner, and to a decline in global commodity prices. It would also lead to a heightening in global risk aversion and to a drying up in capital flows to the emerging market economies in general and to South Africa in particular.
On the eve of a possible European economic, one has to be concerned about South Africa's large Public Sector Borrowing Requirement and about the renewed opening up of a sizeable external current account deficit in South Africa at a time when international commodity prices remain high. One also has to be concerned about the acceleration in domestic wage settlements that go beyond levels that the country can afford. These developments would appear to make the country particularly vulnerable to any sudden stop in international capital flows.
In anticipation of the real possibility ahead of renewed international financial market turbulence, one has to question the appropriateness of the Reserve Bank's stubborn adherence to a policy of non-intervention in the foreign exchange market. One would have thought that by now the Reserve Bank would have seen the benefits that almost every other major emerging market economy derives from preventing their currencies from getting too strong in the good times and from preventing their currencies from becoming a one-way-bet and from becoming excessively depreciated in the bad times.
At present there is a massive financial effort by the EU, the IMF, and the ECB to keep Europe's peripheral economies afloat. However, judging by the German public's growing opposition to indefinite bail-outs and by the peripheral countries' serious solvency issues, South African policymakers would be making a serious mistake to count on this financial support lasting indefinitely. It would seem that they would do well to take advantage of the narrow window that this financial support offers to better prepare the country for the onset of an all too probable full blown Eurozone crisis.
Desmond Lachman is a resident fellow at AEI.