“Cascading default, bank runs and catastrophic risk” lie ahead for the world economy unless Europe resolves its festering debt crisis, Timothy F. Geithner told global finance chiefs on the morning of Sept. 24.
The U.S. Treasury secretary spoke from experience and lessons learned. Three years ago, he was president of the Federal Reserve Bank of New York and working to shore up a financial system in the chaos following the collapse of Lehman Brothers Holdings Inc. His warning last month at a meeting of the International Monetary Fund in Washington was the third in three weekends after he jetted to conferences in France and Poland to appeal directly to Europe’s policy makers for action.
After New York-based Lehman filed for bankruptcy on Sept. 15, 2008, financial institutions lost or wrote off almost $1 trillion; the Standard & Poor’s 500 Index fell 40 percent in six months; and the world slumped into the deepest recession since World War II. The global economy still hasn’t recovered and has been close to stalling anew for the past several months.
Europe’s nightmare scenario would mean fresh financial disaster, according to Nobel laureate economist Robert Mundell. In the worst case, authorities fail to prevent Greece from defaulting on 356 billion euros ($489 billion) and investors react by triggering insolvencies as far as Spain and Italy. Such a firestorm would devastate bank balance sheets, rock markets, derail economic growth and threaten to splinter the 17-nation euro area. The European Central Bank would probably have to lead the response as the Fed did in 2008.
‘Scaring the World’
“Just before the Lehman crash, nobody expected anything like what happened afterwards,” said Mundell, whose research is credited with providing intellectual support for the euro, in a Bloomberg Television interview Oct. 6. “We’re right in the middle of crisis now. It’s not just a crisis of the sovereign debt, it’s a crisis of the banks, and this is now a global situation. It’s going to spread to the United States.”
Geithner’s comments last month were part of an apocalyptic chorus. Europe “is scaring the world,” President Barack Obama said Sept. 26. Bank of England Governor Mervyn King says the financial turmoil may be worse than the Great Depression. The crisis “has reached a systemic dimension,” said European Central Bank President Jean-Claude Trichet on Oct. 11.
$13 Trillion Lost
The dire warnings reflect a mounting sense of urgency. Concern that difficulties in refinancing debt are spreading beyond the euro area’s smaller nations, and unease over the financial system’s exposure to sovereign bonds are shaking global markets. Europe’s woes are responsible for wiping out about $13 trillion of wealth since July 1, analysts at Barclays Capital estimate.
“It’s a horse race between the markets worried about the politics and the politicians who can fix things,” said William White, a former head of the monetary and economics department at the Bank for International Settlements in Basel, Switzerland. “There’s a possibility that the markets win the race, and that would be truly horrible.”
White says policy makers outside Europe are concerned that if politicians fail to protect that continent’s economy and banks, investors would view other markets as the next dominoes to fall. The IMF estimates a U.S. budget deficit of about 10 percent of gross domestic product this year.
“At a global level, there’s a debt problem,” he said. “The U.S. can see they’re next in line.”
European policy makers and those of the world’s 20 major advanced and emerging economies may have their last best chance of forestalling a meltdown in a series of meetings starting tonight in Paris, according to Jim O’Neill, chairman of Goldman Sachs Asset Management.
This weekend’s talks involve finance ministers and central bankers from the Group of 20. European leaders will then convene in Brussels on Oct. 23 and those from the G-20 will gather Nov. 3-4 in Cannes, France.
With markets fragile and Greece negotiating a second bailout, U.K. Chancellor of the Exchequer George Osborne said G-20 officials agreed at a Sept. 23 meeting that the Cannes summit would amount to a deadline for a plan because “patience is running out.”
“If the G-20 comes out of Cannes with nothing, that will be a nightmare,” said London-based O’Neill, who crafted the concept of the BRIC nations to describe the growing economic might of Brazil, Russia, India and China.
Central Bank’s Role
The ECB already needs “to be very active” in managing the regional crisis, said David Mackie, chief European economist at JPMorgan Chase & Co. This will include allowing its bond buying program to reach as much as 1 trillion euros, maintaining liquidity in banks, and cutting its key interest rate to 1 percent from 1.5 percent by early next year, Mackie said. He forecasts an imminent recession.
German Chancellor Angela Merkel and French President Nicolas Sarkozy vowed Oct. 9 to devise a plan by the G-20 summit that would create a “durable solution.” Underscoring the urgency, a tightening of the interbank credit market forced Belgium and France last week to break up Dexia SA, once the world’s biggest lender to municipalities.
“The failure of Greece would be the failure of all of Europe,” Sarkozy said Sept. 30 in Paris. “Remember in 2008, when the U.S. let Lehman Brothers fail, the global financial system paid the price. For both economic reasons and moral reasons, we can’t let Greece fail.”
Crisis Resolution Steps
To stop the crisis from spinning out of control, leaders are working on multiple fronts to manage Greece’s finances, protect banks and overhaul Europe’s economic governance to avoid a repeat. A default or a country leaving the euro weren’t part of the single currency’s original design.
The package of measures should include requiring banks to hold more capital so they can withstand potential losses from bond holdings, according to the IMF, which has put the cost as high as $200 billion. Euro-area banks need at least 150 billion euros of capital under a plan similar to the U.S. government’s U.S. Troubled Asset Relief Program, estimate analysts at JPMorgan Cazenove led by Kian Abouhossein.
European governments also are laying plans to increase the spending power of a 440 billion euro bailout fund, created in May 2010 to provide loans to cash-strapped nations. It is now being revamped to allow it to also buy bonds on primary and secondary markets, offer precautionary credit lines and inject money into banks.
2 Trillion Euros
With taxpayers balking at providing more cash and wealthy countries worried about hurting their own credit ratings, officials may try to leverage the fund’s capacity, perhaps by insuring a portion of new bonds issued by debt-ridden nations. Silvio Peruzzo, an economist at Royal Bank of Scotland Group Plc in London, says 2 trillion euros of capacity is needed to persuade investors that Spain and Italy would have enough funding.
The need to make Greece’s borrowings more manageable also may mean investors will have to take a bigger share of losses on its debt than the 21 percent write-off that formed part of a July aid deal. German banks are preparing for losses of as much as 60 percent, said three people with knowledge of the matter.
Any fresh measures may still fail because of the range of differences over what to do, according to Mackie at JPMorgan Chase. The Germans and Dutch, for example, want a deeper restructuring of Greece’s debt than France and the ECB seem willing to accept, he said.
‘Not So Convinced’
“Markets want to believe that euro-area policy makers will change the pattern of the past and finally deliver a comprehensive package,” he said. “We are not so convinced.”
Mohamed El-Erian, the chief executive officer of Pacific Investment Management Co. in Newport Beach, California, says leaders need to do more to embrace fiscal union, requiring rich nations to dispatch money to the weak, which Germany has resisted. The alternative is a smaller euro zone, he says.
The crisis began two years ago next week with the announcement that Greece had understated its budget deficit. Since then, divisions in Europe have resulted in steps that consistently didn’t go far enough in the eyes of investors and had to be revised.
In Greece, voters have resisted the ever-deepening austerity measures demanded in return for aid, leaving Prime Minister George Papandreou scrambling to find the parliamentary votes he needs. Meanwhile, AAA-rated countries such as Germany have roiled markets by seeking strict terms and trying to push bailout costs onto investors.
‘Unmanageable Political Problem’
“Europe has managed to turn a manageable economic problem into an unmanageable political problem,” said Guillermo Ortiz, who was Mexico’s finance chief dealing with the aftermath of its 1990s debt crisis, in an August interview.
The inability so far to resolve the crisis has investors betting against government debt. Credit-insurance prices point to a 91 percent chance of default in Greece. The cost of insuring German debt has almost doubled this year to an Oct. 5 high of 121 basis points. A basis point is a hundredth of a percent.
“The key issue for the euro zone isn’t the fate of tiny Greece,” said Holger Schmieding, chief economist at Joh. Berenberg Gossler & Co. “Instead, the euro zone needs to prevent contagion from Greece to the much less troubled, but much bigger bond market of Italy.”
The world’s eighth-largest economy, Italy has a debt of almost 1.9 trillion euros, while Spain, the 12th-biggest, owes about 650 billion euros. Fitch Ratings downgraded both Oct. 7 on concern they will struggle to improve their finances. Standard & Poor’s yesterday cut Spain’s credit rating for a third time in three years.
Italy is already on the verge of a debt spiral that might become “ungovernable” should reforms stall and sluggish economic growth persist, said Bank of Italy Governor Mario Draghi, who will succeed Trichet as ECB president on Nov. 1. The effect of higher borrowing costs, which have jumped 1 percentage point in three months, could wipe out the savings targeted by recent budget cuts, he said Oct. 12.
“Action must be taken quickly,” Draghi said. “Too much time has already been wasted.”
The spark for a financial chain reaction may emerge from anywhere. Papandreou could fail to persuade parliament as soon as next week to accept more budget cuts; a country such as Germany could tire of bailouts; a bank could cease to have access to short-term funding; or international investors could run out of patience with policy makers and stop buying European assets.
Widening Capital Shortfalls
Greece’s lenders, led by National Bank of Greece SA, hold about 40 billion euros of Greek sovereign bonds, about a third of the total, leaving them most prone to losses should their home nation go bankrupt.
If defaults spread to other countries, banks across Europe would be endangered, said Jon Peace, banking analyst at Nomura International Plc in London. Marking down holdings of government bonds to market value would create a capital shortfall of 350 billion euros, he said, based on prices last month for debt of Greece, Italy, Ireland and Spain. The shortfall would widen to 675 billion euros in the event of actual default, assuming a recovery rate of 40 percent, Peace estimated.
“No practical amount of capital injection can prepare the sector for large-country sovereign impairment or default,” Peace said. The capital gap would widen as corporate defaults followed and economies plunged into recession, leading to more writedowns and losses, he said.
There “would be a credit and payments system failure caused by balance sheet damage to banks,” said Michael Spence, a Nobel laureate in economics and a professor at New York University’s Stern School of Business.
Currency Union Web
The currency union created a web of assets and debt that leaves lenders exposed across borders. Italy’s top two lenders, Intesa Sanpaolo SpA and UniCredit SpA, with 65 billion euros and 40 billion euros of sovereign debt exposure respectively, are the biggest bank holders of Italian government debt. At the same time, lenders in France and Germany have 508 billion euros in total claims on Italy, according to Bank for International Settlements data.
Contagion may be global. U.S. banks hold insurance on Greek debt totaling 3.7 billion euros, economists at Fathom Financial Consulting in London calculated in June. Adding the rest of the European periphery leaves U.S. banks with a 193 billion euro exposure.
40 Million Jobs
If financial markets freeze and governments cut budgets even more, economies would probably be shoved back into recession. The Geneva-based International Labor Organization said last month that there is a risk of 40 million fewer jobs in the G-20 next year than when the credit crisis began in 2008.
A Greek default with spillover into Spain and Italy may cause the euro area to contract by 1.3 percent in 2012, using the Lehman Brothers case as a benchmark, estimated Laurence Boone, chief European economist at Bank of America-Merrill Lynch in London.
At New York-based Goldman Sachs Group Inc., economist Andrew Tilton says Europe is already slowing the U.S. “to the edge of recession” by tightening financial conditions and limiting American exports. Alcoa Inc.’s profit missed analysts’ estimates, the company said this week, as European customers “dramatically” cut orders because of economic uncertainty.
Ultimate Casualty: Euro
In the worst-case scenario, the ultimate casualty from a Greek default may be the euro. Its breakup may mean a repeat of the Great Depression, according to HSBC Holdings Plc economists Stephen King and Janet Henry.
Dissolving the single currency would threaten the region’s financial system. Banks would have to disentangle a mass of cross-border assets and liabilities. The reintroduction of national currencies and legal ambiguities would rattle markets. Peripheral nations may suffer hyperinflation as their currencies plunged, while the core economies would be hammered by surging exchange rates, the HSBC economists said in a Sept. 30 report.
“Lehman was bad enough for the world economy and its financial markets, but, under any plausible scenario, a breakup of the euro would be far worse,” King and Henry wrote.
If a weak country such as Greece left the euro first to regain control of exchange and interest rates, its new currency would drop 60 percent, and local borrowing costs would jump at least 7 percentage points, imperiling the balance sheets of banks and companies, according to a Sept. 6 study by UBS AG economists. Departure from the European Union would cause trade to fall by half even with devaluation. The cost in that country would be as much as 11,500 euros a person in the first year outside the euro and 4,000 euros in following years, the UBS economists calculated.
Effect on Germany
If Germany, the region’s largest economy, quit the euro, its new exchange rate would probably surge 40 percent and interest rates 2 percentage points, UBS said. Banks would require recapitalization and trade would slide 20 percent. Each person would lose as much as 8,000 euros in the first year, UBS estimated.
The pain would probably spread. The S&P 500 Index would tumble to about 750 from 1,203.66 yesterday, and company earnings would slide as much as 45 percent, according to Credit Suisse Group AG strategists. They assigned a 10 percent probability to a euro breakup.
Such fallout explains why international policy makers are urging European counterparts to rise to the challenge. The failure of Lehman Brothers taught authorities how events in one economy can affect another, said Robert Kimmitt, who was deputy U.S. Treasury secretary at the time.
“European and U.S. policy makers are drawing on lessons learned,” said Kimmitt, now the independent chairman of the Deloitte Center for Cross-Border Investment. “People have very much in mind what happened in the financial crisis of 2007-2009 and particularly in the eventful weeks of September 2008.”