The prospect of a sovereign default in Europe evokes memories of 2008 and the collapse of Lehman. For me, a better parallel is 10 years earlier. Today’s drama has all the hallmarks of a classic Latin American crisis, only this time the Latins are in southern Europe.
The Russian default, itself an echo of the previous year’s Asian Tiger crisis, sent Latin America into a tailspin that took five years to stabilise. Countries many thousands of miles from Moscow, and with few trade links, were caught up in the crisis, their leaders, such as Argentina’s then president Carlos Menem, at first either unwilling or unable to comprehend the impact a Russian default might have on their own creditworthiness. The crisis roamed from one country to the next, causing havoc in financial markets and led to a range of support measures from the International Monetary Fund.
For Russia read Lehman. For Argentina read Greece. For Menem read Papandreou. For Brazil read Italy. For IMF read IMF. There are differences, but the combination of surging sovereign yields, frail banks, ever-larger IMF-backed stabilisation plans, austerity, no growth, falling equities, volatility and bewilderment are common to both episodes. The lesson of the 1990s crisis is to prepare for the worst because it will happen. Countries that did, such as Brazil, recovered, Those that didn’t, such as Argentina, still struggle.
The role of the private sector was key to the recovery in those Latin economies. Latin governments, led by Brazil, adopted a range of financial and economic policies that sought to promote private sector involvement in economic recovery. Asset sales, price liberalisation and fiscal consolidation focused on expanding the private rather than the public sector. I do not recall the Brazilian central bank ever buying government bonds.
In southern Europe today it is not clear what role the private sector is expected to play in economic recovery. The current European Central Bank policy of purchasing sovereign debt is stabilising sovereign yields but it has an unintended consequence, encouraging the banking system to offload its bond portfolios and abandon southern Europe with dire consequences for economic growth. In the next few months, the extent of the recession in continental Europe will become clear and debt dynamics will further deteriorate. This is not what policymakers are assuming. But what else should we expect? We should pursue policies that seek to encourage private sector finance in southern Europe rather than offer it a means of escape.
Before southern Europe can return to growth we need private sector involvement and finance. The experience of the Latin American crises can guide us in Europe today.
First, governments in southern Europe need to commit to primary surpluses and halt the drain on private sector resources. Fifteen years ago, developed countries (and the IMF) demanded that emerging countries such as Brazil run large primary surpluses to stabilise their debts. It is hardly surprising that similar calls are heard from emerging economies now roles are reversed.
Second, the ECB should stop buying sovereign bonds. The purchases should be replaced with a Brady-style plan that “incentivises” the banking sector to renew its lines of credit to southern Europe, while simultaneously lowering the overall debt burden. The creation of a 30-year zero-coupon “Trichet bond” would collateralise the principal of new Greek sovereign securities which would be the centrepiece of a debt-swap plan. The swap, old Greek securities for new, would simultaneously reduce the overall quantity of Greek sovereign debt and extend its duration. Banks would enter the swap voluntarily as the discount to the old bonds would be more favourable than current prices and the new securities would be backed by the Trichet bonds. The Greek government would be responsible for all coupon payments, maintaining fiscal discipline.
Third, banks will require more capital to absorb the financial impact of the debt swap. Accounting standards could be relaxed temporarily to facilitate this, but there will be calls for fresh capital. Equity markets may not be prepared to provide this capital at current share prices, but European banks can sell their non-European subsidiaries to local competitors. They can sell off non-banking businesses. Some troubled banks can be sold to foreign banks in their entirety. American and European banks hoovered up much of Latin America’s banking system 15 years ago.
It is difficult to see an end to this crisis in southern Europe, but it can be solved if policies are crafted to encourage private sector involvement. At the moment the private sector is disengaging from southern Europe and the ECB’s purchases of sovereign bonds is accelerating the process. This can only mean that economic growth will continue to disappoint.
Dominic Rossi is Global CIO Equities, Fidelity Worldwide Investment
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