10/06/2011 03:06 PM

The Ticking Euro Bomb

How the Euro Zone Ignored Its Own Rules

After they joined the euro zone, the countries of southern Europe suddenly discovered they could borrow money at German-style rates, and any hope of sorting out their dodgy finances vanished. But it was France and Germany who set the worst example, when they broke the euro-zone rules they had forced on others.


This is Part 2 of SPIEGEL's recent cover story on the history of the common currency. You can read Part 1 here. The remaining installment will be published in English on Friday.

Act II: Life With the Euro (2001 to 2008)

How the euro heated up the borrowing-fueled economies of member states. Where Greece got its billions from. How the growth miracle failed to materialize. How the Germans betrayed the rules of the EU and benefited from the euro zone.

The Europeans' new determination and palpable desire to make the historic project a success was rewarded. Banks, pension funds and major investors from around the world began to show an interest in this new Europe.

Portuguese and Irish government bonds, coupled with French economic strength and German reliability, suddenly looked like low-risk, reasonable, future-oriented investments. It was at this time that the financial industry developed its new magic tricks.

Sewage treatment plant operators in southern Germany, city governments in Spain, villages in Portugal and provincial banks in Ireland got involved with Wall Street bankers and London fund managers who promised profits by converting debt into tradable securities. And while central governments tried to cap their national budgets to comply with the Maastricht requirements, municipalities piled on debt that was not documented or recorded anywhere at the European level.

Low-interest loans were available everywhere, and it was all too easy to postpone their repayment to a distant future and refinance or even expand government spending.

loophole developed in the Maastricht Treaty. Harvard economist Kenneth Rogoff says that the rule about the maximum debt-to-GDP ratio should have been amended, and that it was wrong to establish the 60 percent limit on a purely quantitative basis without asking where the loans were actually coming from.

According to Rogoff, it would have been necessary to limit the proportion of foreign liabilities in each country's national debt. In the long run, and especially during an economic crisis, this kind of debt leads to an undesirable dependency on the vagaries of the markets.

In fact, governments borrowed excessively from foreign lenders, especially the major European banks. They accumulated what economists refer to as external debt. Deutsche Bank bought Greek bonds, Société Générale invested in Spanish bonds and pension funds from the United States and Japan bought European government bonds. The yields were not particularly high, but neither were the risks of default, or so it seemed. However, it was during this period that the monetary relationships were formed that turned Greece into a money bomb that would threaten the entire euro zone years later.

The Greeks were able to borrow at interest rates that were only slightly higher than those that the German government paid on its bonds. "The euro was a paradise of sorts," says then-Greek Finance Minister Yiannos Papantoniou.

Once they had joined the euro zone, Europe's southern countries gave up trying to sort out their finances, says Papantoniou. With a steady flow of easy money coming from the northern European countries, the Greek public sector began borrowing as if there were no tomorrow. This was only possible because the country, in becoming part of the euro zone, was also effectively borrowing Germany's credibility and credit rating.

The Greeks Establish a Debt Agency

Prior to the euro, Greece had shown little interest in the international bond market. The country was simply too small and economically too underdeveloped to play much of a role. But in 1999, the Socialist government in Athens established a "Public Debt Management Agency," naming Christoforos Sardelis as its director. Sardelis, an economist, had taught in Stockholm during Greece's military dictatorship. Now he headed a staff of two or three dozen employees.

For the first time, the Greeks tried to convince foreign investors to buy larger volumes of debt with longer maturities. The message was: Buy an attractive security from the European Union.

He worked all of Europe, speaking with every fund, Sardelis recalls. Today, he is 61 and a member of the board of directors of Ethniki, Greece's largest private insurance company. "Our task was to obtain money in the best possible way," he recalls.

Greece was soon selling packages of bonds worth upwards of €5 billion at government auctions, says Sardelis. Starting in 2001, there was "enormous demand from all over Europe," as well as from Japan and Singapore, he says. Things were going so well that Sardelis was even able to lure experts away from Deutsche Bank. Greece was in vogue. In reality, the Greeks were auctioning off their own future, without even noticing. They saw joining the euro as their goal, even though it was only a beginning.

In the spring of 2003, rates on Greek bonds were only 0.09 percentage points above comparable German bonds. In plain terms, this meant that the markets at the time felt that Greece, with its economy based on olives, yogurt, shipbuilding and tourism, was just as creditworthy as highly industrialized Germany, the world's top exporter at the time. Why? Because both countries now had the same currency. And because the markets -- as Andreas Schmitz, the head of the Association of German Banks, explained in a recent interview with the German weekly newspaper Die Zeit -- never believed in the so-called "no-bailout" clause of the Maastricht Treaty, a clause that was designed to prevent euro-zone countries from being liable for the debts of other members.

According to Schmitz, the markets were confident that "in an emergency, the strong countries would support the weak ones," a view based on European politicians' lax treatment of their own rules early in the game. Those who bought Greek bonds on a large scale at the time were betting that Europe's statesmen would break their rules if a crisis came along.

Sardelis claims that he had recognized the looming problems and warned against them. Today, he describes a mood characterized by the ever-increasing "illusion that the monetary union could solve our problems." But instead of pushing for serious reforms of Greek government finances, the Greeks simply "relapsed into old mentalities." Instead of saving being promoted, obtaining "as much money as possible" was encouraged.

Germany Undermines the Treaty

In 2002, the German government had other things on its mind than examining Greece's public finances. It was having troubles of its own, with the European Commission threatening to send a warning to Berlin. Germany was expected to borrow more than had been forecast, thereby exceeding the allowed 3 percent of GDP limit for its budget deficit. The result was not, however, an example of German fiscal discipline and exemplary adherence to European rules, but a two-year battle by the Schröder administration against the slap on the wrist from Brussels.

Few within the European Commission openly criticized the loosening of the Maastricht rules. And the Germans, together with the French -- both facing the threat of an excessive debt procedure -- were too busy undermining the Maastricht Treaty. The two countries, determined not to submit to sanctions, managed to secure a majority in the EU's Council of Economic and Finance Ministers to cancel the European Commission's sanction procedure. It was a serious breach of the rules whose consequences would only become apparent later.

The German-French initiative effectively did away with the Stability and Growth Pact, which the Germans had forced their partners to sign. The consequences were fatal. If the two biggest economies in the euro zone weren't abiding by the rules, why should anyone else?

The lapse was concealed behind political jargon. The violation of the pact was covered up with false affirmations of the pact. Its provisions were not formally abolished, but they were informally softened to such an extent that, in the future, they could be twisted at any time to benefit a government in financial trouble. The process also led to a not insignificant side effect: Executive power in Europe, supposedly held by the European Commission, which is informally known as the "guardian of the treaties," was de facto transferred to the European Council, which consists of the European heads of state and government.

Instead of bundling and concentrating the efforts of the euro zone in Brussels, as intended, national interests began emerging once again in Berlin, Paris, Madrid and Rome.

The Greek Deception Is Discovered

Greece's new conservative government, elected in 2004, disclosed that its socialist predecessors had been reporting manipulated figures to Eurostat since 2000, including the numbers used to join the euro zone.

But instead of criticizing Greece, European Commission President José Manuel Barroso, a Portuguese citizen, praised the new government for its openness and congratulated it for taking such "courageous steps" to make up for the mistakes of the past. Now it was Greece's job to put its house in order by 2006, Barroso added.

But the new administration in Athens soon proved to be just as creative with its accounting as its predecessor. Defense expenditures were posted retroactively to the time of order, not payment, cleverly removing them from the current balance sheet. The bureaucracy refused to make projections about budget trends and used a purely fictitious deficit of less than 3 percent in its budget planning.

Sardelis, the director of the "debt agency," was replaced. His predecessor, like Sardelis before him, took advantage of the low rates on his country's government bonds. In 2005, Greek bonds were yielding rates only 0.16 percentage points higher than German bonds. The market was buying and the Greeks were selling. Government debt increased by 14.7 percent in 2006.

A blame game began in Brussels, where officials argued over who exactly had given incorrect or insufficient information to whom. The EU currency commissioner pointed his finger at the director general of Eurostat, who shifted the blame to the EU commissioners, who in turn criticized the European Central Bank. National governments and finance ministers joined the fray and, instead of the spirit of optimism that had prevailed around the turn of the millennium, dark skies were suddenly on the horizon for this new Europe.

To make matters worse, hopes of strong economic growth in the euro zone were dashed. Germany, in particular, was ailing, growth was minimal in Europe and unemployment figures were disconcerting. Europe became a constant topic of discussion at the International Monetary Fund (IMF) in Washington.

The IMF Warns Europe

Europe was under observation at IMF headquarters. The euro countries, after having built themselves brave new economic worlds since the late 1990s, mostly on borrowed money, were already in a deepening debt hole, which was still almost unnoticed and certainly vastly underestimated. They were like a mouse that is overjoyed to have spotted a piece of cheese in a trap, without noticing that by eating the cheese it will set off the trap.

At the time, then-IMF chief economist Rogoff's answer to the question of whether the euro zone could break apart again was simple: "Of course." Rogoff said that, in 10 years' time, some countries might not even be using the euro anymore. When he said these things, his colleagues, particularly the Europeans, always looked at him "as if I had a screw loose," he recalls.

The IMF noted a "paralysis in Europe," says Rogoff. The political union that had been promised for years as a real framework for the technical monetary union did not materialize. But the European party continued -- and as long as the music was playing, everyone wanted to dance. Everyone except the Germans, that is, who were busy introducing painful and unpopular reforms -- known as Agenda 2010 and Hartz IV -- to their labor market and welfare systems.

"What the Germans accomplished at the time is very impressive," says Rogoff. "They recognized a debt problem and the systemic weaknesses, and then they rationally went about eliminating those weaknesses." But instead of developing economic productivity, reforming their social systems and controlling costs, countries like Greece, Portugal and Italy borrowed more and more money, dragging out the maturities as long as possible so as to postpone the necessary decisions into the future.

But the critics targeted Germany instead of these countries. The Germans, they said, were pushing their European partners up against a wall. German exports to countries in the euro zone were growing by an average of 7 percent a year, while 73 percent of Germany's trade surplus came from these countries.

The Agenda 2010 reforms applied pressure on wages and helped reduce unit labor costs, so that Germany acquired even greater competitive advantages over countries like Italy and Greece. While unit labor costs were declining in Germany, they were going up in most euro-zone countries, especially Greece.

Greece's Structural Problems

The Greeks were consuming on credit, using cheap loans. They bought German machinery and cars, which helped increase Germany's gross national product, while neglecting to introduce reforms at home. No elected official was willing to trim the country's enormous bureaucracy, hardly anyone was interested in debt repayment, trade deficits or unit labor costs, and very few fought against corruption, subsidy fraud or unearned privileges. The consequences of these failings are still in full view in northern Greece today, in the region bordering Bulgaria.

Almost all of the many factories and warehouses in the industrial zone of Komotini are now shut down, and yet they look as if they were brand-new. Komotini is a prime example of why the Greek economy doesn't grow, why it is uncompetitive and why there is no progress in the country.

Most of the companies there never even opened their doors for business. In fact, the abandoned buildings are the ruins of subsidy fraud. Their developers obtained funds and low-interest loans from the government in Athens and from the EU to build the factories and warehouses, but they never intended to do any business there.

Transparency International considers Greece to be the most corrupt country in the EU. Permits and certificates can only be had in return for cash. Not everyone in Greece sees this as a problem. Some see corruption as part of Greek culture, and they also believe that taxes are unnecessary. As a result, the government has a double revenue problem. On the one hand, the bureaucracy prevents some businesses from growing and becoming profitable. On the other hand, the businesses that do grow and realize profits find ways to pay almost no taxes at all. Every year, the Greek state misses out on an estimated €20 billion in unpaid taxes. A third of Greece's economic activity is untaxed.

Poor Ratings for Greece

In September 2008, when the Lehman bankruptcy wreaked havoc on financial markets, the Greek government believed it had been spared. Greek banks held very few of the supposedly innovative securities that Wall Street's financial wizards had devised. Nevertheless, in 2008, government debt rose to 110 percent of economic output. Greece's debt-to-GDP ratio had surpassed Italy's, and the proportion of its debt that was held by foreign investors was also significantly higher. The country of beautiful islands was in much bigger trouble than it was willing to believe.

The rating agencies, which had declared massive numbers of worthless securities to be safe investments, came under special scrutiny after the Lehman crash. After all, they were also rating entire countries and government bonds. What were their ratings worth? Had they misjudged the quality of national economies just as they had got it wrong with private companies?

For years, the world's three major rating agencies had unanimously given AAA or AA ratings to the bonds of euro-zone members. On Jan. 14, 2009, one agency, Standard & Poor's, decided to downgrade Greek government bonds to A-. It was the lowest rating among all the euro zone's then 16 members. From today's perspective, it marked the beginning of the crash.

The downgrade set in motion a downward spiral that would show European leaders how fragile their euro is and how contagious conditions in a small country like Greece could be.

Marko Mršnik, a "sovereign credit analyst" responsible for Greek government bonds at Standard & Poor's, was behind the downgrade. The native Slovenian doesn't talk to journalists, but his reports provide an indication of how he assesses the markets.

His office is in Canary Wharf in London's Docklands district, a business center with shimmering façades and coffee bars built on the ruins of the old industrial society. Lehman Brothers also had its offices there, until the end.

The purely economic criteria are readily available in the tables produced by central banks, Eurostat and the IMF. But another aspect, the politics of a country, is not something that can be figured out with a calculator. It has to do with issues such as how well an administration functions, corruption, strong unions, how rebellious a country's young people are and how strong its leader is. These are the soft -- but nonetheless important -- criteria.

Explaining the decision to downgrade the country's debt rating, Mršnik wrote that the ongoing financial and economic crisis had amplified a fundamental loss of competitiveness in the Greek economy. After this assessment was issued, prices plunged on the Athens stock exchange and interest rates rose. The buyers of Greek government bonds, wanting to be compensating for taking on more risk, demanded a higher premium. From then on, if Greece wanted to borrow €1 billion, that is, sell bonds worth €1 billion, it had to promise to pay €2.8 million more in interest than Germany was paying. The debt burden continued to grow and grow.

Alarmed by the downgrade, the European Commission initiated another excessive deficit procedure against Greece. But it was a helpless gesture. Once again, the sanction procedure remained ineffective -- not unexpectedly, one might be tempted to say. To this day, not a single euro country has even been penalized, despite the many cases of rule violations. The euro zone's sanction mechanism is an empty threat. Besides, it was poorly conceived from the start. What good does it do to slap fines on a country that is in financial difficulties?

In October 2009, the new government of Socialist Georgios Papandreou replaced the conservative administration in Athens. After Papandreou's election win, Mršnik wrote, in a confidential letter to Standard & Poor's customers, that in light of the repeated budgetary lapses of the various Greek governments, it remained to be seen whether the new administration had the will to implement a credible budget strategy. This sounded diplomatic, but it was pure sarcasm. Investors got the message, namely that the decline of Greek bonds from secure investments to casino chips was accelerating.

The Greek tragedy had begun.


Translated from the German by Christopher Sultan.

October 5, 2011 5:59 pm

Global gloom places Latin America on alert

By John Paul Rathbone, Latin America editor

Every day Luis Castilla, Peru’s finance minister, says he lights a candle and “prays that China won’t crash”.

His prayers are echoed by many in a region that remains one of the world economy’s few bright spots. South America’s commodity-rich economies grew 5 per cent in the first half of this year. Last year, these new motors of the world economy added half a percentage point to global output.

But slowing Asian demand and plunging commodity prices have raised the spectre that South America, having largely escaped the 2008-09 Great Recession, may not be so lucky this time around.

Another recession would “hurt more than last time, as there won’t be the same positive effects from [growth in] China and India,” Sebastian Edwards, the World Bank’s former chief Latin America economist, said. A recession “would be more global, so it would affect us more”.

Abetted by US and European gloom, markets have swiftly priced in that possibility.

Copper, an export mainstay of Chile and Peru, respectively the world’s largest and second biggest producers, has fallen 27 per cent this year to $6,990 a tonne, below its five-year average. Soya, which accounts for a quarter of Argentine exports, has fallen by 11 per cent.

Meanwhile, oil, which accounts for 90 per cent of Venezuelan exports, has held up relatively well. But at $100 a barrel, Brent is 20 per cent below this year’s peak and only $17 above its five-year average. Further falls would limit President Hugo Chávez’s ability to boost spending before the 2012 elections.

Nonetheless, tight commodity supplies mean most predict only a downwards blip in commodity prices, rather than a crash.

“On a 12-months to two-year view the outlook is very good,” says Catherine Raw, natural resources portfolio manager at BlackRock, the fund manager.

Still, if the commodity price drop does prove prolonged analysts say there would be three main effects.

Tax revenues would fall and investment in marginal mining projects postponed or even cancelled. Peru alone has been expecting more than $40bn of mining investment.

“I really believe that [the drop in prices] will affect the decision for projects that  looked quite interesting with high prices,” Diego Hernández, chief executive of Chilean state-owned copper company Codelco, said.

“Now people will be much more cautious. I really believe that some of those projects will be delayed.”

Second, current account deficits would widen. In an extreme scenariocommodity prices dropping to the depths they fell to in early 2009 Brazil, Chile, Colombia and Peru would run current account deficits in excess of 5 per cent of gross domestic product, estimates Capital Economics, a consultancy.

Third, a drop in commodity-related capital inflows would force exchange rates lower. That might help Brazilian and Mexican exporters of manufactured goods. But it would also crimp local purchasing power and curb consumer credit booms, both of which helped drive Latin America’s decade-long economic boom.

Unfortunately, consumer credit and appreciating currencies are the main drivers of the consumer boom,” says Walter Molano, emerging markets economist at BCP Securities. “That means that it is vulnerable to a reversal in external conditions.”

To counter a domestic slowdown, the region’s better-managed economies still have powerful weapons to deploy. Interest rates have ample room to be cut, sovereign debt levels remain low and foreign reserves are high.

Against that, countries have less fiscal ammunition to fire off than they did a few years ago. The International Monetary Fund warned this week that government spending continued to run ahead in Argentina and Venezuela in particular.

Elsewhere, much of the region is also running structural budget deficits after unleashing powerful stimulus packages in 2009, although Latin America has generally managed the recent commodity price rollercoaster better than previous cycles.

Nobody, therefore, is predicting doom for a region that in many ways is in better macroeconomic shape than the developed world. Banking systems are sound – even if much of them are foreign-owned. Fiscal accounts are solid. And inflation is low.

The International Monetary Fund said in a report on Wednesday that the global economic slowdown will result in a “modest worsening” for Latin America’s fast-growing economies in 2011 and 2012.

Still, a prolonged commodity price drop would pose the first real test of what has almost become the region’s new economic orthodoxy.Lulismo”, named after former Brazilian president Luiz Inácio Lula da Silva, combined social service provision with macroeconomic stability and lifted millions out of poverty. But it was also possible in large part thanks to cheap capital and the commodity boon.

Every good sailor knows that if favourable tailwinds turn into stiff headwinds, you can’t keep up speed,” says Nicolás Ezaguirre, director of the IMF’s western hemisphere department and a former Chilean finance minister. “This is the biggest danger now: that governments try to keep up their speed by launching stimulus packages prematurely.”

Additional reporting by Javier Blas and Jack Farchy

Copyright The Financial Times Limited 2011

US-China trade war: Congress beware what you wish for

Yukon Huang

October 5, 2011

Once again the US Congress is finding it more convenient to play the China currency card as the panacea for America’s economic woes, rather than deal with the difficult issues in President Barack Obama’s recent employment bill.

China’s response to the proposed bill pressuring it into allowing the renminbi to appreciate was predictable, with simultaneous protests from all the relevant agencies. Given the threat to the global economy from the problems in the eurozone and the US, China’s leadership regards the currency bill as a distraction from the real issues that need to be resolved. At a time when China is one of the few sources of global growth, ratcheting up protectionist sentiments only makes it harder to secure the necessary multilateral co-operation. The country’s government sees the currency debate as yet another sign of why the American political system is broken.

Beijing is quick to note that the history of rapid appreciation of the yen under the Plaza Accord under pressure from the US did not eliminate its trade deficit with Japan but in China’s view only contributed to the latter’s long-term economic ills. Moreover America’s trade deficit began to increase sharply in the late 1990s, well before China’s trade surplus began to take off in 2005. America’s trade problems are thus seen as stemming from its large fiscal deficits that emerged with increased military expenditures abroad.

Many within China thought that given recent developments, criticism of its exchange rate policies would become more muted. After all, China has continued its policy of gradual appreciation of 5-6 six per cent annually. With the euro crisis and strengthening US dollar, the renminbi has been the exception in appreciating, while other major currencies have depreciated. China also notes that its trade surplus has declined sharply from 7 per cent to 8 per cent of gross domestic product five years ago to a projected 1-2 per cent for this year. And while reserves continue to pile up, this is seen as having more to do with capital inflows seeking higher returnsencouraged by expansionary US monetary policies – than by misaligned exchange rates.

Moreover, Beijing argues that bilateral trade balances are meaningless in a world dominated by production networks using China as the assembly plant for the world. More than half of the country’s exports come from “processingtrade, with China accounting for some 20 per cent of the value produced and the rest from components imported from other Asian countries, Europe and America. China’s trade surplus comes from processing trade. Thus America’s large bilateral trade deficit is not really with China but with east Asia more broadly. Take the iPod: it is recorded as a $150 export from China to the USyet only $5 of the value added originates in China, the rest comes from half a dozen other countries with the bulk accruing to Apple itself.

In this context if Congress gets its way, the net impact will not be more American jobs but reduced global demand and higher prices for US consumers. As the recent Spillover Report by the International Monetary Fund concluded – a 10 per cent appreciation of the renminbi would have a negligible effect on the US trade balance or its GDP. The positive impact would be greater although still marginal for other Asian economies. Thus any jobs lost by China from a major appreciation would gravitate not to the US but to other developing countries.

Yet China has little appetite to turn this affair into a full-blown trade war since it has benefited greatly from open markets. Thus while the leadership will not let any perceived negative action go unchecked, its motivation will be to work towards constructive solutions. But there is a danger that in the transition to its next generation of leaders, Beijing may find it necessary to take a harder line in response to any perceived politically driven actions by the US.

America should worry more about maintaining its position at the upper end of the technology spectrum as China may feel the need to reinvent itself if the pressure to sharply appreciate its exchange rate continues. Currently China exports an unusually wide range of technologically sophisticated products for its income level. However, its high-technology exports are really processed finished products with the more sophisticated components coming from elsewhere. No wonder most US companies are more concerned about market access and technology transfer than futile currency wars.
The writer is a senior associate at the Carnegie Endowment and a former country director for the World Bank in China

Response by Rodger Baker
The more China reaches, the more insecure it feels

Beijing has embarked on a relatively steady appreciation of the renminbi since shifting to a managed peg last year. The Obama administration is mostly satisfied with this slower pace and has refrained from using the levers available to pressure China for any more rapid adjustments. However, as Yukon Huang argues, the current US domestic situation may be conducive to using the China issue for political gain. When there is a tough economic problem at home that cannot be resolved easily or quickly, it is often politically expedient to accuse a foreign power of unfair practices. The debate alone can often serve as a rallying point for political support.

Whether the bill is a serious attempt to curtail trade or just a source of renewed rhetoric, China must still respond on the basis of potential implications, rather than the likelihood of passage or action. As Beijing’s power increases, and its economy pushes Chinese interests farther from home, it is increasingly in competition with Washington. But the more China reaches, the more insecure it feels, making it particularly sensitive to any perceived pressure from the US.

Domestic issues facing China today – including an economic slowdown and stability concerns – are pushing the government to avoid any rapid shift in the renminbi’s value. And with a leadership transition planned for 2012, China could yet determine it beneficial to ratchet up tensions with the US in response to the currency bill.
The writer is vice president of strategic intelligence and lead China analyst at Stratfor, a Texas-based private intelligence company.