January 11, 2012 8:39 pm

How the globe can grind to a halt

china imports

If the world economy is to maintain any sort of momentum this year, it will be driven by fast-growing emerging markets led by China. But like the developed world, the emerging nations are living in the shadow of the globe’s greatest economic threat – the eurozone crisis.

From Galicia to Guangdong, business is more globalised than ever before. And the explosion of financial links, alongside traditional trade ties, means that economic news travels at unprecedented speed – especially, or so it often seems, bad news.

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While there are reports of progress in tackling the challenges faced by Greece, Italy and other vulnerable eurozone states, the eurozone’s traumas are far from over. “The crisis has damaged the European economy ... and this crisis is by no means behind us,” Olli Rehn, European Union economy commissioner, said this week. “It will take time. Structural reforms often take a long time ... Markets, however, tend to be impatient and this impatience can push sovereigns or banking institutions into a liquidity crisis.”

As things stand, the eurozone is expected to fall into recession in 2012, helping to drag global economic growth down to about 3-3.5 per cent. But the world could fare far worse if Mr Rehn’s fear of a possible liquidity crisis does materialise. Its effects would hit nations far beyond Europe, not least in the developing world.

As the charts show, the economic and financial links between the eurozone and developing countries run deep – and have grown hugely in the past decade. While these connections have contributed greatly to the development both of the EU and emerging markets, they are also transmission belts of economic danger. The dividing line between risk and reward can be very fine and the swing from boom to bust very rapid, as investors found in successive emerging market crises, including Asia in 1997-98, Russia in 1998, Brazil in 2002 and central and eastern Europe in 2009.

In 2011 tentative hopes of a solid global recovery were dispelled midyear by a slowdown in the US, concerns about a Chinese hard landing, and an upsurge in eurozone fears, triggered by panic over Greece. With US growth now healthier than was forecast, and China apparently heading for a soft landing, the focus on the eurozone is even stronger than it was last summer. As Mr Rehn says: “The sine qua non necessary to return to the path of economic growth is that we ... resolve the sovereign crisis and the banking sector problems.”

A glance at the data demonstrates the impact on emerging markets: a big sell-off in equities in 2011, higher bond yields reflecting bigger risk premiums, and forecasts of a growth slowdown in 2012 compared with 2011.

The effects spread through a range of channels, starting with the financial markets. Capital flows from the developed to the developing world have swung wildly since the onset of the 2008 global crisis and show few signs of settling. Meanwhile, bank credit from the developed to the developing world is falling after recovering from its previous slump in 2008-09. Leading this time are European banks as they cover losses and conserve capital to meet tough new rules.

The emerging region most exposed to the eurozone crisis is eastern Europe, especially those states that integrated their economies most with the west of the continent, such as the Czech Republic, Hungary and Poland. Not only do trade links run deep but these countries also depend on western European bank finance.

The risk of a general banking retreat from eastern Europe is limited. But banks are distinguishing between the economically strong, headed by Poland, and the weak, led by Hungary – as the populist government in Budapest has seen to its cost.

Further afield, eurozone-related risks are lower. While Asian exporters trade actively with the eurozone, they are increasingly looking for business in other emerging markets. But world financial markets are so interlinked that a shock for one financial centre quickly becomes a shock for all, including the emerging powerhouses.

Copyright The Financial Times Limited 2012.

January 11, 2012, 3:53 pm

Investment Banking For Europe, Few Options in a Vicious Cycle of Debt

     Simon Dawson/Bloomberg News

As difficult as the last two years have been for Europe, 2012 could be even tougher.

Europe has a $1 trillion problem.

As difficult as the last two years have been for Europe, 2012 could be even tougher. Each week, countries will need to sell billions of dollars of bonds — a staggering $1 trillion in total — to replace existing debt and cover their current budget deficits.

At any point, should banks, pensions and other big investors balk, anxiety could course through the markets, making government officials feel like they are stuck in a scary financial remake of “Groundhog Day.”

Even if governments attract investors at reasonable interest rates one month, they will have to repeat the process again the next month — and signs of skittish buyers could make each sale harder to manage than the previous one.

“The headline risk is enormous,” said Nick Firoozye, chief European rates strategist at Nomura International in London.

Given this vicious cycle, policy makers and investors are closely watching the debt auctions for potential weakness. On Thursday, Spain is set to sell as much as 5 billion euros ($6.3 billion) of government bonds. Italy follows on Friday with an auction of more than $9 billion.

The current challenge for Europe is to keep Italy and Spain from ending up like Greece and Portugal, whose borrowing costs rose so high last year that it signaled real likelihood of default, making it impossible for the governments to find buyers for their debt. Since then, Greece and Portugal have been reliant on the financial backing of the European Union and the International Monetary Fund.

The intense focus on the sovereign debt auctions — and their importance to the broader economystarkly underscores the difference between European and American responses to their crises.

Since 2008, there has been almost no private sector interest to buy new United States residential mortgage loans, the financial asset at the root of the country’s crisis. To make up for that lack of investor demand, the federal government has bought and guaranteed hundreds of billions of dollars of new mortgages.

In Europe, policy makers are still expecting private sector buyers to acquire the majority of government debt. Last month, in perhaps the boldest move of the crisis, the European Central Bank lent $620 billion to banks for up to three years at a rate of 1 percent.

Some officials had hoped that these cheap loans would spur demand for government debt. The idea is that financial institutions would be able to make a tidy profit by borrowing from the central bank at 1 percent and using the money to buy government bonds that have a higher yield, like Spain’s 10-year bond at 5.5 percent.

But the sovereign debt markets continue to show signs of stress. Italy’s 10-year government bond has fallen in price, lifting its yield to more than 7 percent, a level that shows investors remain worried about the financial strength of Italy’s government.

And European banks appear to be hoarding much of the money they borrowed from the central bank, rather than lending it to governments. Money deposited by banks at the European Central Bank, where it remains idle, stands at $617 billion, up from $425 billion just a month ago.

“It’s hard to see why a banker would want to tie up money in a European sovereign for, say, three years,” said Phillip L. Swagel at the University of Maryland’s School of Public Policy, who served as assistant secretary for economic policy under Treasury Secretary Henry M. Paulson Jr.

Italy’s troubles highlight how hard it is to generate demand for a deluge of new debt from a dwindling pool of investors. The country needs to issue as much as $305 billion of debt this year, the highest in the euro zone. By comparison, France, with the second highest total, needs to auction $243 billion of new debt, according to estimates by Nomura.

Governments like Italy’s are at the mercy of markets because they simply don’t have the cash to pay off even some of their bonds that come due. They must issue new bonds to cover their old debts, as well as their budget deficits, at a time when investors are growing scarce.

Banks, traditionally big holders of government bonds, have been selling Italian debt. “We’ve seen a lot of liquidation by non-European investors,” said Laurent Fransolet, head of European interest rate strategy at Barclays Capital in London. For instance, Nomura Holdings in Japan slashed its Italian debt holdings, mostly government bonds, to $467 million on Nov. 24, from $2.8 billion at the end of Sept.

European banks have also been dumping the debt. BNP Paribas, a French bank, cut its exposure to Italian government bonds to $15.5 billion at the end of October, from $26 billion at the end of June.

Italian banks, though large owners of their government’s obligations, may not want to take on too much more, to keep their investors happy. Shares in UniCredit have fallen more than 40 percent since last week as the Italian firm has tried to raise capital to comply with new regulations.

There are ways to avoid spectacularly bad debt auctions, at least in the short term.

The central bank can help by buying a country’s bonds in the market ahead of a new debt sale. That would help bolster prices at the auction, or at least keep them stable.

There is also some evidence that banks’ government-bond selling may have abated at the end of last year, according to Mr. Fransolet. Central bank figures show European financial firms acquired $2.4 billion of Spanish government bonds in November, after selling a monthly average of $4.8 billion in the preceding three months.

Governments may also be able to attract new buyers to their bond markets. Belgium sold $7.2 billion of government bonds to local retail investors last month, in part appealing to their patriotism.

Opportunistic hedge funds, betting the market is too pessimistic about certain European countries, may also bite. Saba Capital Management, a New York-based hedge fund headed by the former Deutsche Bank trader Boaz Weinstein, owns Italian government bonds, though it does so as part of a wider trading strategy that includes bets that could pay off if Europe’s problems worsen.

But it is doubtful that Italy and Spain can find enough new buyers this year to bring their bond yields down to sustainable levels. Instead, if their economies slow — and if their governments become unpopulardebt auctions could fail and their cost of borrowing could rise even more.

All eyes would then turn to the central bank for drastic action. It could lend more cheap money to banks, in the hope that some of it might find its way into government bonds. Or it could become a big buyer of government bonds itself, printing euros to finance the purchases.

But that may not be a lasting solution, since the central bank’s actions could scare off private investors. Typically, when government-backed organizations like the central bank hold a country’s debt, their claims on the debtor rank higher than those of other creditors. For that reason, private investors might think their holdings would fall in value if the central bank became a big owner of Italian debt — and they might retreat.

At the same time, the crisis response in the United States did not depend solely on government-backed entities like the Federal Reserve to buy housing loans. Professor Swagel of the University of Maryland points out that banks and investors also took large losses on existing housing debt. While painful, the mortgage debt proved less of a drag on the financial system.

So far, Europe has been averse to taking permanent losses on government bonds. Except in the case of Greek debt, European policy makers have shied away from any plan that could mean private holders of government debt get hurt.

However, Nouriel Roubini, a professor of economics at the Stern School of Business at New York University, recently argued in a Financial Times editorial that Italy’s debt should be reduced to 90 percent of the gross domestic product from 120 percent. In such a situation, investors might suffer a 25 percent hit on the value of their Italian bonds, he said.

Such haircuts might seem like the recipe for more instability right now. But if Europe struggles to find buyers for its debt, more radical options are likely to be considered. Europe’s debt problem is huge, and the experience in the United States suggests dealing with it may take several, more drastic approaches.

“If you go halfway, you’ll never get to the end,” Professor Swagel said. “And that describes European policy-making.”

January 11, 2012 2:20 pm

West needs to go back to capitalist basics

The Malays have a saying which inter alia means that when you lose your way, go back to the beginning and start again. I believe that everyone has lost their way in handling the current financial crisis. The west in particular needs to rethink some essentials.

The world is still Eurocentric: how Europe handles the financial crisis is of universal importance. But I have serious doubts about Europeans’infallibility”. I particularly dislike their double standards. Centuries of hegemony have convinced them they know best what is good for the world: their values are to be accepted as universal; Asian values are deemed irrelevant.


This explains the simplistic solutions offered to east Asian countries when currency traders impoverished them. Malaysia was told to raise interest rates, have a surplus budget, allow distressed banks and businesses to go bankrupt, etc. This was the formula for all. Yet when America and Europe faced their financial crisis, they did everything they told Malaysia and east Asia not to do. While these measures worked for Asia, they are not going to work for the west.

For Europe for much of the past two centuries, capitalism has had a clear and straightforward narrative. For a long while Europe’s manufactured products lined the shelves of the world’s markets. They monopolised and dominated world trade and business. Their people enjoyed the highest standards of living. This increase in European growth and wealth would have gone on indefinitely. But after the second world war Japan industrialised and produced cheaper yet good quality goods. Then Taiwan, South Korea and China got in on the act. Rapidly the Europeans lost their markets.

Unable to compete, the Europeans and particularly the Americans opted for the financial markets. Inventing new financial products such as short selling of shares and currencies, subprime lending, securitisation, leveraged investments through hedge funds and a multitude of others, they apparently continued to grow and prosper. But the finance market spins off no real businesses, created hardly any jobs and gave rise to no trade. Getting greedy, they abused the system, manipulating the market for greater profits.

In Hong Kong in 1997 I spoke at the meeting of the International Monetary Fund and the World Bank and I blamed the financial crisis in east Asia on currency trading. I told them currencies were not commodities and should not be traded. But the World Bank and IMF did not care. They even accorded currency traders such rights as not having to be transparent and not paying taxes. They gave these exemptions in the name of free trade, and yet others had to be transparent and to be subjected to regulations. We concluded that their recommendation would bankrupt us and make us dependent on their loans.

I was condemned for my criticism of currency trading. But the exploitation and abuses of the financial market could not last forever. In 2008 the bubble burst. Banks, insurance companies, investment funds and even countries went bankrupt. But for its position as the currency for trade settlements, the dollar would be worth almost nothing.

Just as in the east Asian countries earlier, America and Europe became poor. The refusal to accept their impoverishment has resulted in their refusal to accept austerity measures. Their people demonstrate and go on strike against the measures. This simply aggravates matters.

Asian countries behaved differently. When they became poor because of the devaluation of their currencies they lived within their means. Some countries went to the World Bank and the IMF but Malaysia fixed the exchange rate and prevented the currency traders from accessing the ringgit. We were told our economy could collapse, that no one would lend us money, and we were warned of dire consequences. But nothing like that happened. Malaysia recovered faster than the rest.

The others also recovered because people actually gave money and jewellery to their governments to help pay debts. The workers worked harder and accepted living with lower standards. The only way for the European economies to recover is to admit that they are now poor and live within their means.

Then they must go back to doing real business, ie to produce goods and sell services. Wages, bonuses and other perks have to be lowered to become competitive. In addition the financial market should be overseen and controlled by the government. Many financial products should be strictly regulated if not banned.

A newBretton Woods” should be convened with adequate representation from the poor countries. It should consider a trading currency based on gold, against which all other currencies should be valued. The fluctuation of the price of gold would be minimal. Business would be exposed to less uncertainty. Governments should fix the exchange rate based on gold or economic performances. There should be no trading in currencies.

Banks should be better regulated and new rules made to prevent excessive leveraging, limit loans and stop subprime lending. The financial system should be standardised and should support real business. These measures will take time, but will ensure that the kind of crisis the world is going through is less likely to recur.

There can be no return to the status quo ante. Europeans have to accept the days of Eurocentricism are practically over. Europe must look to the east as well for solutions.

The writer was prime minister of Malaysia from 1981 to 2003

Copyright The Financial Times Limited 2012.

A Radical Solution For America’s Worsening College Tuition Bubble

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