Economics: LatAm lesson for EU
Europe’s leaders must heed the precedents of the past if they are to stem the tide of recent economic woes
In spite of the traditional warning accompanying investment products, that past performance is no guide to future performance, when it comes to the eurozone crisis precedents can most definitely be cited.
The most recent of these was Latin America’s financial crises, culminating in Argentina’s default in 2001. Here are some of the lessons investors can learn from the Argentine crisis 11 years ago.
2001: Crisis in Argentina
- Reductions in fiscal deficits through budget cuts or tax increases did not inspire confidence or improve stability in Argentina. Instead they caused public unrest, leading to riots, runs on banks and the eventual resignation of the government.
- Argentina relied on a currency peg to the dollar and only started to recover once it abandoned the peg and reverted to the peso. Devaluation of the currency helped exporters and also boosted import competing companies.
- The country relied heavily on foreign creditors to buy their bonds and the economy, which had a debt to GDP ratio of roughly 50 per cent before its default. It was also sensitive to external events and shocks, particularly from neighbouring countries. The Brazilian and Mexican currency crises exacerbated Argentina’s situation.
- The government initiated an exchange rate policy in the second quarter of 2002. It strengthened foreign exchange controls and intervened in the foreign exchange market by selling and later buying dollars and restricting the outflow of pesos. This helped to stabilise the country and manage the inflation that ensued after the peso was devalued. By 2003 the government set out its plans to maintain a “stable and competitive real exchange rate”.
- Argentina’s default was not as expensive as expected. A paper from the US Center for Economic and Policy Research suggested the IMF placed pressure on the government to offer better terms to the defaulted foreign creditors but eventually a debt swap was arranged in 2005 that wiped $67.3bn of foreign debt off the books, at the time a record 65.6 per cent “haircut”.
- Further measures implemented following the default included two taxes. One was applied to financial transactions and the other to exports. This allowed the government to get some of the windfall profits that exporters received as a result of the devaluation. Together these two taxes pulled in roughly 2.7 per cent of GDP in 2004.
2012: Crisis in Europe
- Peripheral European countries in particular, but also core European countries such as the UK, have imposed austerity measures as a way to tackle government deficits. However, the trend in recent months has been towards growth and away from austerity, as demonstrated by the election of left-wing French president François Hollande.
- The eurozone crisis is exacerbated by the existence of a common currency that is shared by the healthier economies of core countries such as Germany and France as well as the struggling peripheral nations of Greece, Portugal and Italy. Unlike Argentina, this means countries such as Greece can’t devalue their currency to help relieve economic pressure.
- Peripheral countries such as Greece relied on foreign creditors to buy bonds and were also sensitive to external shocks, particularly within the eurozone. Contagion from Greek debt owned by eurozone banks has been one of the key factors in the spread of the crisis.
- European countries have yet to initiate capital controls but might be forced to if one of them abandoned the euro.
- In October 2011 private investors in Greek debt were required to take a roughly 50 per cent ‘haircut’ on Greek bonds as part of a range of measures announced by European leaders. As with Argentina, total default may yet ensue.
- Instead of imposing taxes on financial transactions or exports the ECB has reduced interest rates and introduced long term refinancing operations (LTRO) to ease government finances and make funding more available for the eurozone’s banking system. European leaders have also established the European Financial Stability Facility (EFSF) as a way of providing bailouts for countries in trouble.
So far Greece, Ireland, Portugal and Spain have made use of the facility.
Keith Wade, chief economist at Schroders, says:
“We still expect a Greek exit from the euro in 2013. The EU authorities are expected to be able to contain this, but the tension created by another stand-off between Greece and its creditors will take its toll on business and consumer confidence. Before then, we expect Spain to request and be granted a bailout later this year. With regards to the UK, we have downgraded growth for 2012 and 2013 after the Q2 GDP data showed more fundamental weakness than we had expected. Although the data is being temporarily depressed by the extra bank holiday to celebrate the Queen’s Diamond Jubilee, the breakdown of the data shows that when excluding the contribution from inventory build-up, Q2 GDP would have contracted by 1.6 per cent - the worst reading of final demand since Q2 1980. This suggests that growth is likely to be a little weaker than we had previously forecast.”
Russ Koesterich, iShares global chief investment strategist, says:
“European leaders need to address three broad topics in the coming months – the details of a European wide banking system (including European wide deposit insurance), structural reforms in much of southern Europe, and the path towards further fiscal integration. Unfortunately, they need to demonstrate clear progress on these issues in the middle of several destabilising forces, including growing scepticism regarding Greece’s ability to remain in the euro and a deepening recession in many countries. In the near-term, the ECB will be the critical institution on two counts. First, it is the only institution currently possessing both the means and the potential nimbleness to mitigate the pressure on European sovereign debt. Second, Europe cannot wait for bank reform. As long as a Greek exit is a real possibility, a run on the southern European banks remains an existential threat to the euro. The ECB must move quickly towards more integrated European banking regulation.”