Putting The EU Crisis Into Perspective by Raymond CS Lee

What are the reasonable options for EU in the face of the current financial crisis?

The European Union has the option of either excluding Greece and the other peripheral nations, namely Ireland and Portugal, or set up a fund to absorb the bad debts of their financial institutions.

It has come to pass that EU has decided to set up the European Financial Stability Facility.

Why don't the European Union member countries choose to exclude Greece?

The first reason is banks. Banks with exposure to Greece will have to write-off most of the bad debt.

On 20 August 2011, Kabir Chibber of BBC News reported that French banks have heavy exposure to Greek debt and have already seen sharp falls in their share price in the past months. In September 2011, Moody's downgraded Credit Agricole and Societe Generale after reviewing their exposure to Greek debt. Credit Agricole and Societe Generale have seen their share prices fall by about two-thirds since February, while BNP has fallen by more than half.

Germany's banks also have a heavy exposure to Greek debt. Hence, in the event of a Greek default, Germany would probably also have to bail out its own banks.

In addition, UK banks have a heavy exposure to Irish debt.

The second reason is that contagion may spread to Italy, Portugal, Ireland and Spain.

On 30 September 2011, reported by Kristy Walker of the Daily Mail UK:

According to a report by Fathom on the default probability of France, Italy and Spain:

If Greece fails the probability of Italy and Spain failing will increase to 31.4% and 31.3% respectively, while if all the peripheral nations such as Ireland, Portugal and Greece were to fail, the probability of Italy and Spain failing will move up to almost 50%.

It further reports that should Italy and Spain fail as well, the probability of France failing will also rise to slightly less than 50%.

Hence, Greece is not allowed to fail.

Now if the EU members are not exactly willing to bail out the failing nations but are unable to exclude the "failing nations", what strategy can they adopt?

They are setting up an emergency fund in the form of EFSF (European Financial Stability Facility). This emergency fund derives its assets from the issuance of ECB Bond that are guaranteed by the ECB Bank, hence drawing on the combined might of all 17 EU members.

The purpose of this facility is to provide support to financial institutions that have lent to "failing" EU nations to ensure that they remain a going concern despite the financial market liquidity drying up. Please note that as long as these financial institutions remain a going concern, their operational cash flows can be utilised to write-off the bad debts provided the financial situation do not deteriorate. Hence, the "failing" nations are required to abide with the Treaty of Lisbon euro convergence criteria to keep their deficit within 3% of GDP.

How long will the EU financial crisis likely to last?

According to a report by AFP on October 5 2011 detailing Greece budget deficit run-off, based on the most optimistic scenario, Greece budget deficit will fall back into EU permissible level, ie. 3% of GDP, by 2014. Hence it is not surprising that Holger Smielding, the chief economist of Berenberg Bank reportedly said to the BBC News on 23 June that

"Europe is, as we speak, strengthening its consensus against contagion by raising borrowing capacity and by preparing the permanent European Stability Mechanism by 2013".

So 2013 or 2014 is the time frame that EU nations are working on.

It is not surprising that Greece is putting their house in order by 2014. Italy, Spain, Portugal and Ireland are also adhering to the same time frame. Hence it is not untrue that Greek Prime Minister George Papandreaou lamented that Greece is made the scapegoat. Even though it is not intentionally so.

Now lets take a look at the EU nations fiscal position as at April 2011:

Member State sorted by GDP	GDP in billions of USD (2010)[10]	GDP % of EU (2010)	Annual change  % of GDP (2010)	GDP per capita in PPP US$ (2010)	Public Debt[11] % of GDP (2010)	Deficit (-)/ Surplus (+)[12] % of GDP (2010)	Inflation % Annual[13] (2010)	Unemp.[14] % Q2 2011 (*=Q1 2011)
European Union[15]	16,228.2	100.0	1.76	30,388	80.0	-6.4	2.1	9.5
Germany	3,315.6	20.4%	3.50	36,033	83.2	-3.3	1.2	6.0
France	2,582.5	15.9%	1.48	34,077	81.7	-7.0	1.7	9.9
United Kingdom	2,247.4	13.8%	1.25	34,919	80.0	-10.4	3.3	8.0*
Italy	2,055.1	12.7%	1.29	29,392	119.0	-4.6	1.6	7.9
Spain	1,409.9	8.7%	-0.15	29,741	60.1	-9.2	2.0	21.2
Netherlands	783.3	4.8%	1.75	40,764	62.7	-5.4	0.9	4.4
Poland	468.5	2.9%	3.82	18,936	55.0	-7.9	2.7	9.4
Belgium	465.7	2.9%	1.97	36,100	96.8	-4.1	2.3	6.8
Sweden	455.8	2.6%	5.54	38,031	39.8	0.0	1.9	7.4
Austria	376.8	2.3%	1.96	39,634	72.3	-4.6	1.7	3.7
Denmark	310.8	1.9%	2.07	36,449	43.6	-2.7	2.2	7.1
Greece	305.4	1.9%	-4.5	28,433	142.8	-10.5	4.7	16.7*
Finland	239.2	1.5%	3.12	34,585	48.4	-2.5	1.7	7.8
Portugal	229.3	1.4%	1.39	23,222	93.0	-9.1	1.4	12.3
Ireland	204.3	1.2%	-1.04	38,549	96.2	-32.4	-1.6	14.6
Czech Republic	192.1	1.2%	2.32	24,869	38.5	-4.7	1.2	6.7
Romania	161.6	1.0%	-1.27	11,860	30.8	-6.4	6.1	7.3
Hungary	128.9	0.8%	1.21	18,738	80.2	-4.2	4.7	10.3
Slovakia	87.4	0.5%	4.02	22,128	41.0	-7.9	0.7	13.4
Luxembourg	54.9	0.3%	3.39	81,383	18.4	-1.7	2.8	4.9
Slovenia	47.8	0.3%	1.20	28,030	38.0	-5.6	2.1	7.8
Bulgaria	47.7	0.3%	0.15	12,851	16.2	-3.2	3.0	11.7
Lithuania	36.4	0.2%	1.33	17,185	38.2	-7.1	1.2	15.6*
Latvia	24.0	0.1%	-0.34	14,460	44.7	-7.7	-1.2	16.2*
Cyprus	23.1	0.1%	1.04	28,255	60.8	-5.3	2.6	7.2
Estonia	19.8	0.1%	3.10	18,518	6.6	0.1	2.7	12.8*
Malta	8.3	0.1%	3.65	24,792	68.0	-3.6	2.0	6.5
Euro convergence criteria					60	-3	1.5

A quick look at the Euro convergence criteria will indicate that besides Greece, Portugal, Italy and Ireland, the stronger/larger EU nations such as Germany, France and UK also exceeded the criteria for public debts and deficit as a % of GDP. Hence there is not much leeway to offer additional lifeline to Greece.

Furthermore, prudence should be encouraged because the threat of contagion to other peripheral states such as Lithuania, Latvia and Slovakia is very real given the twin ills of high unemployment and deficits.

On October 13 2011, The Straits Times in Singapore reported that

"Euro zone nations are mulling ways of multiplying by up to fivefold, or to 2.5 trillion Euros (S$4.4 trillion) the firepower of their rescue fund, EU sources told AFP on Wednesday"

The Asian markets reacted with 5 days of "bull run" due to this news.

Note that they are unlikely to (should not) be able to come out with such a rescue package in such a short time because the rich EU nations will never commit to such leverages. Hence the fine print in this news report [underlined].

 "European Commission president Jose Manuel Barroso earlier on Wednesday urged the 17-nation euro zone to increase the firepower of the European Financial Stability Facility (EFSF), without governments providing new guarantees."

Without government guarantees, no financial institutions will commit to plough in more funds.

Another reason that deter Germany and France from doing more is the very real danger that they themselves may be downgraded. This is reported by Daniel Wagner on October 18 2011,

"The euro is falling against major currencies after Moody's warned it may lower France's credit rating.

The rating agency warned Tuesday that it might downgrade France's creditworthiness in the next three months because of the nation's weakened economy and the costs of the European debt crisis. The French economy is Europe's second biggest. France is expected to shoulder much of the burden of bailing out smaller neighbours and propping up banks."

Now that the EFSF [European Financial Stability Facility] is set up and have issued ECB Bond. How is ECB funding this facility?

There are 2 options

·         Through "voluntary" funding from EU members

This ad-hoc arrangement is not very popular among EU members. The Christian Democrat suffered major losses at the recent polls for Brussels and other members such as the Netherlands, Luxembourg etc are asking for cash collateral.

·         Through taxes, beginning with financial transaction tax.

The UK is strongly against this financial transaction tax, or the so called Tobin Tax, and has voiced its intention to veto against it. Is this tax just the beginning?

According to the Daily Mail report by Kirsty Walker on 30 September 2011:

This financial transaction tax will likely haul in approximately £50 bn. UK is strongly against this tax because 80% of the tax proceeds come from UK. Furthermore this tax is expected to spark an exodus of banks and investment firms from London and likely hammer personal and corporate taxes for UK.

This tax, however, signals the beginning of the establishment of a treasury in EU. Strictly speaking, EU is moving towards nationhood and this statement is in complete alignment with the statement of Jose Manuel Barossa, the head of the European Commission as he quoted

"EU is facing its 'greatest challenge' and called for closer economic unification to tackle the debt crisis.

This, however, is not the only integration that is happening. The same newspaper article reported that the British government through Deputy PM, Nick Clegg delivered a

"fiercely pro-European speech calling for greater unity and cooperation between countries on issues such as defence"

In fact, my research on the "Stages of Economic Integration" which I have simplified into a table in Appendix 1 indicate the integration is moving towards nationhood. Other integration in the books include

·         A common defence, foreign and security policy

·         A common economic, employment and social policy

·         A common research and development, technological development and space program

·         A common education, tourism, culture, civil protection and sports

·         A common administrative, energy and transport system

With the establishment of a centralized Treasury and the resulting transfer payments, the rest of the puzzle will naturally fall into place since each EU member would be naturally incline to share their expenses once the revenue mechanism is in place.

However, EU members would have to grapple with the loss of sovereignty and the issue of integrating EU taxes with their own local government taxes. Fierce rejection like the one UK voiced against the Tobin Tax is expected.

What will EU likely to look like after the crisis?

EU will be a democracy with a population of 498 million people - much larger than the US - and a per capita income of US$32,615 with a wide variation across region. Per capita income variation across region is huge: 85,800 euro in Inner London and 7,100 euro in Severozapaden (Bulgaria).

EU as a whole is the world's largest importer and exporter. With an unemployment rate of 9.5% and deteriorating and wide regional specialisation it is likely to be the fiercest and most competitive trading nation such as the world has never seen.

The world can expect fierce rivalry in aircraft manufacturing between Airbus and Boeing when Airbus become a local key industry for the "EU Nation".

Rivalries can be expected in tourism as well when the whole of Europe can be marketed as a single destination with all the supporting industries such as Air France-KLM [largest airline by revenue], Anheuser-Busch InBev [largest beer company], L'Oreal [largest cosmetic and beauty firm], LVMH [largest luxury manufacturer] combining to support the tourism industries.

EU also has the largest financial institutions in terms of revenue [Allianz] and market capitalization [Santander].

EU will also have one of the largest army in the world with more than 1.8 million active armed forces, 6 aircraft carriers, 1,349 transport aircrafts, 3,523 combat aircrafts and 6,895 main battle tanks. Its current combined defence budget of US$406.7 bn is only second to the US defence spending of US$620.5 bn.

We will be witnessing the emergence of a superpower that has no parallel in human history - that surpasses the US - with the economic and military clout to dictate or extract whatever terms of engagement they desire.

But how strong is this coalition given the wide variation in regional specialisation, nationalistic sentiment, the democratic nature of the European council and parliament and the tenure of each president [2.5 years].

The key success factors for EU lies in whether they can integrate regionally [between the east and west as well as north and south]. Their success will depend on whether they can cut the unemployment rate by half to 4.75%. This requires political will to create jobs in different regions according to the different skill sets that they possess. At the same time maintaining fiscal discipline to strictly implement the EU convergence criteria of

• Public debt as a % of GDP of 80%
• Deficit as a % of GDP of 3%
• Inflation % per annum of 2.1%.

EU will definitely be a superpower when they emerge from this financial crisis but whether they will surpass the US will depend on how well they integrate regionally and the political will to maintain fiscal discipline and overcome nationalistic sentiment that come with job re-alignment across regions.

How long will this EU financial crisis likely to last?

The crisis, in all likelihood, might last until 2014 and even then recovery will be gradual unless there is a major war effort or a disaster of a global proportion that provides the opportunity for a major reconstruction effort.

Why such a pessimistic view?

Simple. For an economic recovery given the current level of unemployment in EU (9.5%) and US (9.1%), we need to create jobs. There is only 2 ways to create so many jobs - that is through government spending or private spending.

Monetary easing will not create jobs because making the cost of money cheaper may not induce the public to invest if the traditional sources of investment such as housing and machineries are no longer lucrative. This is due to the housing bubble and the long term negative outlook for the global economy does not encourage expanding the means of production.

Fiscal expansionary policy is currently not an option for EU nations due to their budget deficit and the limitations of the EU convergence criteria. EU will need some help to lift them out of the current crisis, if the world wants to see EU coming out of the current financial crisis before 2013.

So to substantiate my analysis, the following news on October 17 2011 by AFP with regards to the downgrading of Spain reports :

"Both agencies [S&P and Fitch] judged the outlook to be 'negative,' meaning there is a risk of more cuts ahead. A third rating agency, Moody's Investors Service, will likely downgrade Spain's credit standing by the end of October, as it has been threatening to do since the end of July.

All three give similar reasons: feeble growth, bad finances in the regional governments, a banking sector yet to recover from the 2008 property bubble collapse, as well as massive private debt held by households and businesses."

These EU nations are not allowed to embark on any fiscal expansionary policy given their current level of deficit.

The other engine of growth would have to come from the US but the political wrangling between the Republicans and Democrats are unlikely to result in the full implementation of Obama's $442 bn fiscal expansionary policy until after the presidential election at the end of 2012.

That leaves only China with the financial ammunition to give the 2 major powers a helping hand. Actually, China is an interesting case study.

When Wen Jiabao took over the mantel of premiership from Zhu Ronji, he engineered the daring rescue of the state-owned enterprises from a financial abyss and returned them to respectable profits.

What is stopping Wen Jiabao from doing the same with the local governments? My deduction is the coming leadership transfer in 2012. I believe Wen Jiabao will restrain from performing this task because it takes a few years to complete. So with the delay in fixing of the local government debt, are they likely to embark on major fiscal expansionary policy? It is unlikely they will do so before the leadership transfer in 2012.

Will they allow their currency to freely float? I have been wondering why China keep increasing their bank reserves requirement until it stands at 18.5% currently. The answer is quite simple actually. Just look at the matter from Wen Jiabao's perspective. He is staring at global deficits - US, Europe, Japan and the local/municipal governments - simultaneously money keeps rushing to China's shore due to the quantitative easing. The only prudent thing to do is to insulate China's financial system from external and internal shocks and that is exactly what he did. Will he allow the yuan to rise rapidly? My bet is he will not rock the boat before the leadership transfer in 2012.

The Japanese government is already experiencing severe deficit hence is unlikely to embark on any major fiscal expansionary policy.

Why is EU in a deadlock? What does William Hague means when he liken EU to a burning building with no exit.

Germany and France cannot exclude Greece without major consequences, especially on their banks. Worst, contagion may spread to Spain, Italy, Portugal and Ireland. But they are also unwilling to bail-out the "failing" nations. Hence their only option is to set up an emergency fund to provide time for their banks to slowly write-down the losses and for the "failing" nations to put their house in order.

How would Asia react to these changes?

Firstly, I would like to stress that if we look back in year 2099 we may see that we have been wrong again. The 21st century may not be a century of Asian Renaissance. All the trajectories and projections in the last decade did not manage to capture the wide diversity of Europe, the fluidity of capital and the fluidity of human migration [in the coming years]. If the 20th century sees the Jewish, Chinese and Indian diasporas. The 21st century will see the greatest movement of people within Europe, between the English speaking countries and within Asia. Furthermore, we have not factored in the wide diversity of Asia, the fluidity of capital and the fluidity of human migration [in the coming years]. Most importantly we have not consider the political will of Washington.

The key success factors for US in Asia lies in its ability to engage the pacific nations at their needs level instead of dictating US own needs. When the nations engaged sees a common goal to fight the same cause with the US to keep meeting their joint needs the engagement between them will grow. Their needs are economics not military.

Mr Yoichi Kato, the national security correspondent in Japan's Asahi Shimbun newspaper, summed up their dilemma thus: "Most of the countries in the region have China as their major trading partner, if not the largest, while they depend on the US for the maintenance of the regional security order, including freedom of navigation. This dual dependency, however, makes it harder for the regional states to decide what course of action to take, if and when China challenges the US primacy."

I believe the Chinese government will choose to change its political system given the triple threats of the re-emergence of US and EU, the unrelenting migration of rich and educated Chinese from China and as China's push inland to connect with Asia via high speed railway.

How will all these forces come together in China?

Projections into the future of China will naturally require the retrospective view of the past. I believe given the income disparity between urban and rural population in China, the next generation of Chinese leaders will fully liberalise the movements between urban and rural Chinese - so called human or hukou reform to contrast it will land reform. This reform should be implemented within 5 years. In the meantime, the yuan will be fully convertible.

Given the competition from US and Europe after the yuan convertibility, the Chinese government would most likely loosen control over their state-owned enterprise to regain back control over their  monetary policy.

In the meantime, with the extension of the railway system and the business and familial relationship of the Chinese people in Indo-China, Burma, Thailand and South East Asia the two-way movement of these Chinese people from and to China will be beneficial for both economic and political integration.

Someone once asked me, how will these affect the question of Taiwan. I draw a timeline for my answer.

The Taiwan Presidential election is always a close run. The number supporting the status quo and the number supporting the independence of Taiwan from China has been a close 50/50. The population of Taiwan that migrated from China have always had close ties with their relatives in China. Hence it did not come as a surprise when China opened up their Special Economic Zones that it was the Taiwanese who responded enthusiastically to invest in China.

Before the 2008 Taiwan Presidential election, the KMT loses by a whiskers. What happened in the 2008 Presidential election? The pro-business Taiwanese decided to vote for KMT and the tide switch to 58% for Ma's KMT and 42% against. Since then, what has happened?

The Chinese government has established direct flights with Taiwan, invited Taiwanese to study in Chinese universities and has also sent a large contingent of Chinese students to study in Taiwan. Unlike Asians studying in English speaking universities around the world, all these Taiwanese and Chinese students are highly likely to settle after their studies due to their familial links, cultural and language links and they will most likely vote for KMT. These might not have a major impact but these groups are like a tidal wave and their roots with China will only grow deeper. Similarly, those Taiwanese who has moved to China to work and settle down. Over a longer term, the tidal wave will flow in favour of re-unification of Taiwan and China. It is just a matter of time. I expect the KMT's Ma to win the 2012 presidential election with more than 60% of the votes.

The following statement by Ma Ying-Jeou in Taipei on 17 October 2011 as reported by REUTERS will give an indication about the strength of this tidal wave, as this speech is unthinkable in 2007.

"'Under the conditions of a high level of consensus among Taiwan's people and sufficient trust between the two sides, we could consider a peace treaty with China in 10 years,' Mr Ma told reporters at a briefing on his policy outline for the next 10 years."

I would not think it unthinkable to consider the possibility of a rail link and highway connecting Taiwan to China in 20 years time. It makes economic sense.

Now is it possible to consider a rail linking China with South Korea? When we ask the question of South Korea it is inevitable that we talk about North Korea?

Now lets consider the future of a united EU and a liberalised China - after land and human (hukou reform) - with rail connection to a market of more than 2 billion people. Can Korea or Japan afford to ignore China?

Now, back to the question of North Korea. We all know that politics is a science of getting people's support or building a network of support. The Kim's family political control over North Korea will weaken over each passing generation especially with the country in dire straits.

The key to China success is dependent on how well they will be accepted by the states in the pacific region. This depend on the promulgation and enforcement of a morally uplifting and fair sets of laws and in China's fairness in its dealings with the states in the region.

A totally unrelated and unexpected outcome of this discussion is that potentially the manufacturing and back room jobs may flow back to Europe and US after the financial crisis level the playing field between Europe, US and Asia. Whichever nations that missed the development opportunity in the next 5 years may have missed the boat.

The opinions in this document are entirely the authors own and should not be construed as any professional advise.

Important note: While every care has been taken in the preparation of this document. The author makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided

References

¹ Robert Plummer & Lawrence Peter, BBC News, Greek Crisis: Is there a solution? 21 June 2011, www.bbc.co.uk/news/world-europe-13856783

² Kabir Chibber, BBC News, The domino effect in Europe's debt crisis, www.bbc.co.uk/news/business-14985256

³ BBC News, Greece Crisis: What now for the euro project? www.bbc.co.uk/news/business-13872847

⁴ AFP, MyPaper, EU Plan stalls, forcing Greece to cut more, October 5 2011

⁵ REUTERS, Straits Times, Taiwan's president considers peace treaty with China in 10 years, October 17 2011

⁶ AFP, Straits Times,  Spain faces hard 2011 with big deficit, slow growth, October 17 2011

⁷ AFP, Straits Times,  Euro zone mulls hiking rescue firepower to $4.4 trillion: Sources, October 13 2011, http://www.straitstimes.com/BreakingNews/Money/Story/STIStory_722827.html

⁸ Wikipedia, Military of the European Union, http://en.wikipedia.org/wiki/Military_of_the_European_Union

⁹ Wikipedia, Economy of the European Union, http://en.wikipedia.org/wiki/Economy_of_the_European_Union

¹⁰ Kirsty Walker, Daily Mail, Euro IS a burning building with no exits, says Hague as his warning of 13 years ago is proved right, September 30 2011, http://www.dailymail.co.uk/news/article-2042808/William-Hague-Euro-debt-crisis-burning-building-exits.html

¹¹ Zakir Hussain, Straits Times, Allies Torn Between Security and China Trade, October 22 2011

¹² Daniel Wagner, The Associated Press,  Euro falls vs dollar on France downgrade warning, October 18 2011

Appendix 1

Stage	Stage of economic integration	General Category	Obstacles/ barriers
0	Normal trading relation
1	Preferential trade		Reduction of tariff
2	Free Trade		Eliminate tariff
2	Free Trade		No import quota
2	Free Trade		No preference on goods & services traded
2	Open border		Free movement of people
2 to 4	Custom union		Common external tariff
2 to 4	Monetary Union		Common currency
3 to 5	Transition to Common Market		Common external trade policy
3 to 5	Transition to Common Market		Common competition policy
3 to 5	Transition to Common Market		Common policy on product regulations
3 to 5	Economic Union	Common Market	Freedom of movement of capital & labour
5 to 6	Fiscal Union	Nationhood	Common treasury
5 to 6	Fiscal Union	Nationhood	Collection & expenditure of taxes
5 to 6	Fiscal Union	Nationhood	Transfer payments
5 to 6	Fiscal Union	Nationhood	Common defence, foreign & security policy
5 to 6	Fiscal Union	Nationhood	Common economic, employment & social policy
5 to 6	Fiscal Union	Nationhood	Common research & development, technological & space program
5 to 6	Fiscal Union	Nationhood	Common education, tourism, culture. Civil protection, sport, administrative, energy, transport etc