When The Economy Implodes

When the Economy Implodes

 18^th October 2009

The Malta Independent on Sunday

Alfred Mifsud

Never in a million years had I thought it possible that I could live to see three rich European countries experiencing an economic implosion. I am not talking about bottom-of-the-league countries like Ukraine or Albania; I am talking about countries that, before the financial crisis of 2008, were considered amongst the richest and most successful. Specifically, I am referring to Ireland, Iceland and Latvia.

Politically, these countries enjoy a different status. Ireland is a fully-fledged EU member that adopted the euro and transformed its economy through substantial financial assistance from the EU funds. Its GDP was among the highest in the EU and many referred to Ireland as a shining example of a country that made the best use of EU opportunities to attract huge waves of foreign investment and become leaders in financial services and back-office operations. This sparked massive bank-credit-financed investment in real estate, residential, commercial and leisure.

Latvia is one of the Baltic countries that regained its sovereignty after the collapse of the Soviet Union and successfully achieved EU membership in 2004, along with eight other eastern European countries and two Mediterranean countries, including Malta. Its economy was floating up nicely with improving GDP and it had attracted European foreign investment to the extent that its banking sector was practically dominated by acquisitions made by Swedish operators. Sweden acted as a sort of a sponsor for the economic development of the three Baltic states to ensure that they continued to distance themselves from economic dependency on their former Russian motherland and Latvia was in line to convert its currency to the euro around 2012.

Iceland was not an EU member, much less a member of the euro area. However, along with Norway and Liechtenstein, it was a member of the European Economic Area, which gave it many rights of freedom of establishment in other EU countries. It is a large country with a small population, very resourceful and having a thriving fishing industry that was one of the main reasons why it frowned on EU membership, which would have entailed opening up its territorial fishing waters to intrusion by other EU countries, particularly Spain. It had adopted a very aggressive international economic posture, punching well above its weight, with its banks opening operations to raise deposits from other EU countries in order to finance the boastful foreign acquisitions by its flamboyant entrepreneurs, which also included ownership of a local healthcare company Pharmamed.

The economy of three countries enjoying a different status collapsed as the plumbing of the world’s financial and credit system became clogged as a result of the US property sub-prime crisis. Their banking systems lost the confidence of depositors, domestically and internationally, and had to be supported by their states and, in the case of Latvia, by the Swedish owners of its banking system, following nudging at EU level to ensure that Sweden lived up to its moral responsibilities not to let Latvia implode. In case of Latvia and Iceland, the IMF had to be called in to engineer a rescue operation and basically take over the economic management of the countries from their governments to ensure that the necessary but hard adjustment decisions were taken.

Both Latvia and Iceland are living through a harrowing experience, with GDP contraction in high double figures and a brutal reduction in government spending, even in socially sensitive programmes, resulting in deep and sudden cuts in the standard of living of the ordinary citizen. Iceland has experienced a sharp devaluation of its currency and is now trying to embark on an EU membership project to bring back stability to its economy and inspire fresh confidence in foreign investors.

Latvia is desperately trying to avoid devaluing its currency and has shifted the adjustment pain to the real economy by cutting wages and other social expenditure. Currency devaluation would normally ease the political, if not the real, pain of adjustment. The US and the UK have embarked on a subtle programme of letting their currency devalue to regain competitiveness without having to cut government expenditure. Latvia cannot really do this, for two reasons. Firstly, because it would basically postpone its ambition to join the eurozone by at least a decade and, secondly, because many Latvian households had already converted their mortgages into euro or Swiss Francs to benefit from low interest mortgages, on the assumption that Latvia would simply sail into euro membership. Devaluing the Latvian currency would increase the burden of mortgages in local currency terms at a time when property values have collapsed, leading to massive defaults, foreclosures and more economic implosion.

Ireland has not so far had to seek IMF support. But it has had to nationalise its main banks, guarantee all deposits and, with credit in short supply, has experienced a massive collapse in its property market, leading to a substantial loss of revenue by the state, which is running atrocious deficits. The situation is untenable. This is what an Irish government minister warned this week:

“We’re spending e500 million a week more than we’re raising. If government hasn’t the capacity to do what’s needed then others will come in like the IMF and overnight they will make decisions. We can’t let the deficit drift past 12 per cent and 15 per cent next year and 20 per cent the next. Without reform, Irish public debt would rise from about e76 billion today to e160 billion by 2013 by when two out of every three Euros raised in taxes would be going to service the debt.”

Thankfully Malta’s position, whilst not comfortable, is not as bad as that. But we should not underestimate our exposure to the property market. Our banks are considerably exposed to the property sector and a collapse in property values could bring into question the solvency of our banks, which would require recapitalisations to avoid loss of confidence. So far we have sailed through the international financial crisis with minimum damage, but the over-exposure to the property market should be keeping our bankers and regulators awake at night.

If the 2010 Budget is to have a short-term objective, than this ought to be stabilising the local property market and fiscal measures in this sense should be seriously considered.