Sunday, 7 February 2010

PIGS must be helped to Fly

PIGS must be helped to Fly

7th February 2010

The Malta Independent on Sunday

Alfred Mifsud


PIGS is not pigs. It is the new acronym coined by the financial services industry to group together the four euro area countries that are struggling to service their huge budget deficit and to continue financing their burgeoning public debt. PIGS is Portugal, Ireland, Greece and Spain. It is similar to the more popular acronym BRIC, which was invented to group together the up and coming emerging economies of Brazil, Russia, India and China.

Tension has been building in the market about the ability of PIGS to meet their sovereign debt obligations. These tensions are being expressed in two distinct ways. The market value of their sovereign bonds has dropped to reflect the perceived increase in the risk they carry. They are also visible in the bond insurance market (technically referred to as CDS – Credit Default Swaps) where premiums for insurance against the sovereign default of PIGS show substantial increases.

Let me explain in as non-technical terms as possible why the situation is serious and is of interest to all other euro members, and indeed all EU members.

Members of the euro monetary system take certain obligations on which limit their policy discretions. Most obviously they give up the facility to use the rate of exchange as a policy tool, as they no longer have their own domestic currency but a common currency whose exchange value is fixed by the markets, as influenced by the decisions of the European Central Bank (ECB), and not by the decision of any government of a participating country. Members also hand over monetary policy discretion to the ECB who sets and enforces interest rate levels for the whole euro area that may be out of synch with the narrow requirements of any single component thereof.

Members also take on the obligations to operate a prudent fiscal policy with maximum annual deficits within 3 per cent of GDP but with the aim to achieve balanced budget over the economic cycle. They also pledge to keep their cumulative public debt within 60 per cent of the GDP. Where the public debt is above this level there must be a plan to bring it down to such level over an agreed term.

Failure to abide by such rules could lead to an escalation from warnings to sanctions, including fines.

What benefits would countries get to justify their assuming these rigid obligations? The benefits are basically two. Joining the euro gives a perception of stability and sound macro-economic management and offers the perception of support from the other euro countries to overcome any economic difficulties along the way. I state ‘perception’ because the statute of the monetary union does not provide for any such automatic support and, on the contrary, speaks only of sanctions and penalties on countries that do not honour their fiscal obligations.

No penalties have ever been applied; indeed when a country is going through a bad patch it generally needs support to reform rather than penalties that make a bad situation worse. The penalties are presumably a last resort solution in case a country obstinately refuses to adopt corrective measures to improve its fiscal position and bring it back within the rules.

The other major advantage of being in the euro area is that the credibility gained will permit cheaper borrowing on the international market. Normally, the perception that euro membership is a practical guarantee against the risk of default, the prices of bonds of the weaker members like PIGS are very very thinly above the price paid by the strong members like Germany and France.

Suddenly this reasoning is no longer working. PIGS are being forced by the market to pay much higher coupons on their debt. The flight to safety is reducing the borrowing costs of Germany and France and is increasing the borrowing costs of PIGS.

Furthermore, the assumption that euro membership practically guarantees prudential macro-economic management has been invalidated by the way PIGS has been thrashed by the recession.

Consequently, the major advantages of euro membership are no longer accruing to PIGS, which so far have been forced to carry the burdens on their own. Exiting the euro is no solution to indebted countries. Even if exiting were possible, this would cause them havoc as the cost of their borrowing in their newly re-established domestic currencies would skyrocket and they would incur huge exchange losses on their EUR debt, which suddenly becomes a foreign debt.

This is the strongest and most serious test for euro sustainability so far. As is normal, the strength of a floating structure is not tested in calm waters. It is tested during a severe storm and this is the first real severe storm since the euro area was created.

As members of the euro, the developments are of direct interest to Malta. Our fiscal position, especially the true one if many off-balance items are brought into the mainstream budgetary calculations, is not much better than that of PIGS. Where we score better is that the private sector here is liquid with very high savings ratios so we have not had to get to excited about whether the government would be able to fund its borrowing requirements.

What saved us so far is the savings culture that our forefathers instilled in us as a nation.

This savings culture is evident in the way consumption has been cut back during these difficult times.

This cutback in consumption creates short-term problems for the retail and distribution business sector, but in the longer term it preserves macro-economic stability.

As a member of the euro we must do our part to ensure that the integrity of the system is preserved. Obviously the first approach is to place the burden and responsibility for the necessary macro-economic adjustment on PIGS themselves. Failure to do so would create dangerous moral hazard precedents and would remove the political will to undertake the necessary reforms.

But in acknowledgement of the pain of the reforms and as an incentive to stick them out, rather than risk some violent protestations (Greece is well known for such theatrics) that could risk the very democratic stability of sovereign member governments, the system has to offer rewards and encouragement for persistence. They must not be left alone. They must not be left to face their future borrowing needs from the markets at high rates, as this works against the very nature of the needed reforms.

To restore the benefit of borrowing at cheap rates through the overall support of the whole euro area, new initiatives are needed for PIGS to borrow through euro-wide sovereign bonds or to channel such borrowings through special programmes of the European Investment Bank whose bonds would be counter-guaranteed by all the governments of the euro area.

As a last resort, Greece should be channelled to the IMF to organise a reform programme, which would be supported and aided by the EU, as has already been done for Hungary, Latvia and Rumania. Greece is a euro member and the involvement of the IMF could be a humiliation for the monetary system; but if the alternative is worse than humiliation than let’s get on with it. After all, if the humiliation were translated into some euro weakening against other currencies, the benefits in international competitiveness would more than justify the embarrassment of humiliation.

This is the time to show that the euro monetary system is also a tool of solidarity for those of its members who go through difficult times. Otherwise it can just as well be dismantled.

No comments:

Post a Comment