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Where To, The Euro Zone?

CFO Connect, March 2012


Frank-Jürgen Richter gives his prognosis of the Euro Zone crisis

In an economically integrated world, upsets like the Euro crisis usually have larger effects on the world which will come about soon. The question is whether funds will be found in time to bail out the defaulting member States of the Euro Zone. This will be challenging because each member is a sovereign State and has to go back to its Parliament to seek its vote on it. Unfortunately, there is no common `pot of money´ to go around as the Euro Zone is not a cohesive fiscal union, but only a monetary union. Even so, every country in the Union will be impacted because of the crisis. For instance, UK is a State inside the EU, but not in the Euro Zone, but while it maintains its independence, because of the level of cross-indebtedness in Europe, the Bank of England is not isolated from the affairs of the Euro Zone. So, it too has to take prudent decisions. The Bank of England has all the instruments to control the economy under its management control, and whether it uses them, only time will tell. In an interview to Jayadipta Chatterji for CFO Connect Dr Frank-Jürgen Richter, says there is a great need to compromise some country specific objectives for the good of the whole, and he is hopeful that this will happen soon, and the Euro crisis will serve as a wake-up call. Dr Richter is the former Director of the World Economic Forum and Founder and Chairman of Horasis, a Zurich-based global business community.

What is the exact nature of the Euro sovereign debt problem?
To answer this I shall draw an analogy with a group of friends who are on holiday, each has a separate spending budget, as the group has not created a communal pot from which its members can take money to pay their way. So, when one person runs out of money, who will lend him the money over the rest of the holiday? The reason why they do not have a communal pot of money is because of a repayment risk that they fear, even between friends - and nothing kills friendship more than arguments over money.

It was Margaret Thatcher, former UK Prime Minister from 1979-90, who had drawn on her status as a wife and mother to construct a benign image of the `housewife managing the nation´s budget´. This thinking now pervades in each of the 27 states in the European Union: Like Ms Thatcher´s housewife, each manages its own budget as there is no fiscal union of the States.

Opinion is however, divided on the extent to which it is a Union. Take again the UK, as an example - it is not in the Euro Zone, but is geographically situated in the broader economic community which we can loosely call `Europe´. UK´s geographic location confers on it some advantages for trade, but it has felt that it has also had to cede many control issues to Brussels (the de facto capital of the EU). Eurosceptics in the UK have said that too many rules have been imposed on the UK. More recently, at the Brussels meeting of heads of state and Governments of the European Union, held in early December, where a new European agreement was reached to solve the Euro Zone crisis, UK PM David Cameron expressed his apprehension that the UK may be asked for more money and more controls will be placed on his country. From a general view point, in Europe, there is some control exercised by Brussels, but individual nations have their own banks and fiscal policy; they are not yet controlled by Brussels, but it can seem very confusing.

Was the crisis just waiting to happen? The Euro arrangement has been criticised for ceding national monetary and economic sovereignty, but lacking a central fiscal authority.
Yes, this seems to be the case. This is what Jacques Delores, a former President of the European Commission, and one of the original architects of the Euro, has recently confirmed in the media. He said that he believed the Euro Zone is a weak concept if it does not embody a stronger federalisation and centralisation of fiscal control. But, "the individual European finance ministers did not want to see anything disagreeable (in their own economies)...", which they would be forced to deal with to allow for common fiscal and economic policies, he said. He also said that he does not now believe it is feasible to attempt to run a single currency, managed by one central bank, spanning a single continent in which each participating country manages its own fiscal affairs. The failure of member-nations to deal with imbalances in their own economies has brought the currency to the brink of collapse today.

When growth occurred with ease, the EU expanded and new nations found it relatively easy to conform to the rules of the Union, as did incumbent members. Banking too, was easy and the commercial side was happy to loan to other banks; the bond yield was low; and in the public sector, the banks could lend easily to many people who, like the US sub-prime mortgage case, did not really possess good financial guarantees. But now there is a crisis, and there is no central `pot of money´ for all to use. However, Angela Merkel, Chancellor of Germany, in particular, has hinted that a `pot of cash´ might have exacerbated the profligacy of weaker Union members, increasing the cost for the stronger members, since the weaker nations will have applied for a loan from the central bank, which may have too easily, granted the money without due consideration to the downside risk.

Once again, citing the UK example, it has the freedom to act and it did, by using its veto power and not signing the new European economic agreement at Brussels. However, because of the cross-indebtedness in Europe, being within the European area does not isolate the Bank of England from the affairs of the Euro Zone. It too, has to take prudent decisions.

How do you see the crisis playing out over this year and the next? Do you see an end in sight?
First, looking more widely, the global financial crisis which began in the US in 2007 has not ended yet, and its waves come and go, affecting all nations, though not in any sequence. When some recovery seems evident, a lack of demand elsewhere causes an instant deflation in euphoria. China, for instance, was weathering the storm quite well, but now its exports are hit by the lack of purchasing power in Europe, its largest market. America is seeing better employment figures, but this alone will not rapidly boost its financial standing, especially since too many in the US are defined as poor and cannot help growth by spending real cash.

Now there is a crisis, and there is no central `pot of money´ for all to use. However, Angela Merkel, Chancellor of Germany, in particular, has hinted that a `pot of cash´ might have exacerbated the profligacy of weaker Union members

How will it play out? If it is a business as usual scenario, then the `calming of the waters´ will take a long time; but if the EU comes quickly to a decision to strengthen its financial position, then the many inter-dependent institutions will again become active and shorten the recovery period. I do not see the latter scenario occurring soon, since each State has its own decision timetable, and in some, there is the `confusion´ of impending elections, during which Ministers `grandstand´ to boost their popularity, but this does not really solve the EU issues. Even after the elections, if a new minister is elected, the permanent civil service packs away the old documents, clears its desks, and begins afresh. Sometimes, this is a good idea to stifle prejudices, but in this case, the recent history needs to be absorbed by the new ministers to minimise the slow creep of several extensions to the problem, without a solution.

Is the Euro crisis a part of the on-going global rebalancing, which is likely to take several decades to complete?
Yes, as I said earlier, the financial obligations of debt and borrowing and the real cash-flows due to international balances of trade have grown vastly since the early 1900s. We have all benefited from cheap Japanese, and Chinese (now Asian, in general) goods, and those nations in turn, have increased their bank balances. It is quite clear that we must come to terms with these dependencies as few can compete with Asian manufacturing prowess, or with European, and Anglo-Saxon financing instruments.

But the financial instruments have become complex and many financial managers were not bright enough to pick through the complexity of the new instruments. The same can be said of financial regulators who are stuck with state-regulated salaries, and did not attract the `rocket scientists´, who were paid astronomical salaries in the commercial banks. They designed the new instruments and only they can understand them, while we thought they looked okay, and we used them unwittingly. We cannot however, go back to the very old days of the true gold standard. That system is too slow and cumbersome in today´s digital market. Therefore, we have to come to a common understanding of our common goals - at the national, regional, and global levels; each interacts with the others.

The weaker Euro will benefit many small manufacturers inside Europe while the big firms continue to look to a sustained levelling of the euro vs the USD, hoping to hit perhaps USD 1.25, while it is only about USD 1.30 now. The recent changes following the new agreement being signed, just give some breathing space, but the strategies are not altered, just evaluated. The drop in the dollar rate might add 0.5 percentage points to the euro-zone growth if manufacturers can make haste to remove themselves from the current problems of low unemployment rates and find a way around the toxic mix of economic stagnation, growth-draining austerity measures, and rising borrowing costs.

Several reports point to the importance of the ECB buying more Euro bonds to bail out defaulting governments, and this suggestion has been rejected. Who will want to buy bad debt?
Oddly enough there is a market for `distressed debt´. Fund managers will review the assets of a firm and come to some conclusion of what a purchase may yield in salvage terms, or in renegotiation working rules that could result in a reinvigorated working entity.

But buying a nation is a risk of a different magnitude. This is what is keeping international players away for the moment - and just think, what will you call the bought-out nation? Will a name change be in accord with its people? Again, we might draw a comparison with buying out a firm - asset-strippers are hated, but revitalisers revered. However, usually the name change of the new firm is not a great event, but old memories linger on and some resentment remains, even if the new entity is a success.

The Belgian nation faces this problem at present. Its debt is large, its credit rating is low, it did not have a truly elected government for a record 535 days (it has just got one recently), and there is a clear possibility of returning the country to its old heritages to its north and its south. But that will off end its own 11 million people who know themselves to be `Belgian´ - they were born and brought up there, and their families have fought through two world wars as `Belgians´.

What is the extent of the interconnectedness of European countries with each other?
Across Europe, indeed the globe, most nations lend to each other hoping they will be paid back. Some of this is a very understandable `household business´ of borrowing in the short term to pay off a debt that is about to be due, in the knowledge that in the longer term there will be growth, and thus profit, and there will be money to pay off the new debt. Right now there is little growth and thus little lending. Private lenders are prudent and understand the risks they bear, but governments are less prudent as they can print money to carry themselves out of debt. The EU States could do this once, but now, no one may do so as they are bound by common rules.

The EU over the years has worked hard on common goals. There is the Schengen Agreement which allows passage across borders of all its citizens, without the hindrance of Customs checks. This is a pleasure for individual travellers, but it is also of great benefit to haulers who do not now waste time in being checked, having their cargo opened, and perhaps pilfered, and having also to fill in many different but similar pieces of documentation. Of course, tax equalisation follows the goods, but this happens later, as it can be done end-to-end, digitally.

What will be the role of the permanent European Stability Mechanism (ESM) which will replace in 2013, the temporary European Finance Stability Facility (EFSF), in arresting a financial contagion?
If there was normal fluidity, this would work well and the funds would pass from lender countries to the ESM and from there to the affected Euro States with no adverse effects. But at the present sticky time, the funds´ flows are irregular; risks are hard to evaluate; and how outsiders will lend to Europe is not well understood. The outsiders are free to invest where they wish, but they understand that if they do not support the new instruments and modalities in Europe, which will, in turn, support individual States and their development, the outsiders will be harming their own future. Contagion is a heightened risk.

The real question is, "Will the outsiders be in time to invest?" Members of the Euro Zone have repeatedly shown that since they are sovereign states they must go back to their Parliaments to ask if taking a step forward is okay. Inevitably, we come back to the comparison with the UK - which, as earlier discussed, is a state inside the EU, but not in the Euro Zone, so not completely controlled by Brussels and its many off shoots. The Bank of England has all the instruments to control the economy under its management control, and whether it uses them well only time will tell, but it can react quickly. The ESM is scheduled to come into being in 2013, but we will have to hope that those who drafted the rules of the ESM had perfect foresight, as the changes in the Euro Zone are taking place in days, not years.

How easy will it be for donor countries and institutions to lend to the IMF for Euro funding, which is now part of the new agreement?
It is very easy to lend to the IMF - if one has spare cash. The difficulty is the moral hazard faced by Europeans if they themselves give cash to the IMF to bale themselves out of their own mess. As they have no pot of cash (like my aforementioned holiday group), they cannot create a fictitious one; it is either a real central bank or it is not.

The rules of the IMF have gradually changed over the years, from a mode of rigid control to more of guidance now. But a loan is a loan, some states do not like the idea of having to call on a loan - but surely it is better to have prudent financial management in which a gap is foreseen and a loan used to fill it, than calling for a bailout?

How has the new fiscal compact agreement changed the shape of the Euro?
It is too early to say. Some have likened the new EU agreement to, "... it´s like the Loch Ness Monster. We all know about it, but we have not yet seen it." The agreement is still being drafted in detail and members of the Euro Zone and of the EU have yet to fully agree on its content - this will be many months´ away. As the new agreement will cut across a few legally binding rules, some States may have to face a referendum in order to get the new text accepted locally. The outcome therefore, remains uncertain.

Why did we need to have a whole new agreement instead of just carrying out the changes in the existing Maastricht treaty?
There are legal difficulties in `adjusting´ a treaty, in fact this is impossible - but in this case the `legal wizards´ have suggested clauses that may be reinterpreted without breaking the sense of the original: This has resulted in an accord, which is less than a treaty. Even so, while the recent accord may not carry large changes, it cuts through some of the existing agreements and requires new ratifications of detail, but maybe not a full new treaty as per Maastricht. This is why some states will have to seek a referendum as even the slightest change has to be referred to the people.

The crisis is historic as it has resulted in the premature end of a number of European national governments and impacted the outcomes of many elections. Yet there is no solution to the crisis.

Well this must be a part of the European crisis. I mentioned Margaret Thatcher. She was a formidable leader in her cabinet and across the UK´s private and state-owned businesses. She attacked economic orthodoxy and won, and history is thus kind to her. Had she been weaker, or allowed her advisors to create conflicting edicts, the UK would not have grown as it did during her period in office. A similar strength was not seen in some of the past European leaders or in some of the global leaders at present. It is sad to see leaders being goaled for infractions, yet it is good to see that the rule of law works fairly for the common man as well as top officials.

At the risk of being too extended, the crisis is also one of procrastination. We see this time and again when managers - even family members - hesitate to act as they feel it will somehow `upset the apple cart´. But inside themselves they know that the delay was wrong and they have missed an opportune time of change. We put off to another day something we could do today - but tomorrow never comes. I have written on this elsewhere, where I said that we all know what putting off something we ought to do means to us. There is even a day set aside for this task - Frenchman David d'Equainville has proclaimed that March 26th, 2011, should be called the International Procrastination Day, but he also said that he did not mind if it were later.

What effect will the falling euro have on small developing nations, and on the larger India?
Many developing country economies are still growing strongly, but their forecasts have been downgraded substantially in the space of a few months. Meanwhile, East Asia still grows, as does Sub-Sahara Africa, while the OECD nations´ growth has fallen off . That this is a `normal´ consequence of growing up and becoming a developed nation is no real pleasure to those within, who are struck with changing work-styles (off-shoring, etc), but now also suffer a real recession and the fall of output, as well as a rapid rise in unemployment numbers. There are also signs of a slowdown in Asia, which has been the engine of world growth: First Japan, then Korea, and now China. During the last two months, the Asian Development Bank (ADB) has revised its growth forecast for Asian countries downwards by 1-2 percentage points.

The global flux of economic immigrants will also slow down. All nations need a much more open policy towards immigration, as the global population growth will slow after 2035 (says the UN). But, as this is way beyond the politicians´ next elections, they maintain a harsh barrier against immigrants. The barriers become even stronger when an electorate faces high indigenous unemployment rates. There will be fewer economic migrants coming to developed countries when they are in a recession, resulting in fewer remittances, with the possibility of lower volumes of remittances per migrant, decimating the small nations´ GDP figures, their borrowing capacity, and so on.

Aid volumes are under pressure in the developed nations who now are much less wealthy; but there may also be implications for the composition of aid. Should aid be provided to countries with high risks, and how should it be channelled? Are existing IMF and World Bank schemes sufficient for this, as they already need to address balance of payment problems in countries due to high food and oil prices? And who will give to the IMF, as we have discussed earlier.

What will it mean for India? Economically India is at risk from the falling euro, as is the whole globe - we all trade together and pass debt across borders. India is becoming quite like China in offering a market of cheap, high-quality (physical) goods that have to be made and transported to its main markets - the US and the EU - which are both buying less day-by- day. India also exports intellectual (digital) capital and this will continue. However, for many firms it is time to expand and acquire overseas´ operations through buy-outs, or green-field development so as to reduce their costs in terms of time and money, of their managers doing jobs both at home and abroad - on a plane. Even if it is the most modern, there are limits to the range of office operations that may be carried out.

What is your prognosis on the Euro crisis?
I am hopeful. We are, I hope, not on the film sets of a James Bond movie, where the villain (usually always a man), remains supreme and is on the point of maiming the world for his selfish gain. Equally, I do not spy James Bond arriving in the nick of time to urbanely save the world from this fate.

There is a great need to compromise some local wishes for the good of the whole. I hope to see this happening in the near future as global upsets like the Euro crisis, usually mask really large effects that will come about soon - fuel starvation (it has to be true that fossil fuels will be depleted, and before that time, their price will rise vastly); tied to this will be global starvation (due to a lack of present-day transportation); and these will occur well before (a) the global population plummets (after 2050 according to the UN), or (b) catastrophic sea level rises (due to global warming after 2100 onwards). These effects lie beyond the political vision of the present incumbents of governments: Sadly they only seem to look to their next elections.

My vision may seem gloomy, but it is positive - I feel we will see sense before it is too late. And the Euro issue will be seen as a wake-up call.


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