Ireland’s DIY devaluation

With the downgrading of Spain’s credit rating piling further pressure on the euro, questions are being asked about the future of the single currency as never before

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Ever since what was originally the Greek financial crisis first erupted seven months ago, the value of the euro has been falling on the foreign exchanges. By the beginning of this month the euro was down 19% against the dollar to $1.22 and by 9% against sterling to 83p.

What started as a local crisis when the Greeks, who had already lied their way into the euro in 2001, admitted last November that they had been fiddling the books to understate the size of their budget deficit, has now escalated into an existential crisis for the eleven-and-a-half year old eurozone.

Instead of moving decisively to address the crisis, EU leaders have consistently been playing catch-up. When they finally do agree on something it is invariably a case of too little, too late. To make matters worse, when the various “rescue” packages, which were announced with such fanfare are subjected to subsequent scrutiny, there always seemed to be much less to them than originally met the eye.

Matters weren’t helped by the fact that, in what now looks like a case of arrogance bordering on hubris, the EU Commission, the ECB, France and Germany were determined to exclude the IMF, the international body with more experience of dealing with sovereign financial crises than any other, from participating in any Greek “rescue” package.

Cracks beginning to show

Even more damaging was the fact that the crisis exposed serious rifts in the Franco-German relationship upon which the EU has ultimately rested ever since its foundation in 1957. While French president Nicolas Sarkozy favoured an interventionist policy, German chancellor Angela Merkel, whose country would end up footing most of the bill for any such intervention, was far less keen.

Matters came to a head in mid-May when, with the crisis spreading to Spain, Portugal and Italy, it was time for the eurozone to put up or shut up. Previous objections to IMF participation were swept aside as the EU and IMF unveiled a €750bn package designed not just to rescue the Greeks but also to prevent the crisis spreading to the other PIIGS (Portugal, Italy, Ireland, Greece and Spain).

While the May package temporarily reassured the markets, doubts soon re-emerged. The underlying problem is that while the EU and the ECB could, if they chose, rescue one of the smaller PIIGS such as Portugal, Greece or Ireland but the sums needed to bail out Spain, in the event of that country’s financial crisis worsening, are enormous.

While Spain’s sovereign debt, about 53% of GDP or €550bn, compares favourably to Greece, whose e300bn sovereign debt represents over 100% of GDP, it has, like Ireland, huge private-sector debts. As in the case of Ireland most of this private-sector debt, which has been calculated at over 200% of GDP, was borrowed from overseas, mainly French and German banks to fund property-based lending.

Dud property

Unlike Greece, whose banks have so far weathered the financial storm reasonably well, there are clear signs that the bursting of the Spanish property bubble is beginning to hit that country’s banking system hard. With close to half a trillion euro of dud property lending on their loan books, the Spanish banks have been frozen out of the international capital markets since early April, being forced to rely on the ECB for short-term funding instead.

While the worst impact of the Spanish property bust has so far been confined to the cajas or regional savings banks, two of which have been seized by the Spanish central bank, there are now clear signs that concerns are mounting over the health of the two largest Spanish banks, Santander, and BBVA, both of whose share prices have fallen sharply over the past two months.

In many ways the comparisons between Spain and Ireland are remarkable. Property busts, banking crises, apparently low public-sector debt and sky-high private sector debt. Now, with its debt being downgraded Spain is being forced to follow the Irish example once again and implement spending cuts.

The cuts, which include public sector pay cuts of up to 15% and are designed to reduce the Spanish budget deficit from its current 11% of GDP to just 3% of GDP by 2013, passed the Spanish parliament by only one vote. While the Spanish spending cuts, like the Irish spending cuts, were necessary to maintain the confidence of the international bond markets, they are very much a two-edged sword.

A deflationary spiral

While spending cuts might cut budget deficits in the very short-term, there is also a serious risk that, by further depressing the economy and with it tax receipts, they trigger a deflationary spiral that makes it more, not less, difficult for a country to repay its debts. With economic activity contracting and prices falling the real value of a country’s debts, both public and private, rises. Even if individuals and businesses can borrow, deflation makes it a very unattractive proposition. This is what is now happening in Ireland, Spain and the other PIIGS.

Under normal circumstances a country stuck in a deflationary debt spiral would devalue its currency. This would kick-start its economy by boosting exports, which would in turn increase tax revenues. By making imports more expensive, a devaluation also solves the deflation problem. This helps make borrowing a more attractive proposition for individuals and businesses.
Unfortunately our membership of the euro rules us out of the devaluation option. Unless they quit the single currency, which of course massively increases the value of the money governments and banks borrowed overseas, devaluation isn’t on the cards for the PIIGS.

DIY devaluation

While the other PIIGS, who conduct the vast bulk of their external trade with other eurozone countries will derive little benefit from the fall in the value of the euro, we of course do most of our trade in the dollar and sterling. This means that, more by accident than design, we have managed a sort of DIY devaluation, with our exports now much cheaper in our main markets.
Even better, by not having to leave the euro our external debts have not increased in value. While we are by no means out of the woods yet, the recent sharp fall in the value of the euro against the dollar and sterling is the best piece of news this country has had for a long time. Of course a worsening of the Spanish crisis could bring the whole euro edifice crashing down but let’s be thankful for small mercies in the meantime.

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