THE HANDSTAND

FEBRUARY-MARCH2010

updated:

Icelandic PM warns EU over Icesave

LEIGH PHILLIPS

05.02.2010 @ 09:24 CET

EUOBSERVER / BRUSSELS - The prime minister of Iceland, Johanna Sigurdardottir, has warned the European Commission of the "damage" that could be caused by making links between the ongoing Icesave banking dispute and the economic support being delivered by the International Monetary Fund (IMF).Meeting with the commission president, Jose Manuel Barroso, and enlargement commissioner Ollie Rehn, in Brussels on Thursday (4 February) she "underlined potential unfortunate and damaging effects of any link made by member states between the Icesave issue and the second review of Iceland's economic programme with the IMF," according to a statement from her office, referring to the row between between the north Atlantic nation and the Netherlands and the UK.

After the Icelandic Icesave internet bank collapsed in 2008, depositers in the UK and the Netherlands were compensated by their governments to the tune of €3.8 billion. The Hague and London now are demanding Reykjavik pay them back.The government has agreed to do so, but the terms are considered onerous by a majority of the population. Under the terms of the agreement the loan will be paid back over 15 years with interest, with estimates suggesting every household will have to contribute around €45,000.The president of the country refused to sign the government bill that approved a schedule of payments to the two governments, provoking a referendum on the matter due on 6 March, which analysts and pollsters expect the government to lose."Many Icelanders believed that they were the victims of imperfect EU legislation and that many believed the burden to be unfairly distributed between the three countries involved," Ms Sigur­ardˇttir told the EU leaders.

The prime minister also noted how important the IMF loans and related loans from the Nordic countries and others are for the rebuilding of Iceland's economy."We discussed frankly the Icesave issue and the situation in Iceland," she said. "It is extremely important to explain to key players in the EU the situation in which Icelanders find themselves and to explore all possible avenues for solutions and of course everything was on the table."Ms Sigurdardottir also underlined that EU accession procedures should not be held up by the current dispute during a discussion with the two commissioners over the state of play with the country's membership application.

Markets turn on Portugal as EU trade union opposition grows................"PIIGS"

ANDREW WILLIS

05.02.2010 @ 09:23 CET

There was no let-up in the turmoil caused by European budget deficits on Thursday (4 February), with investors turning their attention to the weak state of Portugal's public finances.The country's stock market plunged nearly five percent, the biggest daily fall since November 2008, and bonds yields rose, even as opposition parties proposed to increase public spending on the Atlantic islands of Madeira and the Azores.Portuguese finance minister Fernando Teixeira dos Santos from the centre-left Socialist party implored members of parliament not to follow through with the opposition regional finance bill, warning it would only add to investor doubts.In a televised address, he said it would send the "the worst possible message" to financial markets, at a time when Europe's peripheral states are under intense scrutiny.

Portugal, Ireland, Italy, Greece and Spain - occasionally referred to collectively has the "PIIGS" countries - have drawn extensive heat from markets since the financial crisis began, although a series of hairshirt budgets in Ireland has started to provide some let-up from investors.

Greek plans to rein in its budget deficit won European Commission support this week, with Mr Teixeira dos Santos promising that Portuguese plans, expected later this month, would be "no less ambitious."

Portugal had taken over from Greece as the main victim of the "animal spirits" of financial markets, said the finance minister, adding that the concerns were not justified.

European Central Bank president Jean-Claude Trichet also sought to soothe fears over the eurozone on Thursday, saying the bloc's average deficit of around six percent compared "very flatteringly" to other countries such as the US where is close to 10 percent.

For his part, Spanish Prime Minister Jose Luis Rodriguez Zapatero attempted to convince investors that his Socialist government had a solid grip on the country's budgetary problems.Speaking at a closed-door gathering at the US Chamber of Commerce in Washington on Thursday, he stressed the point that Spain's deficit was a consequence of stimulus spending that had now peaked, and pointed to fresh austerity measures outlined last week.Despite the panoply of remarks intended to allay market fears, doubts remain over the ability of European governments to push through spending cuts and tax increases without causing social unrest.Spanish unions on Thursday threatened massive protests in response to the government's plans to slash spending in a bid to save €50 billion by 2013. The country's employees are also concerned by the recent proposal from Madrid to increase the age of retirement by two years to 67.

The backlash in Greece against government measures also escalated on Thursday, with the country's customs and tax officials launching a 48-hour strike that shut down ports and border crossing points.Greece's largest union, the General Confederation of Greek Workers, which represents private sector employees, also announced plans to hold a one-day strike on 24 February as a sign of solidarity with public sector workers, set to bear the brunt of Athens' tough new measures.



credit contagion

By Nouriel Roubini and Arnab Das

Published: February 2 2010 Financial Times

A nother Great Depression may have been averted but the crisis is far from over. Credit is tight and contagion is spreading to all highly leveraged points in the global economy: mortgage-ridden households (Iceland, the US, the UK, Spain, Ireland, central and eastern Europe); banks (Iceland, the US, the EU, Russia and the former Soviet Union); quasi-sovereign debt (Ukraine’s Naftogaz,Dubai World); and now Greece and other weak links in the eurozone.

Greece has long been an accident waiting to happen due to heavy public debt and lack of competitiveness. But its problems are not unique. On their resolution rides the fate of its neighbours, the eurozone and perhaps the European Union itself.

Fiscal incontinence and uncompetitiveness are interlinked across southern Europe. Euro accession and bull-market “convergence trades” pushed the bond yields of Portugal, Italy, Greece and Spain towards German bunds. The ensuing credit boom supported consumption but papered over wage inflation that outstripped productivity growth and priced Greece out of traditional export markets.

Excessive bureaucracy and rigidities in labour, product and service markets, meanwhile, discouraged investment in high value added sectors, despite wages well below the EU average. The resulting noxious mix of large current account and budget deficits led to rising foreign debt. Dramatic euro appreciation in 2008-09 compounded these problems.

As bond yields rise, Greece and its peers face difficult choices. The best course would be to follow Ireland, Hungary and Latvia with a credible fiscal plan heavy on spending cuts that government can control, rather than tax hikes and loophole closures that depend on historically weak compliance. This could achieve an internal devaluation with deep real wage cuts and structural reforms to boost competitiveness, as Germany has since unification.

The easy option would be to resort to financial engineering and fiscal fudges, delaying adjustment. In this scenario market access would eventually be lost, perhaps by mid-2010. Greece would then have to turn to other member states for direct loans (denied – at least so far); to the International Monetary Fund (ruled out – so far); or to non-traditional creditors, say China (denied). Alternatively, it could devalue, default and re-denominate liabilities into a “new drachma,” Ó la Argentina (unthinkable).

A credible austerity plan would restore solidarity with EU countries that are adjusting, improve the rhetoric of the European Central Bank and key member states, and bring Greek bond spreads back to earth. This approach is working in Ireland – spreads exploded as public debt ballooned to save its banks, but came back in as public spending was cut by 20 per cent. But it is no cakewalk: Portugal has been deflating to boost competitiveness for a decade. Harsh medicine is best ingested quickly.

Greece’s adjustment would ideally be backed by a large IMF programme to prevent a run on public debt and banks during the tough times ahead. In a Europe-only plan, the European Commission would monitor adjustment and the ECB would lend. Neither has imposed conditionality on members, which is what the IMF does for a living. The IMF is ruled out because it would signal weakness. But an EU-only plan may be seen as a fudge by interested parties,given the risks to Europe of failure.

Failure to take the tough decisions necessary would draw attention to an uncomfortable historical truth: that no currency union has survived without a fiscal and political union. The contrast between the eurozone and the US would become ever starker. Many US states are also in fiscal crisis, but local problems can be solved at a federal level. Should transfers fail to do the trick, a chapter of the bankruptcy code is devoted to sub-federal governments. The eurozone lacks such burden-sharing mechanisms.

The story of the other eurozone stragglers is different in degree but not principle. All are highly leveraged – the fundamental source of financial contagion. Spain, like Ireland, has a massive contingent public liability in its banking sector, arising from mortgage debt. Its growth model – residential construction driven by a house price boom – is defunct. Spain, too, needs fiscal consolidation and structural reform to restore debt sustainability, reinvigorate growth and reduce its 20 per cent unemployment rate. Italy’s government is highly leveraged so it too must cut spending and regain competitiveness. Portugal urgently needs structural reform to restore economic dynamism and fiscal health.

Greece, then, is the front line of a wider battle to stay on the path demanded by European Monetary Union. The political commitment to the eurozone of every country that has come under the gun is unwavering – witness Ireland’s deep budget cuts; Portugal’s painful deflation; the sharp adjustment of aspirants such as Latvia or Hungary. Lack of political and fiscal union, limited labour mobility but free capital movement make such adjustments critical to the long-term viability of the eurozone.

Ideally, formal rules for fiscal burden-sharing should be developed to give teeth to no-bailout clauses, such as debt restructuring mechanisms for eurozone sovereigns. Otherwise, doubts about EMU sustainability will return in every downturn. Sooner or later, these doubts will be validated.

Nouriel Roubini is chairman and Arnab Das head of market research at Roubini Global Economics