Euro crisis behind us

The EU and IMF have agreed to set up an almost US$1tn line of credit for troubled EU nations, which should have a similar effect as the US Federal Reserve’s TARP package in restoring confidence in financial markets. This massive step follows the US$147bn bailout package for Greece on 2nd May, 2010 to prevent it from defaulting on its public debt. In return, Greece had to agree to reduce its fiscal deficit to 3% by 2014. Greece's fiscal deficit had risen to almost 14% in 2009 and public debt was as high as 115% (US$400bn), while domestic savings were abysmal at about 5.5% - necessitating the bailout.

Greece's problems are symptomatic of its high median age of 42 and the resulting low savings rate of 5.5%. In our view, a country with a high median age has two options to improve growth - if it is a net exporter of capital then on the back of its strong currency it can run a higher fiscal deficit to support growth. The other option is to devalue its currency to increase exports as a driver for GDP growth.

In case of Greece, till it is part of the EU, currency devaluation is not an option. In such a situation, even though it does not have its own strong currency, having a higher fiscal deficit on the strength of the Euro would have been a viable option, had it been acceptable to other EU nations. But in its current form, unlike the US bailout packages last year, this bailout comes with substantial strings attached, requiring stringent belt-tightening like public sector wage cuts, sharp increase in tax rates, cut in pension payments and raising of retirement ages, which we believe would have a detrimental impact on domestic demand in the country.

Given its small size (less than 3% of EU GDP and 0.6% of global GDP), the burden on EU to support its fiscal imbalances appear manageable. Therefore, we believe eventually, domestic dissent notwithstanding, the stronger EU nations may end up relaxing the fiscal targets as well, in the larger interest of maintaining financial and political stability. Portugal faces a similar situation, with its GDP less than 2% of EU GDP and 0.4% of global GDP. As far as Spain and Italy are concerned, in our view they have better fundamentals (savings rate of 22% and 16% and current account deficit of 5% and 3% respectively) and, with confidence getting restored in the financial markets, they are unlikely to actually draw down materially on the bailout funds.