This week, the IMF cut its growth forecasts for the Eurozone by 0.2 and 0.3 percentage points for 2015 and 2016, prompting it to cut its global economic growth forecasts by a similar magnitude. Clearly, economic expectations are turning increasingly pessimistic.
The reasons that could explain this “economic pessimism” are broad and complex but one explanation looks particularly interesting in light of recent news out of Europe: the impending threat of the Eurozone going back into recession. This threat is a shared concern among market participants and policymakers around the world. On January 22, the European Central Bank (ECB) reacted announcing a large scale quantitative easing program (QE).
Interestingly, the origins of the threatening Eurozone crises are familiar for Latin America, a survivor of several economic crises in the past whose experiences are particularly relevant when discussing the Eurozone situation.
Considering that the core issues of the Latin American crises during the late 1990s —sudden stops of capital flows, spikes in sovereign risk, and banking system instability—are eerily reminiscent of the current challenges facing some of the peripheral Eurozone countries, Latin American countries have a lot to share.
The Latin American experience with Sudden Stops in capital flows appears particularly relevant for peripheral European countries with large external liabilities. In our estimation (Cavallo, Fernández-Arias, and Powell, 2014) the full implications of a lack of access to private capital markets, the need for relative price adjustments to boost net exports, and the implications for debt sustainability may not yet be fully appreciated in the Eurozone context.
Adjustments in real exchange rates are likely to continue to increase debt-to-GDP ratios.
This point is very important. To see why, consider the following: if a Eurozone country — let’s say Spain — suffers a sudden stop and has no other sources of financing, it has to adjust, which implies real exchange rate depreciation for the balance of payments to remain in balance. Since Spain has adopted the Euro, the value of its currency is not determined by its particular set of circumstances, but rather that of the Eurozone as a whole. Thus, from the perspective of each individual country, having Euro debt is just like having debt in foreign currency: i.e., its value inflates when the real exchange rate depreciates. This was lethal in many Latin American countries in the 1990s. Importantly, it suggests that the Eurozone country in question would suffer in a similar fashion to the economies of Latin America in the face of a Sudden Stop in private capital flows because a real depreciation would have a negative impact on debt sustainability.
True, any Eurozone country has access to liquidity support from the Euro-system, which makes the “no other source of financing” scenario less likely. However, this form of financing cannot go on forever. At some point, countries in peripheral Europe will wish to reduce the stock of Euro-system financing; at that point, the sudden stop scenario becomes binding. Moreover, the Latin American experience shows that if underlying fundamental problems are at the root of financial distress, liquidity alone is no cure. It even becomes counterproductive over time because it allows the rot to deepen and embroils official liquidity providers in credit risk.
Some may argue that external adjustment has already taken place in the Eurozone. Current account deficits have been reduced or eliminated in many peripheral European countries. The problem with this argument is that unemployment rates remain stubbornly high, suggesting that the adjustment has been affected by lower demand and recession, rather than a change in relative prices. We would argue that if the country in question does not obtain access to new private capital flows, but wishes to reduce the stock of Euro-system financing and get back to somewhere close to the level of unemployment in 2010, then it will have to continue the adjustment process and engineer greater real depreciation. Consequently, the debt-to-GDP ratio will have to continue to rise from current levels just due to valuation effects.
There are important lessons to bear in mind for the peripheral European countries with large external liabilities:
- The longer it takes for private capital flows to resume, the more likely it is that solvency will be at risk. Debt overhang can hurt growth because it acts as an implicit tax on investment, especially in the absence of clear rules for its resolution. Fiscal contraction may easily fail to reduce the debt overhang because it depresses economic activity.
- The role of the ECB has been critical to the survival of the common currency in Europe. External official support to troubled economies can provide time for economies to adjust, but it is no substitute for structural reforms aimed at reducing structural vulnerabilities and restoring long-term growth. The experience in Latin America shows that it is more likely for growth-enhancing reforms to be implemented in the aftermath of crises, especially in supportive institutional environments.
Even though Europe is in a better position than Latin America was in the 1990s, with better cooperative mechanisms to create a successful way out of the crises, the reminder of the trials and errors of economic policies on this side of the Atlantic could be pretty useful. Clearly, there’s no recipe for success; however, what is important to take away is that reviewing economic policies around the world may help policymakers avoid repeating the same mistakes.
For further information visit: Is the Eurozone on the Mend? Latin American Examples to Analyze the Euro Question