<B>Satyajit Das:</B> The shaky future of Europe

European roads, especially German autobahns, are known for their excellence. In marked contrast, Europe’s economic and financial road ahead resembles the potholed, crumbling and treacherous stradas of emerging countries. How these obstacles are negotiated will shape not only Europe, but also the global economy.

In 2012, the euro zone faces a number of challenges, including the implementation of the new institutional arrangements, possible downgrading of a number of nations, re-financing maturing debt and meeting required economic targets.

The new fiscal compact negotiated in December 2011 made no attempt to tackle the real issues — the level of debt, how to reduce it, how to meet funding requirements or how to restore growth. Most importantly, there was no new funds committed.

But even the implementation of this fundamentally flawed deal is not a fait accompli. Delays, changes and legal challenges cannot be ruled out.

At least four governments have indicated that agreement to the changes is contingent on the precise legal text. A key area of concern is the structure of the European bailout fund, where a qualified majority of 85 per cent will have the power to make emergency decisions. Finland currently opposes acting by super majority instead of unanimity. Others are also reluctant to pay in capital, which can be placed at risk without the right to a veto.

Negotiations on the Greek package of July 2011 have also stalled. There is a risk that a significant number of banks will refuse to participate in the complex debt restructuring, entailing a writedown of 50 per cent of private debt. With a euro 14.4-billion bond maturing in March 2012, inability to finalise the restructuring will push Greece closer to default. The major agencies are reviewing the ratings of 15 euro-zone members. If France, Germany and the other AAA guarantors lose their highest credit rating, the bailout fund will also be downgraded, weakening its already compromised ability to raise funds to meet existing commitments to Greece, Ireland and Portugal and to support the funding of other countries.

European sovereigns and banks need to find euro 1.9 trillion to refinance maturing debt in 2012. Italy alone requires euro 113 billion in the first quarter and around euro 300 billion over the full year. Given that banks and investors have been steadily reducing their exposures to European countries and banks, the ability to finance this debt is uncertain. The bailout fund and the International Monetary Fund (IMF) with euro 200-250 billion each cannot absorb this issuance.

The only solution available is for European banks to purchase the sovereign debt, which is then pledged as collateral to borrow unlimited funds from the European Central Bank or national central banks. This perpetuates the circular flow of funds with governments supporting banks that are in turn supposed to bail out the government. The real economy in Europe is moribund, in danger of slipping into recession.

For the nations that have received bailouts, the austerity measures imposed have not worked. Growth, budget deficit and debt level targets will be missed. In Ireland, the much lauded poster child of bailout austerity, third quarter GDP fell 1.9 per cent and its gross national product fell 2.2 per cent. Spain may already be in recession. The budget deficit is above forecast and the need for support of the Spanish banking system may strain public finances further.

Italy is forecasting a recession in 2012. While budget measures to stabilise debt have been passed, they focus on increasing taxes rather than cutting expenditures. Structural reforms to promote growth are still under consideration and the content and timing is unknown. The plans may not be fully implemented or work.

Lack of demand for exports within Europe and from emerging markets combined with tighter credit conditions is slowing growth in the stronger countries in Europe, like Germany. The risks of political and social instability remain elevated. Greece faces elections in April 2012. The French presidential elections, scheduled for May 2012, also create uncertainty. The principal opponents to incumbent Nicolas Sarkozy either oppose the euro and the bailout (the National Front led by Marine Le Pen) or want to renegotiate the plan with the introduction of jointly guaranteed euro-zone bonds (the Socialists led by Francios Holland).

The European debt crisis is also creating political problems in Germany, Netherlands and Finland, especially among governing coalitions.

A downgrade of Germany’s cherished AAA rating or any steps to undermine the sanctity of a hard currency (by printing money or other monetary techniques) will focus attention on the costs to Germans of the bailouts. Germany’s commitment to date is euro 211 billion in guarantees, euro 45 billion in advances to the IMF and euro 500 billion owed to the Bundesbank by other national central banks — around 25 per cent of GDP. The increasing risk of losses may even divert attention away from the 2012 European Soccer Championship where Germany is drawn in the “Group of Death” with Netherlands, Portugal and Denmark.

It will take the technique and experience of a champion rally driver to negotiate the difficult road. Given the skills demonstrated to date by European leaders, it is doubtful whether the course will be completed without a crash or two. The only question is the extent of the damage, both direct and collateral.

Slowing European growth, knock-on effects on the US and emerging markets like China, the deterioration in money market conditions and the withdrawal of European banks from lending in Asia will pose significant challenges for India in the year ahead.

Satyajit Das: The shaky future of Europe