A new financial crisis is brewing in Europe, one that will prove as devastating as the last economic crisis. This one will also be centered in southern Europe, only, this time, instead of being triggered by the rising debt of the region’s governments, it will be triggered by the mounting bad debts of commercial banks.
Across Spain, Portugal and Italy, the amount of non-performing loans is now over €540 billion (C$786 billion). In Italy alone, it exceeds €360 billion (C$524 billion), and amounts to 18 percent of all bank loans in the county.
Italy, which has the highest level of non-performing loans in the European Union’s (EU) banking sector, will be the nexus of the banking crisis. It also has a high operating cost, inefficient, highly-fragmented financial industry. Italy has over 500 banks and, according to The Guardian, “more branches than restaurants dotted across the eurozone’s third biggest economy.”
Rome has a threefold response to Italy’s developing banking crisis. First, creating a $6.35 billion fund, named Atlante, to bail out insolvent banks. Secondly, allowing banks to package non-performing loans into government guaranteed, asset backed bonds that can be sold to investors (The bond plan skirts the EU prohibition on bailing out banks, and may yet be challenged). Finally, the Italian government has introduced legislation to streamline the process of foreclosing on bankrupt properties.
Italy’s banking problems are the most recent example of a far deeper problem – a fundamental lack of economic competitiveness across the EU’s Mediterranean region, after years of persistent – and under-reported inflation.
Before the creation of the euro, governments were free to devalue their currencies to adjust for ongoing inflation and restore their competitiveness. In the case of Italy, this was a regular and predictable event. When currencies were freely trading, financial markets would make these adjustments automatically.
A shared euro currency, however, makes such adjustments impossible. The only alternative is either a painful structural reform, as Greece has been forced to attempt as a condition of its bailout, or an exit from the euro. Neither option is particularly attractive. The structural reforms that would restore economic competitiveness would require a sharp reduction in government spending and a significant reduction in wages. This is neither politically, nor always legally, feasible.
A euro exit is equally problematic. Since all of the debt is denominated in euros, an exit, and the reissuance of a new currency, would increase the face value of existing debts by the same percentage that the new currency is devalued.
While estimates vary, it is generally believed that the EU’s southern members would need to devalue their currencies by between 20 to 30 percent to restore their economic competitiveness. The discount that their currencies would trade for, relative to the euro, would be even greater, unless investors are convinced of these governments’ newly found fiscal prudence.
Borrowers could be given the option of paying their euro debts with the new currency at some artificially set rate. Argentina tried that trick when it defaulted on its U.S. dollar denominated foreign debt. That’s the same as a partial write-off of that debt, and transfers the loss to the debt holders.
Alternatively, borrowers can buy euros at whatever market rate is established and pay back their loans, but this will saddle them with much higher loan balances. Its unlikely most companies could withstand the shock of a dramatic increase in their outstanding indebtedness.
The EU’s richer members, all of whom are in the north, could continue their transfer payments to their southern neighbors, but those governments have made it clear that they are not willing to finance ever growing subsidies, nor do they have the political support to continue to underwrite southern Europe’s dolce vita.
One solution is to split the euro into two currencies – a soft euro for southern Europe and a hard euro for its richer northern members. The soft euro would trade at a discount to the hard euro, allowing some of the benefits of devaluation, but possibly mitigating the extreme discounts that a complete euro exit would create on the newly issued national currencies, as well as preserving some of the advantages of a common currency.
Europe’s northern and southern economies are on divergent paths, ones that will make it increasingly difficult to function in the context of a common currency. Without an apparent solution in sight, the EU has been content to deal with each successive crisis as it comes up and postpone dealing with the long-term problem. In the meantime, the next European financial crisis is inexorably building.
Joseph Micallef is a historian, best-selling author and, at times, sardonic commentator on world politics.
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