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EUROZONE CRISIS

Philippe Legrain, economist and author of Aftershock and European Spring, on the global economic recovery and the risks that could further disrupt the world.

In 2008, the financial crisis brought the global economy to its knees. Today, six years later, the world has still not fully recovered from the impact of the crisis. At the same time, several big structural shifts are reshaping the global economy as we know it. Philippe Legrain, a British economist and author, specializes in economic issues pertaining to the global economy and also Europe specifically. He has authored four books including Open World: The Truth about Globalisation; Immigrants: Your Country Needs Them; Aftershock: Reshaping the World Economy After the Crisis and the most recent European Spring: Why Our Economies and Politics are in a Messand How to Put Them Right. Legrain has also been at the heart of Europe’s economic decision making: between 2011 and early 2014, he was Principal Adviser and head of the analysis team at the Bureau of European Policy Advisers to the President of the European Commission.

During a recent visit to Beijing, Legrain sat down for a lively exchange with Liu Jing, Associate Dean and Professor of Accounting and Finance at CKGSB, who is an acclaimed expert on the Chinese economy. Read on further to understand better the big shifts in the global economy, how the European Union and the US are recovering from the crisis, and China’s role on the global stage.

Q. What are the mega-trends that are affecting the world?

A. There are three big trends at the moment. First, there is a cyclical shift this year which is the recovery in the US and to a lesser extent in Europe, with the associated risk of tapering of quantitative easing (QE) in the US, [which may impact] emerging economies, and therefore indirectly China.

Second, a big structural shift [is underway]: the new wave of technological innovation whether it is digital, manufacturing, 3D printing, or in the field of energy. Here in China, obviously, it is the shift from an economy which has been primarily based on imitation and the mobilization of resources to one that is more based on innovation and, then, overriding that huge geopolitical shift, which is the rise of China and how the US will react to that, what strategies China should pursue in response.

Philippe Legrain, economist and author of Aftershock Photo Credit: FT Live
Philippe Legrain, economist and author of Aftershock
Photo Credit: FT Live

Q. How would you rank the risks the global economy is facing?

A. In terms of the impact of QE, we’ve already seen some disruption in emerging economies. Some people have talked about a ‘Fragile Five’ [a term coined by Morgan Stanley to describe fast-growing emerging markets that are overly dependent on foreign investment: Brazil, India, Indonesia, South Africa and Turkey]. I’ve listed a ‘Tenuous Ten’: economies that are particularly vulnerable [Brazil, India, Indonesia, South Africa and Turkey plus Argentina, Chile, Russia, Ukraine, Venezuela. Emerging economies most at risk of a crisis because of current account, currency, commodity and political exposure].

The risk is one could have an all-out emerging economies crisis. Even if one doesn’t, it has important implications for the world and for China. For example, Chinese exports to these economies and other trading partners may be affected. Then there are financial linkages, for example, Chinese banks are invested in Indonesia, South Africa and elsewhere. Then you have indirect linkages, which are not always as apparent but can also be significant. Last but not least, the impact of commodity prices. If we see a weaker growth, in the Tenuous Ten, China enjoy lower commodity prices.

Q. Would you say that the risks are more concentrated on developing economies, than on the advanced economies?

A. For the past few years, most of the risks have been in advanced economies. This year, in a sense, the West has exported its problems to the rest of the world. For the past five years, the US and the Eurozone have been struggling with very difficult issues. Whether it’s the banking system or the associated levels of high debt, they’ve taken exceptional policy measures to tackle them. In the US, it’s QE. In the Eurozone, it’s a big shift towards running current account surpluses. Both of these imply capital inflows to emerging economies.

Now you’re seeing the pressure in the opposite direction: as QE is tapered and then reversed with high US interest rates coming, you will see capital flowing back from the US. Likewise, the market pressure on emerging economies is going to amplify that pressure. You see [that] for China, which is caught in the middle. You have the opportunities [to] sell more to the US and Europe, it’s more attractive there compared to before. But you have potential backlash from the tensions in emerging economies.

Q. China is undergoing a structural change from a manufacturing, export-led economy to a consumption-driven and service economy. Obviously, such big change is going to pose a lot of risks.

A. No one would have forecast China would have done so well over the last 35 years. Or even over the past five years against the backdrop of the worst financial crisis since the 1930s. One has to give credit to Chinese policymakers, and [also] the benefit of the doubt in tackling the huge challenges ahead. There is awareness at the highest level of the shifts that need to be made, that pursuing a certain level of GDP growth is not necessarily the best thing. It’s also where the GDP is coming from, and its implications for the labor market. Clearly, there are vested interests that benefit from the current configuration, and it is a political challenge to overcome [them]. Many of the arguments made about the potential vulnerabilities of the Chinese economy are misconceived. So many people in the West are saying [they] invested too much. If you look at its capital stock per person, it’s actually relatively small, and if you continue to grow at a rapid rate, it can rapidly become appropriate. In a sense you are building before the demand comes.

Likewise, debts have built up, particularly, at the local government level. But assuming you have a high rate of nominal GDP growth, provided you stop adding to those debts, you can also grow out of them quite quickly. In terms of the financial sector, generally, people have talked about the expansion of shadow banking. Clearly there has been some bad lending and some mistakes. On the other hand, it’s also a natural reflection of the regulation of the state-run banking sector.

Many of the things that we are seeing in China exist in the West, too. The development of money market funds came from the regulation of bank deposits in the US, it’s natural we’re seeing that in China too. The risks of a financial crisis in China are greatly overstated. If you have an economy which still has a largely closed capital account, if you have a government whose solvency is unquestioned, and if you have a large foreign exchange reserves which can be brought to bear in the event of problems, China is well-placed to handle this transition. I won’t say this is forever. The bigger challenge is a shift from an economy based on imitation to one based on innovation.

Q. What is the number one risk facing the world in the next 3-5 years?

A. In the short run, it’s the potential impact of the unwinding of QE. We live in a world where the financial sector dominates everything and the core country is the US. The monetary policy decisions of the US Federal Reserve and, in turn, their impact on the US financial sector, and therefore, the global financial sector dominates everything. If you look slightly further out, technology and structural shifts start becoming more important.

Q. You have seen European economic decision-making firsthand. Are we getting out of the problem in Europe?

A. The crisis in the Eurozone began as part of the broader crisis in the Western financial system. It is part and parcel of what happened in the US, Britain and elsewhere. In 2010, the solvency of the Greek government came into question, and because of policy mistakes, sovereign bond markets in the Eurozone panicked. There was a threat that countries might be forced to default and the Eurozone might break up. That panic came to a head in the summer of 2012. The European Central Bank (ECB) intervened, and the panic is now over. You can see countries [that] only a few years ago had to pay double-digit rates, could now borrow at 3% or 4% which is lower than they could borrow before the crisis. That financial element to the crisis, I think, is over. The ECB has solved that problem.

What remains is the legacy of the [time] prior [to the] crisis: a banking sector, which is over-laden with bad debt. It is like a zombie banking sector. And the household sector, in particular, which too is the counterparty to that, is high in debt. An economic process which has only partly been completed, i.e., you‘ve seen a shift from countries running current account deficits, now to surpluses, so now you see them being net-lenders abroad. You’ve seen a big rise in exports in countries such as Spain. But you haven’t seen the full structural shift that needs to happen. These legacy problems need to be tackled.

The ECB this year is conducting a comprehensive assessment of the balance sheet of Eurozone banks. It will report at the end of the year before it becomes a single supervisor, with luck, this will lead to a restructuring of the banking system, and that, in turn, will provide credit for businesses to be able to grow. The issue of restructuring of unsustainable debts is not yet on the agenda, and needs to be. The last element which is in terms of the economic adjustment, we need to have an increase in investment. In that area, Chinese investment can play an important role. There are a lot of opportunities now as the Eurozone economy begins to recover.

Q. What about the argument many years ago that there’s a structural issue in the EU? So, somewhere along the line you will have problems in terms of fiscal policy. Each country decides its own fiscal policy, so there’s this a sort of mismatch. So you know there will be a crisis, but you don’t know when. In that sense, the probability of a crisis is a certainty.

A. It is true that when the Euro was created in 1999, many people said that a single currency requires a common treasury, a common budget; most federal systems, whether it is the US or Germany or elsewhere have such a system. The Euro was slightly different because it’s not a single country, but it’s a single currency shared by many countries. I think that is not what caused this crisis. This could have caused a crisis, but in fact it was a financial crisis which was part and parcel of the broader Western financial crisis. Its origins come from excessive risk-taking in the banking sector, from excessively low interest rates by the US Federal Reserve and by the ECB, and foreign financial deregulation which made this bad lending possible. Yes, that is potentially a problem in the future. But I don’t think this is what caused this crisis.

Q. So you seem to be saying the cause of the crisis is actually very similar between the US and the EU: too much risk-taking, too much leverage. To what extent are the two major economic blocs similar?

A. Many people like Alan Greenspan blame China and the global savings glut for the US financial bubble. This is a ridiculous argument, which is to say, “We are the most powerful country in the world, I’m Alan Greenspan, I’m in charge of monetary policy. Sorry it’s not my fault, and it’s China, a relatively small economy, which caused this”. If you look at one country, at one region that played an important role in the US financial bubble, it’s Europe. German, French, British banks invested into the subprime market, in the CDOs (collateralized debt obligation) and all these complex bets on US house prices. And that, in turn, the initial transmission mechanism from the US crisis to the Eurozone came in the summer of 2007, when French and German banks which were exposed to subprime ran into difficulties. The two crises are intimately linked. In the case of the European banks they didn’t just lend badly in the US, [but] they also lent badly in Southern Europe: housing bubbles in Europe and bad consumer loans in Portugal, and too much lending to the government in Greece.

Q. When the crisis hit, different places had different issues. In the US, some people said that we should let the banks die, but others said the banks are systemically important, and we need to save them to save the economy. In the end, there was a national rescue plan for the banks and the economy, but there are wealth transfers in this process. In the EU, it seems to be even more complicated: different countries are arguing about who should be paying for the rescue. It seems to be the European countries got together and decided we need to save the EU. To your mind, how difficult was it to actually come to this solution?

A. The ultimate issue in a financial crisis is drawing a line under the losses and sharing them out, hopefully in a fair way, or at the very least, in a way everyone can bear them. In the first part of the financial crisis, the banks that got into trouble were bailed out by national governments in Britain, France, the Netherlands, etc. In the second part of the financial crisis, when Greece ran into trouble, in effect, European governments lent money to Greece so that Greece could repay its creditors which, in turn, were French, British and German banks. It was an indirect bailout of the banking system. At the moment, there is a kind of battle between how these losses are ultimately going to be borne. Germany thinks that as much of the burden should fall on Greek taxpayers. It’s pretty clear that Greek taxpayers can’t bear the full burden, which will be pushed onto German taxpayers. Ultimately, there has been a transfer of the losses from the German banks to the German taxpayer, that issue is still unresolved.

What has been resolved is the firm conviction from all sides that they want the Euro to stay together. There were questions about whether Greece was going to stay in the Euro. There were questions whether Germany wanted Greece to stay in the Euro. That question is resolved now, everyone wants to stay in the Euro, everyone wants to make it work well. What’s up for debate is how we go about achieving that.

Q. Going forward, how would the crisis actually affect the rules and regulations, and how the EU is put together?

A. We’ve seen big changes in this crisis. We’re seeing the creation of a banking union with the ECB acting as the single supervisor for bigger Eurozone banks. The creation of a single resolution mechanism, i.e. a single mechanism for restructuring and ultimately closing down banks that run into trouble. We have common EU regulation, in particular, capital adequacy which is based on the global Basel rules. We have seen changes in the fiscal area: more elaborate fiscal ratios set and enforced in Brussels as well as national limits on borrowing imposed in domestic constitutions. And we’ve seen a new mechanism for tackling excessive macroeconomic imbalances, for example, excessive credit growth, or large current account deficits. There’s been a lot of institutional innovation during this crisis, many people think that we need to go further, but we discussed earlier on, potentially the need for a Eurozone budget, which would act as an automatic stabilizer, in the same way as the US federal budget does, which France is pushing for, and which would be a good idea.

There are also moves to try out to complete the single market; the EU single market is the biggest single market in the world. For the moment, it’s mostly in manufacturing goods. And then there is energy, which is even more important now with the crisis in Ukraine, which is connected to the domestic energy market. So you can have trade across countries in energy which would not only be of huge benefit economically, but also important in terms of energy security.

Q. So what is your projection of the European economic recovery in the next three years? In the US, the economy seems to be on a good footing.

A. Europe is obviously doing better compared to two years ago. At the moment, real GDP growth will be roughly 1%. Nominal GDP growth will be 1.5-2%, because inflation is so weak. That is, not a particularly strong recovery, but it is better than the rapidly shrinking economy two years ago. Looking further out there’s hundreds of other imponderables, so I would only hazard a guess for this year.

Q. What is the European view on China’s rise?

A. I think there are two views: there are some that welcome the rise of China as creating a multi-polar world rather than one dominated by the US. And there are others that fear the rise of China, partly for economic reasons, partly for cultural reasons. Personally, I’ve always been of the belief that China’s rise is a good thing, that it would be economically beneficial for Europe.

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