Asia and the euro crisis

September 30, 2011

(Paul Donovan is a Managing Director and Global Economist at UBS. The views expressed in this column are the author’s own and do not represent those of Reuters)

The euro should not exist. More precisely, the euro should not exist in its current form, with its current membership.

A monetary union of 17 countries with little in common (beyond geographic proximity and a history of invading each other) was never likely to work. This crisis seems to have been inevitable — I, and most of the rest of the economics profession, have argued against the euro (in its current form, with its current membership) for sixteen years.

So the euro should not exist. However, the cost of breaking it up is hideous. Rough calculations suggest the Greek economy would halve in size if Greece were to exit the euro. That is a far greater cost than anything Asia experienced in the 1997-98 crisis. If Germany were to try to exit, it would cost it a quarter of the German economy. There are also political costs. The economic damage (and unemployment) would be the worst since the 1930s. In extremis that economic pain could provoke anything from widespread social unrest to military government or even civil war.

This leaves Europe trying to work out how to make the euro work. The solution must involve some kind of fiscal confederation. No monetary union has ever survived without a fiscal union alongside it. Unfortunately, the politics of fiscal integration are not playing out smoothly. Euro area politics sometimes seems akin to the politics of the playground. Politicians seem inclined to yell “shan’t” whenever economists ask them to play nicely with one another.

The euro will develop in time. Unfortunately, the process is unlikely to be rapid or easy. The euro area seems set to experience a series of crises in the coming years. Each crisis will be accompanied by uncertainty, market volatility and consequences for Asia.

Why should Asia care about the crisis of the euro area? For two reasons — the current account and the capital account.

Asia does a lot of trade with Europe. The European Union (the larger grouping of twenty seven countries, to which the euro group belongs) is the largest single economy in the world, accounting for 27 pct of GDP. In comparison, the US is 23 pct of global GDP. Asia (excluding Japan and Australia, but including China and India) is 18 pct of the world economy. Asia exported $541 bln to the European Union in 2010. Europe swallows 16 pct of Asia’s exports directly — before accounting for the intra Asian trade that ultimately feeds European demand (for instance Korea exporting components to Thailand which then exports a finished product to Europe).

If the euro is hit by a series of crises, then weak euro area economic growth seems likely. The euro area will be a less dependable source of demand for Asian exports. That means that Asian demand will have to substitute for euro area demand.

When looking to Asia’s capital account, it is obvious that the euro area has been an important investor into Asia in recent years — both in financial assets and in direct investment. With the advent of the euro crisis, euro area investors are keen to have their capital in liquid assets, in euro currency, and to take profits where they can. All three factors suggest repatriation from Asian financial markets; that now seems to be happening.

Moreover, with financial market turmoil in the euro area, it seems quite likely that governments will increase financial sector regulation. Some of the policies of the past two decades, which liberalised capital flows, may be reversed. If banks, insurers, or pension funds are told to increase holdings of euro bonds (for “prudential” reasons) they will be less able to invest overseas. The future flow of capital from the euro area to Asia will be less than it has been in the past few years. Indeed, the capital flow could be substantially less.

Asia cannot afford to ignore the euro area. The debates across the chancelleries of Europe are unpleasant to watch, but Asia must pay attention. What happens with the euro will impact Asian economies and markets in years to come. Asia must change to meet the challenge of a more crisis-beset euro area. Asia needs to rely more on domestic demand and more on domestic capital.

So what happens now? I look at the rest of this year with apprehension. It seems inevitable that Greece will default. For financial markets, the question of Greek default is “when” not “if”. But “when” is very important. If Greece defaults before there is a plan to assist Euro banks and stabilise the financial system, then the crisis could escalate into catastrophe. The euro area needs to stabilise (potentially to recapitalise) the euro area banks: then, and only then, can Greece be allowed the dignity of an orderly default. While I hope and believe that euro area politicians understand this, there is always a risk that politics triumphs over good sense.

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