Against the backdrop of U.S. healthcare reform end increasingly upbeat economic reports, the euro zone is struggling to keep its head above water.
The fiscal tragedy enveloping Greece has been widely covered. Portugal has joined the growing list of European nations that have become a serious credit risk.
Today, Portugal’s credit grade was cut by Fitch Ratings for the first time, underscoring a mounting concern that Europe’s weakest economies will fail to meet their swelling debt commitments as their finances continue to deteriorate. As a result of these worries, the Euro slid to a 10-month low against the U.S. dollar.
At the present time, there is no uniform international procedure similar to bankruptcy that permits a country to restructure or entirely eliminate its liabilities by declaring insolvency. As a practical matter, however, it’s a distinction without a difference.
Consider the crippling debt problems facing the tiny island nation of Iceland.
The Financial Bottom Floated Away
Unlike the Greek and Portuguese crises, which can be traced to fiscal mismanagement and corruption, the crisis island arose from the insolvency of the Nordic nation’s three largest banks.
To attract investors and depositors, these Icelandic banks offered returns that were remarkably higher than the rest of Europe. As long as the value of their high-risk portfolios kept expanding, the banks were able to keep pace with their financial obligations.
Then, along with U.S., the European real estate market collapsed. This left the Icelandic banks with mountains of worthless paper, triggering a panic among their many international depositors.
As the crisis deepened, the government in Reykjavik was forced to nationalize the banks to prevent a failure of the entire economy.
Relative to the size of its economy, the Icelandic banking implosion is the largest suffered by any country in economic history. Iceland’s national currency fell sharply, foreign currency transactions were suspended for months, and market capitalization of the nation’s stock market dropped by 90 percent.
By some estimates, the full cost of the crisis exceeds 75 percent of the country's 2007 GDP. On top of the domestic impact, nearly half a million international depositors in Britain and the Netherlands were unable to make withdrawals because their accounts were frozen.
The political backlash in this country of only 225,000 has been epic. On Saturday, Icelanders will vote on a national referendum to determine whether the country should reimburse the U.K. and Dutch governments that stepped in with more than $5 billion in aid to prevent the nation’s banking system from imminent failure.
Dissatisfaction at 75 Percent
In a recent poll prior to this weekend’s vote, three-quarters of the population says they will reject the government’s repayment plan. Rejecting the reimbursement referendum will not only impede further aid to Iceland, it will likely jeopardize the North Atlantic nation’s pending application to join the European Union.
Although France and Germany are nearing a deal to bail out the Greeks, further economic deterioration in Portugal, Spain, Ireland and even Italy, could strain the overall solvency and viability of the entire euro zone.
Portugal’s deficit is 9.3 percent of its gross domestic product, more than triple the European Union’s 3 percent limit. Failure by the E.U. to agree on a mechanism to help these countries shore up their finances will continue to hurt the euro, putting it on course for its worst quarter against the dollar since 2008. In spite of brightening prospects among Europe’s largest economies like Germany and France, some analysts fear that the rising fiscal instability confronting the zone’s lesser economies could trip the dominoes, causing a second recessionary wave.
Unless the Portuguese and Greek electorate accept the austerity measures their governments are being forced to impose, both economies could face a slow death, compelled to dedicate an increasingly higher proportion of their wealth to paying off debt and the premium demands of investors who hold their bonds.
If these governments and their European partners don’t act quickly, they, too, could doom themselves to the same fate that has befallen the frozen Icelandic economy.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com
