A dichotomy between the 1997 Asian Financial Crisis and the 2011 Euro crisis

    Empire’s rise and fall, just like stock markets. Japan faced a lost decade in the 1990’s , and now it’s the turn of Europe to face a lost decade sort of situation, and as economics will have it, Europe will also one day come out of this crisis which  would plunge some other country into ‘crisis’ .

     We live in an absolutely hilarious world where policy makers make policies such that boom’s last longer than busts, yet we have a situation where:

Greece owes $360billion to other Euro economies

Ireland owes $865billion to other Euro economies

Spain and Italy owes $1 trillion to France, Britain and Germany

France and Britain are themselves struggling with poor economic growth

Spain owes $40billion to Italy

Italy owes $27 billion to Spain

People are selling Euro to buy $ because the US economy is strong. Why is it strong? Because it is owned by China!

So broke economies owe money to other broke economies, and none of them have any resources to pay each other back.

    Buoyed by fiscal overspending and budget imbalances, Greece is increasingly looking isolated and there is talk that all the nations which have got a high debt/GDP ratio should be thrown out of the Euro zone and a new currency should be floated for each one of these countries. Now the countries which fall under this category are Spain, Ireland, Portugal, Greece and Italy. That means if all these countries are taken out of the Euro zone then each of them will have their own currency which will be severely devalued against the Euro.

    If we look back at a similar crisis which happened in Thailand in 1997 then we get a few important tips as to what may happen if a currency severely looses its value against another currency. There is a great dichotomy in both these situations in terms of currency analysis.

Thailand was recording 5%-7% growth for 10 years consecutively backed by their export sector, but the real emergence of China in 1997 as a low cost competitor severely tarnished Thailand’s exports. The Baht was at that time pegged to the USD at the rate of USD: BAHT 25. When exports plunged it gave an asymmetrical opportunity for traders to short the Baht and hope that if the peg was taken out then the only way that the currency could go was down. Thailand’s central bank used 22 Billion Thai Baht to save its currency, but the efforts went in vain and the economy collapsed.

    One very important thing that happened in this crisis was that Thai companies had foreign currency denominated loans in their Balance sheet, (which were encouraged by the the fixed exchange rate regime) and severe devaluation led the Thai companies to default on their loans. These loans were mainly taken from banks in Russia and other Asian banks. Thai debtors were unable to pay back the loans they had taken from banks outside their nation due to the devaluation. Bad debts in the books of the banks forced them to stop lending to the businesses as each loan would be an asset in the books which required tier 1 capital according to BASEL norms. Their capital had already been eroded due to the Thai devaluation and could not risk further losses. Russia eventually entered into a depression because of the Baht collapse and for the first time in its history defaulted on its sovereign debt, which led to further collapses of well renowned hedge funds that never saw this problem coming.

    If a similar situation unfolds  in Europe with 2-3 countries being thrown out of the Euro Zone, then bank’s in Spain , Ireland and the UK would collapse or would need massive recapitalisation to maintain the new BASEL 2 norms.

To explain this to a layman,

Each asset on the balance sheet of a bank is given a weightage from 0 to 100%, and the bank need’s to keep aside Tier 1 capital to safeguard itself against operation risks that a bank may have.

Now loans given to Greek businesses or to any business which is operating in the troubled economies will be a bad debt in the Balance sheet of these bank’s if these troubled economies start floating their own currencies. If this happens then there will be utter chaos , as central bank’s from the “core euro” economies would need more euro’s to recapitalise these bank’s which would extend the severity of the crisis instead of shortening it , as loans given to non Euro countries would get a higher risk weightage in the risk model’s of banks.

  This means printing more money, or borrowing from the IMF to just recapitalise the banks. So instead of saving the Euro, the currency may boomerang to even lower levels.  This even increases the possibility that we may see ‘run on’ on bank’s if the situation is not handled properly by Central banker’s (The fall of Northern Rock is a classic example of regulatory apathy towards preventing a ‘run on’)

   This problem is just the tip of the iceberg, Greece has officially defaulted on its bonds the haircut which European bank’s had to take due to this is a different story all together.  Already one trance of recapitalization of these banks has taken place. Italian bond yields are now trading close to Indian bond yields. If they too officially default which is a very likely probability considering the fact that only Haiti and Zimbabwe had a lower economic growth than Italy in the decade upto 2010. It will have unprecedented ramifications throughout Europe. Taxpayer’s money will again be used to bail out the banking sector, which would lead to tremendous social unrest and a global meltdown

    I do not have the exact figures in front of me as to how much would the loss be to the euro bank’s tier 1 capital if certain nations were thrown out of the Euro. Judging by the scale of these troubled economies if Greece is thrown out then it may be manageable, but if a country like Italy is thrown out then it can result in windfall losses for the bank’s operating in the ‘new core euro’ area.

- Abhishek Gupte

Disclaimer: - Mine is an advisory role, the facts and figures in this article cannot be guaranteed. The final decision and consequences based on my information is solely yours.