Credit Crunch II – coming soon to a bank near you?

What a difference a year makes. Back in November 2010, South Africans were still basking in the glory of a world-class World Cup, summer was on its way and the mood was generally good. Yes, there was a new acronym in the world’s financial media– PIGS, but then there was also BRICs and some were even talking about BRICSA. And anyway, Europe and America surely couldn’t really be in that much trouble. After all, don’t they represent the ‘civilised world’?

A year on, and the world has changed substantially. The outlook has moved from uncertain to unpleasant. Talk of an imminent Lehman-style collapse is everywhere and solutions seem remarkably thin. Frustrated markets now rise on a lack of bad news.

So how did we get here, what can be done about it, and what is the likely impact on South Africa?

How did we get here?

Decades of politically expedient tax breaks from Western governments, designed specifically with the intention of prolonging their stay in power and focused only on the period that they would potentially be in power, saw a spoiled and pampered populace become increasingly expectant and less productive, with complete disregard for who would eventually, if ever, pay back their debt. Of course, not everybody was the same. The Germans, for instance, were frugal in their spending and diligent in their work; the Mediterranean nations more spendthrift and lazier.

In a world where credit was abundant, the problem was masked for longer, but as credit was sucked out of the system in late 2008, the guilty were suddenly exposed and the levels of debt became unbearable.

What can be done?

A variety of proposals have been put on the table.

· Let Greece default, investors (mainly the world’s banks) take a 50% haircut (i.e. lose 50% of their investment), give Greece another €130bn bailout to stay afloat and make them accept more austerity. There are three problems with these measures:

o Even after these measures, Greek debt as percentage of GDP will be at unsustainable levels of around 120%, so this won’t be the end of their problems.

o The Greeks don’t want it. Like the Italians, Irish, Portuguese and Spanish, the public are outraged at the size and scale of the bailouts, as they feel they were designed to rescue German, French and British banks rather than the taxpayers themselves, yet it is the taxpayers that will have to pay back the bailouts!

o And finally, nobody predicted the devastation that would follow ‘letting Lehman go’. When Lehmans was allowed to collapse, banks around the world realised that if authorities were prepared to let Lehmans, the world’s fifth largest bank, default, then nobody else could expect to be saved. Overnight, banks’ attitude to lending changed; they refused to lend to each other as nobody knew how much subprime rubbish the banks they were lending to had inside, and therefore what the chances were of them defaulting and not being able to pay back their debts. Who is to say that exactly the same wouldn’t happen again if Greece were allowed to collapse? There is a very real possibility that the system would once again seize, but this time instead of banks questioning how much subprime their counterparty was exposed to, this time it would be how much dodgy sovereign debt they were exposed to, and Credit Crunch II would be coming soon to a bank near you

· Another option bandied about is to print more euros and get the European Central Bank (ECB) to buy up the dodgy bonds, thereby creating demand. This would be inflationary and detrimental to the value of the euro.

· Another option is to boost the size of the European Financial Stabilisation Fund (EFSF). With Italy and Spain requiring €350bn in refinanced loans over the next year alone, the current size of the EFSF at €440bn is clearly insufficient to meet near-term financing needs. So the idea of recapitalising it has been mooted, but the problem is that the Europeans (read Germany) can’t really do it alone, so the idea has been suggested that the G20 contribute pro rata on the grounds that it is in everybody’s best interest that the Eurozone doesn’t collapse. Even SA, according to Pravin Gordhan, would have to contribute several hundred million dollars. However, not all are impressed – Gill Marcus, the Brazilian President and the Chinese have all been fairly vocal in saying that Europe must sort out their own problems, although it seems they would not be averse to contributing to the IMF.

So options do exist, but the problem is that Europe is leaderless. Despite Merkel and Sarkozy’s best efforts to force decisions, with 17 different nations, many of whom don’t really like each other, decision-making is near impossible and austerity has lead to crisis and regime change, further exacerbating decision-making. So far, austerity measures have seen regime change in Ireland, Portugal, Slovakia, Greece, Italy recently and now Spain. And with current levels of high debt and low growth, more are likely to follow.

Ironically, the US as a whole is in more trouble than Europe Inc., yet all we hear about is Europe and not the US. Why? The answer, very simply, is that the US has one tax system; all the money goes into one pot and they have one decision-making body. The US Treasury decides where that money goes, so they can take taxes from Texas and given them to California, without having to ascertain what the Texans think of the Californians. That is the crucial difference. The Europeans have to rely on the generosity of the Germans.

What will the impact be on SA?

The impact on South Africa will depend entirely on what ultimately happens in the Eurozone.

· Option 1 would see the lack of decision-making and volatility continue to the point where eventually one of the affected countries defaults, disorderly or not. This would likely be followed by a sucking of confidence out of the system and with it, most likely credit, as banks once again question the potential stability of each other. In this world, everybody is suddenly risk averse and the big investment funds pull their money home, primarily to Europe and the US, but particularly out of emerging markets. This would see emerging market currencies, in particular the rand, which is more liquid so they can escape faster, depreciating rapidly, possibly by as much as 30%. Stock markets too would be punished in the retreat, not dissimilar to 2008.

· The more likely option is one which sees Europe continue to muddle along, putting out one fire at a time, possibly ejecting a few countries from the Eurozone and implementing a common fiscal system with a defined set of rules for both borrowing and spending, which would essentially see the whole of Europe living, spending and working like the Germans. In this world, American and European investors, who in the nineties saw no need to invest anywhere but home, (i.e. in US and European equities and currencies) will be starved of growth and yield and venture forth into countries and markets that look more exciting. In this world, SA, which fortunately trades with both the East and West, would would sell off initially but over time experience slow but relatively impressive growth, gradually strengthening and delivering moderate yet inflation-beating returns.

In short, everybody gets hurt, one way or the other. Some countries just get hurt more than others. Even after haircuts, Greek debt to GDP will apparently remain around 120% for the next decade. All the bailouts will have to be paid back by the European taxpayers for the next few decades, so expect austerity-induced pain and slow growth to be around for a while.

Obviously, a Chinese hard landing would be disastrous for the global economy, but given the arsenal of stimulus at their disposal which includes reducing rates, easing credit restrictions not to mention $3 trillion of reserves, they can stimulate their way past most bubbles that possibly exist in their real estate and financial sectors. So yes, expect them to slow from current levels of around 9%, but not to hard-landing levels, which would be around 6%.

In summary, be thankful that you are not a European taxpayer. Tread carefully, keep some powder dry, i.e. cash, as there will be some great buying opportunities ahead. Don’t allow emotional reactions such as fear to keep you out of the market forever. This too will pass, and with the amount of cash sitting on the sidelines, when confidence returns to the system, the relief rally will be quick. This explains why most individuals have been investing in balanced funds, allowing the professionals to make the decision as to when, where and how to phase back into the market.

A last thought – if there is a silver lining for SA from the Eurozone crisis, it is that just as the devastation suffered by Zimbabwe’s agricultural industry as a direct result of the land grabs eased pressure on the calls to the do the same in SA, so too will the experiences of Greece etc. make it much easier for Government in SA to see tangible evidence of what happens when your people live beyond your means, which should make following policies of financial prudence a lot easier than may otherwise have been the case.