The looming euro zone liquidity and credit crisis could have significant consequences for B.C. and the rest of Canada.
Ireland, Portugal and Greece have been bailed out. Spain could not support its own banks, and it, too, will receive funding from the European Union (EU). Around the corner awaits Italy, whose debt-to-GDP ratio of 120% is second only to Greece in Europe.
Aging demographics, overspending welfare states and a failed common currency experiment have caught up with the euro zone. Markets and lender governments are imposing high interest rates, austerity and bailout conditions that require ceding sovereign fiscal rights. Governments that are borrowing and suggesting that growth and reduced debt can be achieved simultaneously forget that they don’t hold the purse strings and don’t have the global reserve currency.
In the past, when a country became insolvent it defaulted, imposed capital controls to restrict bank runs and restructured its debt. Creditors took a hair cut. The currency devalued and increased import costs created high inflation. Jobs were shed, savings liquidated and government revenue and spending slashed.
However, within three to five years, a more competitive currency and an enforced pay-as-you-go discipline spurred exports, curtailed consumption and created jobs. Economic recovery followed a necessary restructuring. Look at Argentina during the period from 1999 to 2002 as an example.
Despite the recent Greek election, the chances of a euro exit will continue to grow because the financial fundamentals in Greece have not changed. Chances that the others will revert to their own currencies are also increasing. Whether or not countries exit the euro, we will see capital injections to shore up banks and stimulus from the EU.
If there is an exit, it will be attempted in an orderly way with restrictive capital controls to stop liquidity flight. However, the short-term impact will be a spike in risky credit spreads and devaluation of the euro as markets watch for possible contagion.
Capital will seek the safe haven of U.S. treasuries, causing the Canadian dollar to devalue temporarily against the greenback. In 2008-09, the Canadian dollar dropped to US$0.80 for six months before recovering to near parity.
In 2009, B.C. real GDP declined 2.1% before recovering to 3% growth in 2010. The impact on B.C. this time is likely to be less severe, because we have far less exposure to Europe than the U.S.
Canadian banks, already well capitalized and with relatively small direct exposure to Europe, should avoid tripping minimum capital requirements. However, being one step removed should not make us complacent. In the last crisis, most economists and policy-makers underestimated the knock-on effects of financial contagion. Massive and speedy government intervention was required to avert a meltdown. The greatest risk in Europe is that the bureaucracy will not act as quickly as required.
Exports represent 42% of B.C.’s GDP. Commodity price declines and weak international demand would slow the growth of our provincial economy over the short term, and sales would fall for businesses with direct European operations. Be prepared if you or your customers have European exposure.
Eventually, all that freshly printed stimulus money will again find its way into asset prices, such as gold, oil and real estate, which overall is positive for B.C. in the medium term.
With AAA credit ratings, Canada’s federal and provincial governments are well placed to act if required. The Bank of Canada could also expand monetary policy further. Compared with most places in the world, B.C. is well positioned to weather a euro-induced storm. •
