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China should prepare for worst outcome in Europe|
By Sun Lijian | 2012-6-8 | NEWSPAPER EDITION
MASS protests against austerity have erupted in debt-laden euro nations like Spain, casting a pall over the worsening sovereign debt crisis.
Under these conditions, European Central Bank officials have mentioned the possibility of a Greek exit from the euro.
Why could troubles in a few nations have grown to the extent of triggering a full-blown, region-wide crisis that has severely impaired global recovery and cast into doubt the euro's future?
In effect, economists including Robert Mundell, often known as "the father of euro," and Nobel Prize laureate Paul Krugman, envisioned long ago a scenario in which a supranational currency would succumb to three combined factors and fail.
They argued that if a country keeps overprinting its currency to fill budget deficit, and meanwhile struggles to maintain a stable exchange rate, a currency debacle is inevitable when that country opens up its capital account to foreign investors.
The debt crisis that has swept Europe is akin in nature to the scenario prophesied by Mundell and Krugman in three respects.
First, there's an inherent flaw in the euro's exchange rate policy. Since the eurozone is a single currency bloc, depreciation is not a viable option regardless of whether the economic fundamentals of Greece, Italy and Spain are in dire straits.
Even if the ECB devalues the euro to boost the export advantage of indebted eurozone members, that will do little to improve Greece's fortunes, for exports represent a tiny proportion of its national economy.
Its pillar industry of tourism, however, is seriously hobbled by a sluggish Western economy.
Germany: the locomotive
But if we look at the eurozone's overall economic well-being, we'll see that a steep depreciation should not be in the cards.
Germany, the eurozone's locomotive, is still full speed ahead, thanks to its export strengths.
Germany's spectacular performance indicates that a depreciation, though highly unlikely, will be short-lived, for German growth will soon make the euro strong again.
Another consequence is that a vast number of hedge funds will rush to speculate on the interest rate differences, and with the complicity of the ratings agencies in their countries of origin, they will buy euro assets at rock bottom prices, adding to the euro's miseries.
Second, the eurozone is naturally deficient in macroeconomic control.
Although a single monetary policy greatly contributes to the euro's global creditability and status, the region's inability to bail out members in trouble the same way the Fed saved tottering banks is its Achilles heel.
In the absence of fiscal discipline, indebted euro nations had expanded their expenditures on social welfare well before the crisis, something encouraged by a credit market once awash in liquidity.
But now with the crisis in full swing, Greece, unable to get fiscal help from the EU, can expect no monetary policy to work magic either.
Moreover, the lack of coordination within the EU has widened the gap of distrust between member nations whose taxpayers are against bailout of their neighbors and debt-ridden nations whose citizens oppose austerity.
As that gap widens, the market is gripped by mounting fears of a Greek, Italian or Spanish default. Those fears have prompted a cascade of fire sales of euro assets.
Finally, the lack of effective financial oversight has created room for speculators to short-sell euros.
European financial markets, wary of a credit crunch, will be even more reluctant to lend to Greece to service its debt.
A vicious cycle emerges that compounds the euro's woes.
If Western nations or the International Monetary Fund can join hands in regulating the financial market and curtailing the short-selling of euros, the vicious cycle may relent a little.