The markets are jittery that the late-hour financial rescue package for Greece is a harbinger of more bad news out of Europe. At the heart of the crisis is a basic weakness of the European Union which markets see as a conglomeration of diverse countries held together by nothing more than a single currency.
If the crisis spreads through contagion, there is a real danger that the single-currency glue can no longer hold the membership together. As the Managing Director of the IMF recently told the European Parliament “The crisis has shown you can’t have a common currency without having a more coordinated economic policy”.
We can expect the Union to come under increasing strain if weaker members, with their larger fiscal deficits, mounting external debts, and lack of competitiveness, do not mend their ways in the interest of the collective membership. Thus while the financial rescue for Greece may temporarily cauterize the loss of confidence in the EU, the larger issue, involving this fundamental disconnect between monetary discipline and fiscal profligacy, remains unresolved and hangs over the EU like the sword of Damocles.
Can the membership cast aside its cultural, political, and economic differences in the larger interest? That’s a tough call because old habits die hard. That explains why members of the Union do not seem particularly willing or able to relinquish their fiscal sovereignty as that would involve changing long-standing behavior and expectations in those countries.
As the EU ponders its policy alternatives, the markets are looking nervously at Portugal which is one of its most indebted members. The build-up of negative sentiments against the Euro zone is reflected in renewed pressure against the Euro vis-à-vis the U.S. dollar and in rising Portuguese government bond yields.
The country had a large fiscal deficit of around 8 percent of GDP in 2009 and the gap is likely to increase further this year to 8.6 percent. Reminiscent of the Greek crisis, the IMF has recommended that Portugal raise VAT revenues and cut the public wage bill and social welfare expenditures.
The government has started to cut its fiscal deficit. However, as the economy is already very weak and unemployment levels are high, serious policy measures to close the gap will probably be back-loaded pending a firmer foundation to economic growth. Otherwise, there is a distinct possibility that fiscal tightening will nip any nascent recovery in the bud. In the meantime, low labor productivity due to weak competitiveness and heavily indebted households are exacerbating market sentiments against the country’s long-run solvency.
Non-performing loans are rising as domestic banks become more vulnerable to default in the wake of increasing consumer and corporate debt. Research at Global Financial Integrity (GFI), a research and advocacy group in Washington DC, confirms that deteriorating economic conditions have been fueling massive illicit flows from Portugal over several years.
Flow of funds analysis, which looks at a country’s source of funds against its recorded use, show that Portugal lost a total of about US$138 billion through illicit transfers over a five-year period ending 2009. Apart from such balance of payments leakages, model estimates based on IMF’s Direction of Trade Statistics indicate that Portuguese traders also over-invoiced exports (probably to gain VAT refunds) and under-invoiced imports (to evade duties or VAT on imports).
The government lost significant revenues during this period as a result of the criminal falsification of customs declarations which shifted US$75 billion illicitly into the country. The IMF’s call to raise VAT revenues may lead to more evasion if the increase in VAT rates are not accompanied by customs reform and economy-wide improvements in governance.
Under the traditional method of analyzing capital flight, economists would net out illicit inflows from outflows and estimate that Portugal lost an estimated US$63 billion in illegal capital flight, even though the government could not have taxed the unrecorded inflows of capital. In contrast, by setting illicit inflows through trade mispricing to zero, the GFI method estimates that Portugal lost US$138 billion or an average of US$27.6 billion per year in that five-year period—a loss of much needed capital that can be linked directly to Portugal’s difficult financial situation.
Regardless of methodology, the Portuguese case illustrates the “revolving door effect” between debt and illicit outflows in that new loans merely financed illegal capital flight from the country. Such a loss of capital could only have acted to weaken the country’s capacity to meet upcoming financial obligations. However, there is a silver lining in the gathering cloud over Lisbon—measures to curtail illicit financial flows also strengthen the country’s capacity to service external obligations. The coincidence of policies does not mean that the policies would be easy to implement but rather that Portugal needs to make a clean break with the past in order to restore market confidence.
Dr. Dev Kar, a former IMF senior economist, is lead economist at Global Financial Integrity, Washington DC