How euro zone woes affect Asia

By Jonathan Eyal Europe Correspondent In London

THE problems that currently dog the euro zone countries can be traced back to the end of the Cold War two decades ago, a period when, paradoxically, Europe seemed to be at the height of its powers.

It was then that the European Union embarked on its most audacious project: the creation of the euro as its single currency. Some experts warned that no monetary union can succeed unless national economies approach a similar level of development and spending priorities are decided centrally, rather than in each state.

But the Europeans ignored such warnings because at the time, their economies were growing, the Soviet Union was defeated and the former communist countries of Eastern Europe were rushing to copy the West's economic and political model.

The result, however, is today's disaster.

What went wrong? A currency designed for an economic powerhouse such as Germany was also adopted by Greece, whose exports are less than a tenth those of Singapore's.

According to European treaties, governments were required to watch their finances and not borrow more than they could afford. But the restrictions were simply ignored. In the past, governments of weaker and poorer European states had to pay higher interest when they borrowed. But once everyone in Europe had the euro, they could all borrow at the cheap interest rates which previously only a country like Germany enjoyed.

Debt piled up as it became easier for politicians in poorer countries to borrow money in order to offer their voters new social benefits than it was to tax their people to pay for these spending promises.

Yet the game had to stop at some point and it did, once it became clear that some countries were simply unable even to keep up with the repayments on their loans, since their total debt was higher than the value of their entire economy. By 2010, for instance, Greek debt stood at 120 per cent of the country's gross domestic product (GDP). In effect, the country was bankrupt.

Others such as Portugal, Ireland and Spain too ran into debt problems. They were ultimately bailed out, but only in return for agreeing to apply severe austerity measures. The Greek economy has fallen by an average of 5 per cent for the past four years. Unemployment in Spain stands at 23 per cent of the population.

Nor is this all, for Europe's long-term economic competitiveness is being destroyed by an over-valued currency as well. For example, since Italy adopted the euro, its effective exchange rate - based on its labour costs - rose by 26 per cent. The only way this disparity can be addressed is by either devaluing the currency, or by depressing the salaries of workers, a method which economists call "internal devaluation".

The first option is not available, since the euro is controlled by a bank beyond the influence of any government. And the second option is equally impossible, since workers will not tolerate a huge drop in their earning power.

Getting out of Europe's monetary union is not an option either. According to the most optimistic calculations, an exit from the euro could cost Italy about 10 per cent of its GDP and it will need about 25 years of uninterrupted growth to merely recover from this loss. In short, the Europeans are damned if they stay in the euro, and damned if they don't.

What lies ahead is decades of misery. Since the end of World War II, Europe's economic model had been broadly the same. Each government came to power promising to expand the provision of health care and welfare services. And each took it for granted that the economy would inevitably continue to grow. Capital was cheap, companies made fat profits and jobs were plentiful. Europe's model has been fraying for years. An ageing population has already made the generous provision of pensions unsustainable.

Europe's current crisis means that the hard choices can no longer be postponed. As debts are being repaid, welfare entitlements will be slashed. And Europeans will be forced to save rather than spend, leading to a prolonged period of zero growth.

The consequences for Asia are both direct, and potentially severe. Europe is still the world's biggest trading bloc: the overall value of EU exports and imports of goods and services and foreign direct investments is worth about €3.5 trillion (S$5.6 trillion) a year. And although by 2015 it is estimated that 90 per cent of world growth will be generated outside Europe, it still accounts for about 18 per cent of world trade, so what happens in Europe directly affects economies everywhere.

Furthermore, a prolonged recession in Europe also means that China's economy may not be able to grow as fast as anticipated, and that in turn could hurt the economies of other Asian countries which depend on exports to China for growth as well: that's why, as a rule, bad economic news in Europe tends to depress stock market valuations across the world, and particularly in Asia which relies so much on trade for its prosperity.

There is also a risk that, as the crisis in Europe continues, there will be pressure on European states to protect local jobs by restricting trade, or by deliberately pushing the currency down to make their exports cheaper. For the moment, such protectionist temptations are being avoided; indeed, the EU is negotiating a bigger free trade agreement with the United States, and with key Asian countries. But as the crisis continues to bite, the danger of protectionism will loom large.

The failure of the euro to become a truly global currency on a par with the US dollar also affects Asia, partly because it would have been good to have an investment alternative to the US dollar, but also because most Asian central banks hold a part of their reserves in euros, and could therefore suffer losses.

Still, not all the consequences of Europe's crisis are negative for Asia. The prolonged recession in Europe means that Asian countries can pick up some good investments in Europe, since these are cheap. Sovereign wealth funds from Asia have been purchasing European assets, particularly those in the high-tech industry, luxury goods and design, areas in which Europe continues to excel. Most of Europe's car manufacturing sector also has a large content of Asian capital, particularly from China.

Europe's prolonged recession also means that highly-qualified Europeans are available to be hired for jobs in Asia; their talent can help Asian economies grow even further.

And ultimately, the crisis over the euro is also a reminder of the pitfalls inherent in introducing a one-size-fits-all currency for a number of countries; Asean, which also occasionally contemplated the introduction of a single currency, now knows what to avoid.