Kenneth Rogoff on Europe's debt and China property

On July 6 and 7 FinanceAsia and AsianInvestor will jointly host the annual Asia Pacific Debt Investor Forum. This year, the conference will focus on strategies to minimise uncertainty through the sovereign debt crisis. Kenneth Rogoff is the guest keynote speaker.

Rogoff is the Thomas D Cabot professor of public policy and a professor of economics at Harvard University. From 2001 to 2003, he served as chief economist and director of research at the International Monetary Fund, and he is a former director of the centre for international development at Harvard.

Rogoff is also a co-author of This Time is Different: Eight Centuries of Financial Folly, which he wrote together with Carmen Reinhart, professor of economics at the University of Maryland. In the book, Rogoff and Reinhart provide an historical account from as far back as mid-14th century England to the recent US-led financial crisis.

The preface to the book states that the main theme of the study was that excessive debt accumulation, whether by governments, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. As Rogoff and Reinhart mention in the book, "such large-scale debt build-ups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and constantly needs to be refinanced".

In the lead up to the conference, Rogoff spoke to FinanceAsia about the current sovereign debt crisis in Europe and the impact it is having in Asia.

How did the markets end up in the current sovereign debt crisis so soon after the financial crisis?
Whenever you have a wave of international or regional banking crises, one typically has a wave of sovereign debt crises following within a few years. We've seen this time and again. Reinhardt and I have documented this in our book. In fact, we had already predicted a couple of years back that this would happen somewhere in the world.

It's not surprising that this happened because firstly, the governments had to build up a lot of debt during the credit crisis in order to combat it; and secondly the crisis had shaken up the financial markets quite considerably, which hurt debtors. It is also important to note that this is no overnight phenomenon that will go away over the next couple of months. The wave of sovereign debt crises that is affecting the markets will play out for a few years to come.

Why Europe? How did they get themselves into this situation?
Specifically why it happened in Europe was clearly the advent of the euro, which had seduced investors and borrowing countries into believing they could sustain much higher debt levels than before, either because of membership or the prospect of membership.

Greece and Portugal shouldn't have been admitted to the eurozone so quickly and should have been given a longer incubation period. Now, many of the Eastern European countries will get into trouble over the next few years as the IMF tightens the screws. Most are probably a decade or two away from being suitable for eurozone membership, at least -- so we are likely to see the debt problems worsen there before they get better.

Many European countries are still emerging markets and the debt levels that they're taking on are far beyond what is normal given their state of development. Yet, governments and investors thought it would all be okay because they have the euro (like Greece) or soon will get it (like Eastern Europe). This is the crux of what Reinhardt and I talk about, with the "This Time is Different" approach to financial crises.

How robust is the bail-out package issued by the European Central Bank?
It is a necessary step but it's almost surely not enough to stop the bleeding because some of the countries pitching into the package are the ones in trouble. So the true amount available is less than meets the eye.

The same goes for the funds issued by the International Monetary Fund. The IMF has said it will put in up to $300 billion to the package, but a large chunk of this would really only come into play if the big countries such as Germany, Italy and France were to collapse.

The real problem is that the adjustment required in Greece, Spain and Portugal is so draconian and so sustained that it's not credible. Greece is being asked to go into debt for the next two to three years and at the end of the period is expected to have a much higher debt-to-GDP ratio than when it started. Somehow the markets are meant to believe that this is sustainable, but the scenario is just not plausible. Because of this, the European Central Bank finds itself in an awkward position.

The bailout is enormously unpopular with the voting public in Germany and it is not terribly popular anywhere else in Europe. Despite governments signing the €750 billion ($917 billion) package, given the objection by the public it will be difficult for the money to materialise in full in the borrowing countries once it is known how long the debt will keep the countries in recession just to avoid restructuring. If the public decides that it is not a good trade the bills won't get passed in the respective parliaments.

There is talk in Asia that the longer this crisis is drawn out, the more it becomes a region-specific problem. How immune is Asia to what is happening in Europe?
Europe is a major trading destination for Asia to the extent that if all of Europe goes into recession that can't be good for growth in Asia. The most likely scenario is that Europe figures out a solution, which allows at least the larger countries to sustain their recovery. That's all still a question mark right now.

Reinhardt and I find that typically these sovereign crises that follow after a financial crisis are after-shocks that aren't as bad as the original. Asia needs to find ways to sustain more domestic consumption growth, which has been a challenge in the past. If it achieves that, it can expect to maintain reasonably robust growth over the next few years even as Europe struggles.

Within Asia, all eyes are on China and the property sector in particular. What's your opinion on this? Is it a bubble or not?
It is difficult to evaluate with any certainty as to what is going on in China as the data coming out of the country is poor. Nevertheless, one has to be concerned whenever one sees a housing price bubble that is being driven by big rises in leverage. Leveraged-finance housing bubbles are perhaps the best leading indicators of a financial crisis, although they are not decisive.

The question is whether the China property price explosion is an indication that there may be broader imbalances in the economy that could lead to, at least at some point in the next few years, a significant slowdown to work off these imbalances. Surely, the Chinese economy is subject to business cycles like every other economy. And even though it has excellent stewardship, there are limits as to how much the cycle can be tamed. The world learned that at the end of the Greenspan era. I suspect that imbalances in China are still growing but it's hard to know.

A fundamental aspect of financial crises is that it is virtually impossible to precisely call the timing, because so much depends on confidence, politics and human behaviour in ways that are difficult to model. Even in the US we were calling it both ways until the crisis happened. There were arguments on both sides and those of us calling it a bubble were in a distinct minority.

Given all the volatility that has been disrupting the markets in the current quarter, are the prospects still bullish in Asia?
This should still be a very strong growth year in Asia, even with the uncertainty coming out of Europe. Asia is experiencing a v-shaped recovery from the crisis because it wasn't at the epicentre and, by and large, Asia didn't have the excesses that Europe and the US had, which got them into this situation to begin with. Through the crisis, the Asian governments maintained very large foreign exchange reserves, which helped stave off any serious reverberations into Asia.

For the moment, Asia remains the most robust growth story in the world.