Contagion – now a word heard often in relation to economic financial crisis

By Ron Doyle

When I wrote a series of blog posts, starting in July 2010, “contagion” was a word seldom heard in a financial context. Six months later, it’s a buzz word in the papers every day and used in the same context as in my blog posts.

The premise for "contagion" is that large sovereign debts can not be contained to one or even a group of countries. The infection spreads to other countries and financial institutions. Brian Milner in his Globe and Mail article of November 30, 2010, Contagion spreads to euro zone banks, and Rex Merrifield, in his Reuters UK story, Euro zone periphery hammered as default fears rise - also published in the Globe's Report on Business - clearly explain how the contagion is likely to spread further.

The major points made are:

1. The infection is spreading to banks throughout Europe and even in the USA, as the US hold billions of Euros of debt obligations with Portugal and Spain (179 billion and 668 billion respectively). The value of this debt is dropping daily as yields on the bonds increase, i.e. the sale prices of the bonds are dropping.
2. The debt of Spain dwarfs the debts of Ireland and Portugal, and the largest holders of Spanish debt are French and German banks.
3. The crisis has now spread beyond Europe to Japan, and even Italy and Belgium are feeling the effects of higher borrowing costs.

Now, let’s apply factors from the study of macro economics to the evaluation of commercial creditworthiness. If it is perceived there’s greater risk on the debt of banks in Portugal and Spain, it is unlikely they will be able to avail themselves of normal, overnight inter-bank lending, which is a major source of liquidity. Further, the banks in rest of the world will be holding substantial amounts of debt, devaluing daily. Under Basel II and III, the banks will have to hold larger amounts of Tier I Capital Reserves, thus reducing their ability to lend. This tightening of credit will negatively impact companies around the world – those that are either seeking new financing or to roll over their existing facilities. Trillions of dollars of financing must be renegotiated before 2014.

So far on the world front, we have been dealing with the equivalent of the common cold. The crises to date have used remedies put into place after the Greek meltdown, thus preventing any failure or defaults. The perception of this situation is that the banks made billions in profits from imprudent loans. When the loan couldn’t be repaid, the banks were in trouble and the government had to step in and save them from themselves. Unfortunately, governments had to borrow billions to bail out the banks leaving governments with huge deficits. The international institutions lending the money to the governments imposed conditions that forced the governments to in turn impose severe austerity measures. These countries will have to pay for the recklessness of the banks through higher taxes and reduced services for decades to come.

The real “plague” will hit if countries or banks are forced to default rather than accept a bailout because the population refuses to accept having the problem solved "on their backs", or if countries increase the money supply in order to use the traditional method of inflation to get out from under deficits. The devaluation of any major currency could trigger huge defaults as debt holders rush to conserve the value of their loans by selling them.

In today’s environment, where we live in a world of fear, an event does not need to occur to cause a crisis. Just the fear of an event can cause a crisis. Does one throw up one’s hands in hopelessness, or does one look at what practical measures can be taken to mitigate the commercial and political risks to the assets of the business?

(Ron Doyle is a founder of Millennium CreditRisk Management – credit and political risk insurance specialists – www.mcm.ca. ICBA is the world’s largest team of independently-owned, specialist trade credit insurance brokerages. Partners combine local service with global coordination to provide credit and political risk insurance solutions for multinational companies.)