Europe's lost decade has only just begun

OUR story begins with a global banking system flush with cash and eager to lend. A sustained period of easy credit ensues; large volumes of debt are issued in a supranational currency over which the borrowers have no control. A feeling of economic euphoria prevails; belief grows that cheap financing from the short-term debt markets will allow the good times to keep rolling.

Sound familiar? It is, of course, one way of summarising events on the Eurozone's periphery in the decade prior to the collapse of Lehman Brothers. It is also, however, a pretty good description of what happened to Latin America in the 1960s and 1970s.

The worrying aspect to this comparison is that the period that followed Latin America's giddy, credit-fuelled expansion has come to be known as "la dcada perdida", the "lost decade". If the similarities persist, the European version of the Latin American debt crisis may still have some time to run.

From the mid-1960s, many Latin American countries, especially Mexico, Argentina and Brazil, borrowed heavily from the international capital markets. Lenders were keen to extend credit, their coffers brimming with the petrodollars of oil-rich clients. Spending on infrastructure soared; a rapid period of industrialisation set in. Across the 1970s, Brazil's economy grew at almost 9 per cent a year and employment increased at a rate faster than the rise in population. Growth was plentiful across Latin America, and looked like it was there to stay.

Unnoticed by most, though, were the clouds forming on the horizon. Rising oil prices in the late 1970s triggered a surge in inflation, which the chairman of the Federal Reserve, Paul Volcker, was determined to control. US interest rates rose from 11 per cent in 1979 to 20 per cent by the middle of 1981, making credit much harder to come by.

Most of Latin America's debt, though, was short-term, and lenders became unwilling to roll it over at more affordable rates. As US interest rates peaked at 21.5 per cent in the summer of 1982, Mexico's finance minister declared his country's debt unmanageable.

As with Europe today, it was hoped that austerity packages and continued economic growth would solve the problem. But the withdrawal of credit across the region and the associated capital outflows slowed the economy and depressed currencies. In 1987, five years after Mexico's default, the announcement that Brazil was suspending interest payments on $68 million it owed to foreign banks showed that the problem was not going to go away. One of the southern hemisphere's biggest debtor nations was plunged into default.

Not until 1989 was the true extent of the indebtedness properly assessed - and with it, an appreciation of the real ability to repay and consequent extent of default. It also came to be understood that the solution had to involve sovereign backing from a trusted source of credit. Thus "Brady bonds", named after US Treasury secretary Nicholas Brady, were born. The debt relief was given, and the residual debt was backed by the US government with newly issued US Treasuries.

In Europe it has become increasingly evident that the mere passage of time will not make the debt problem go away. As was the case in Latin America, growth is slowing in the indebted countries of Europe. Citizens have reacted angrily to the austerity packages governments have put in place to assuage the debt problems. The bond markets confirm this: ten-year debt trades at less than 75 cents in the euro in Portugal, at less than 70 cents in Ireland, and at less than 55 cents in Greece. Holders of this debt are effectively assuming the countries will go into default. A painful ten years is certainly being forecast.

Time is not proving a great healer as regards the mountain of debt, but it has worked wonders for banks' balance sheets. In the early 1980s, the US banking system could not have coped with the debt "haircuts" that came with the Brady Plan.

Similarly, the European banking system is still recovering from the global credit crisis. With each day, though, it becomes a little stronger and more able to deal with future defaults. The recent capital raisings in Europe are a clear sign that the banks are heeding their regulators' wishes and building up capital buffers for a rainy day. In turn, politicians seem to be trying to ensure that the rain doesn't come for some time, and only at a point when the financial system can bear it.

What Latin America teaches us is that an overarching sovereign guarantee will eventually be required. Despite the gyrations around the formation of the European Stability Mechanism it is not clear that the politicians are willing - yet - to provide such a guarantee. The rate at which the European Central Bank is buying up sovereign debt may reduce the number of counterparties eventually involved in any negotiation. Yet any suggestion of European guarantees may prove difficult for some of the stronger members of the single currency, particularly Germany.

If there are differences between the Europe of today and the Latin America of the 1980s, there is at least one striking similarity: there has been too much debt, and that debt has to either be repaid or defaulted upon. The bond market has been telling us that Europe will default; Latin America has taught us that it may take many years for this admission, and a suitable response, to be realised.

Whisper it softly, but we may be only three years into our own dcada perdida.• Richard Dunbar is investment director of UK equities at Scottish Widows Investment Partners

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