Path of Sovereign Debt Crisis in Europe
The world markets had not yet fully recovered from the effects of the sub prime crisis when news began to surface of a debt crisis faced by some of the leading European countries, shattering the investor’s confidence and sending the global stock markets to a nose dive. Since 2008 US and UK the two major giants suffered a complete set back.
European debt crisis is a profound financial distress faced by a few major European countries (Greece, Ireland, Italy Portugal and Spain-GIIPS), suffering the most making them so vulnerable that they were compelled to seek refinance from various external nations in order to meet their debt claims. Many consider the European sovereign debt crisis to be the most serious debt crisis after the great depression of 1928-30.
The root cause of the problem in Europe may be different for various concerned countries but the sovereign debt crisis comprises of two main problems in its core – first, widening sovereign deficits and ballooning debt of GIIPS to unsustainable levels; and second, European fragile banking system which hold a large amounts of these European sovereign debt. Though all the crisis hit members of European Union have a common problem of towering debt levels, how these countries sourced and deployed the money differs, like loans from Ireland and Spain’s banks find ways to real estate markets which resulted in steep rise in property prices in the country and a bubble formed in the property market.
As the credit conditions tightened during the time of crisis the property bubble burst, leaving the government as well as banks trapped with huge amount of private debts. So, the crises in Ireland and Spain was originated mainly from millions of euros worth private sector debts arising from a property bubble, which eventually got transferred to sovereign debt in the form of banking system bailouts by the respective governments.
Against this, lower interest rates led growth in Greece resulted in increased government expenditure. The public expenditure viz. wages, pension benefits etc. to public workers surged very high. The wages rates in the country thus increased two fold within the span of 10 years. So, the source of widening sovereign deficit in Greece and Portugal was the problem in government budgetary policy which eventually led to increased debt burden.
In the era of open market economy and interlinked financial markets, the sovereign debt crisis like the one prevailing in the Eurozone will have a domino effect if one country fails to repay its debts or its economy falters. Similarly, the concept of debt protection is also a factor which contributes to inter-linkage of the economies. In this, banks that have purchased credit default swaps will have to make payment if default occurs on the underlying debt instrument. But, as a number of Credit Default Swaps could be bought on the same instrument, it increases the exposure of each country’s banks to these instruments.
With soaring public and private debt levels and a series of downgrading of sovereign debt in some of the EU members, the sovereign debt crisis of Europe came in limelight in 2009 just after the emergence of subprime crisis in US. Since then Eurozone leaders have been trying to tackle the situation by taking various measures like formation of European Financial Stability Facility (EFSF) for ensuring financial stability in Europe, restructuring of Greece government bonds held by private creditors, agreement to create a European Fiscal Compact etc, but the crisis is still far from over and it continues to haunt global markets.
Root cause of the European sovereign crisis
The debt crisis of Europe is a resultant of a variety of factors which led to widening of sovereign deficit and ballooning of debts in many affected countries in Europe (GIIPS). Among the major reasons behind the ongoing crisis are- easing of credit conditions for GIIPS post formation of EU that fueled practice of lending/borrowing which involved high level of risk, faulty fiscal policy pertaining to public revenues and expenses, Structural problem of Eurozone system as it has a common monetary policy without having a fiscal union, widening external imbalances, formation of property bubble, ailing banking sector burdened by bailout, and global financial crisis.
Easy credit conditions with formation of EU
European Union (EU) borne in February 1992 when European leaders signed Maastricht Treaty, after which the currencies and monetary policy of all the signatories became common. The European Union was formed with expectations that the stability and wealth of Northern Europe members (Austria, Belgium, France, Germany, and the Netherlands) would spread throughout the Europe including the GIIPS.
With increased confidence in the prospects for growth and stability of the GIIPS after the formation of EU the perceived risk of lending to these relatively weak EU members declined dramatically. This in turn resulted in public borrowing costs in these countries plunging to converge with those of the North European countries. The spread of long-term government bond yields of the GIIPS and Northern European countries shrank from a steep 5.5% in 1980s to a mere 10 basis points in late 1990s.
Propelled by attractive interest rates and improved confidence domestic demand and spending in GIIPS rose sharply pushing the debts higher. With increased demand, prices of domestic activities like housing surged higher relative to the products traded in international markets. Higher prices in housing sector attracted more investment, whereas sectors involved in exports-imports received least attention.
Further, speedy growth in the GIIPS stimulated increase in wage rates that outpaced productivity resulting in higher unit labor costs. The labor cost in GIIP surged higher by 32% during 1997-2007 against a mere 12% increase in labor cost in north European countries during the same period. Hampered by higher labor cost and poor investment, domestic industries in the GIIPS lost their competitiveness in the regional and international markets. Against this, exports of the stable and strong EU countries in northern Europe surged higher led by strong demand in the GIIPS.
Meanwhile, adoption of common currency made the industries in northern Europe more competitive as despite huge trade surpluses as these countries do not see their currencies appreciate relative to other Euro zone countries due to common currency. As a result trade surpluses of strong economies of EU like Germany and Netherlands increased as a percentage of GDP after 1999, whereas the deficits of the GIIPS on the other hand worsened over the period. Adding to this, a rapid growth in Chinese economy, enhanced labor productivity in the export sectors of the United States and Japan also eroded the competitiveness of the GIIPS in the global trade.
Fiscal mismanagement by the governments seems another major reason behind the current situation in Europe. Attractive credit condition led expansion in domestic demand post adoption of Euro boosted government revenues in the GIIPS in the form of tax. However, mesmerized with rapid growth in revenues the government of Greece and Portugal significantly increased spending instead of saving some of these windfall gains for rainy days. Such a fiscal mismanagement added to the problems in Greece.
Once the subprime led financial crisis emerged, economic growth story in GIIPS ended abruptly and the countries slipped in to recession within a short span of time. The government’s tax revenues dried and their spending proved to be unsustainable. The lack of competitiveness of domestic products in the international markets also closed the doors for recovery in the scenario of faltering domestic demand. Laden with high public and private debts, the long term growth prospects of the GIIPS looks grim, unless they find means to cut deficits (may be by reducing public spending or increasing tax) and improve competitiveness.
Monetary union without Fiscal Union
Structural problem in Eurozone system looks another reason behind the recent financial turmoil in Europe. Eurozone system follow common monetary policy and they have a common currency, the value of the same is determined by broader European competitiveness trends. At the same time there is no fiscal union in the system, so the fiscal policies like individual countries have their own policies regarding taxes, pension etc.
Though, the members of the European Union are asked to keep a common fiscal policy, but absence of common treasury results in individual countries having their own way of handling their fiscal system. So, the monetary union with stronger and stable economies of northern Europe gave relatively weak economies like GIIPS advantage of lower interest rates which resulted in unrealistic demand growth in these countries without a parallel growth in supply. At the same time, absence of fiscal union provided these countries to have freedom in fiscal policies in taxation and expenditure, which in turn resulted in unnecessary surge in public spending in countries like Greece.
Having a monetary union or a single currency has another drawback. As EU members follow common monetary policy, any debt trapped member country cannot take independent decision to print currency to repay their creditors avoiding the chances of default. Whereas in case of individual countries out of monetary union, the country’s currency gets devalued relative to its trading counterparts by printing money, which in turn makes exports attractive, improves its trade balance, boosts GDP and government’s revenues in the form of tax climbs higher.
So, during recessionary period, the problems in GIIPS were aggravated by their inability of easing the monetary policy due to common currency in the monitory union. In the absence of control over interest rates limited the ability of Greece, Ireland and Spain to deal with the crisis. Similarly, if Italy and Portugal struggling with slowing economic growth would have any freedom of changing the monetary policy, they might have adopted looser monetary policy to cope with the situation.
Real Estate Bubble
Increased confidence in the GIIPS after adoption of common currency and steep decline in interest rates gave boost to the investment in housing sector especially in Ireland and Spain. Increased demand pushed property prices high and this speedy growth in the prices again attracted more borrowed towards the sector. The share of construction in Spain’s GDP increased from about 10% to 14% during 1997-2000; similarly, the share in Ireland’s GDP surged past 10% from below 8% levels during the same period.
With increased influx of funds in the sector, the real estate prices skyrocketed by about 12.5% per annum in Ireland, whereas prices rose by about 8% per annum in Spain during 1997-2000. The extent of heating up in property prices in these two countries and formation of a big bubble can be gauged by the fact that property prices in US increased by mere 4.5% per annum during its subprime period. In the meantime, the domestic credit in Greece, Spain and Ireland increased to about 2.5 times as compared to less than 30% increase in north European economies like Germany.
GIIPS Losing confidence among investors:
Looking at the growth story in the Eurozone before the emergence of financial crisis, sovereign debt from the Eurozone countries appeared to be safe to the banks and regulators. A slight premium on sovereign bonds from relatively weaker economies like GIIPS attracted banks as these economy seemed equally sound due to monetary union.
However, with the emergence of the crisis, the risk associated with bonds of these weak economies came to the fore and the resultant loss of investor confidence pushed sovereign CDS prices higher, mirroring the market expectations about decline in creditworthiness of these nations. Further, looking at the inability of these troubled nations in using monetary policy to solve the problem due to common currency, the investors have doubts about any quick solution to the crisis from policy makers as it requires cooperation within all member countries.
Thus, the loss of confidence among the investors has resulted in heavy bank withdrawals in many weaker Eurozone countries viz. Greece and Spain. Though the bank deposits in the Eurozone are insured by the agencies of the respective governments, in case of default by banks the probability of the government fully honoring their commitment is limited. The asset withdrawals in these weak economies increased further recently as Euro plunged to new lows in June 2012.
Increasing interest on long term sovereign debt
With emergence of crisis and corresponding loss of confidence over creditworthiness of the crisis hit EU members, the interest rates on long term sovereign debts of these countries have surged higher. Increased borrowing costs in these countries in the scenario of economic slowdown is posing problem in the path of their recovery. Recently, interest rate on long term debts of Spain and Italy rose rapidly after negotiation of Spanish bailout line of credit. Interest rate reached close to alarming levels of 7% from just above 6% before the line of credit was approved.
EU losing rating
The recent downgrade of ratings of 15 members Eurozone by S&P in December 2011 raised concerns in the global markets. The rating agency placed its long-term sovereign ratings on 15 members of the eurozone on “CreditWatch” vategory with negative implications. The agency says that there were five systemic factors behind the same:
1) Tightening credit conditions across the eurozone;
2) Increasing risk premiums on sovereign debts of eurozone countries including some the stronger economies that are currently rated ‘AAA’;
3) Lack of consensus among European policy makers on how to cope with the ongoing market confidence crisis and, how to ensure greater economic, financial, and fiscal union among eurozone members in long run;
4) Ballooning public and private debt levels across a large area of the eurozone; and
5) The increasing risk of economic recession in the entire eurozone in 2012.
Status of the Crisis in GIIPS and other EU members
Greece –The worst hit
Causes of Greece’s Debt Crisis
Greece has been the center of attraction for the world since the European debt crisis came in limelight. The main reason behind the Greece’s problem lies in its huge and growing debt burden and loss of competitiveness.
Prior to joining Euro, Greece was among the worst performing countries in the Eurozone with towering inflation, high interest rates and slowest GDP growth in Europe. Once Greece became member of euro zone and adopted Euro, the inflation came down drastically and interest rates declined sharply to close to the levels in Germany. Soon, the country became attractive destination for foreign capital. Boosted by cheap foreign capital and lower interest rates, domestic demand surged, which in turn resulted in deterioration in current account balance.
During 1997-2008 the country’s current account balance declined from -3.7% to -14.4%. The surge in domestic demand resulted in increase in domestic prices as compared to other EU members. Labor cost in the country rose by about 34% during 1997-2009, which hampered the competitiveness of the country in the region as well as in the international markets.
The competitiveness of the country was hurt further by a shift away from manufacturing sectors in favor of the service and non-tradable sectors like construction. The shift in Greece however was not as large as the shift in some of the troubled European economies. The share of manufacturing sector in GDP declined by about 2.5% during 1997-2007, whereas, construction sector’s share increased by 2% percentage points during the same period. The price of services also increased briskly during this period which attracted more funds toward services.
The flurry of foreign funds at relatively lower cost and corresponding increase in domestic consumption resulted in some temporary growth in the economy. The country’s GDP which grew at an average 1.1% during 1980-97, expanded at about 4.1% per annum during 1998-2007.
With this growth in country’s GDP, the government’s tax revenues also surged higher. But, the government started spending these revenues in social transfers and public sector wages. During 1997-2008, Greece increased government spending per capita by 140% as compared to 40% in other member countries. Further, Greece’s sector per capita employee compensation in the public sector also grew by 112% during this period against a mere 38% percent increase in the Euro area. In the coming years these fiscal mismanagement proved very costly to Greece and became the real cause of country’s debt crisis. Greece’s annual fiscal deficit ruled above 3% of its GDP for the past decade thus exceeding the Maastricht criteria.
The rapid economic growth in the country managed to hide these fiscal imbalances. However, once the financial crisis hit the global economy, Greek economy came to a halt all of a sudden, pushing down tax revenues and underpinning deficit. Unsustainable levels of public and government debts started building up and governments did not reveal the true statistical data. In November 2009, George Papandreou, the new prime minister of Greece revealed that the nation was under heavy debts as the country’s annual budget deficit was 12.7% of Gross Domestic Products (GDP).
Later in 2010 Eurostat announced that Greece’s budget deficit in 2009 was 13.6% of the Gross domestic product rather than 12.7% revealed earlier. As per the data released by the Eurostat the deficit rose from 5.1% in 2007 to 13.6% in 2009. Thus Greece’s huge fiscal deficit and vast public debt together created macroeconomic imbalances and thus resulted in the country’s debt crisis.
After the recent turmoil, Greece will need to improve its growth to rekindle economic growth, but this strategy faces hurdle in the form of Greece’s severe loss of competitiveness. Restoring competitiveness in Greece will require reduction in wages and increases in productivity. But the measures to improve productivity and reduce wages would take time. If these measures are not implemented within a reasonable timeframe, the crisis in the country will aggravate further.
- In December 2009 George Papandreou outlined the details of first austerity package.
- In February 2010 the first austerity package was announced and in March a second austerity plan was announced that was intended to save 4.8 billion Euros. However these austerity packages were not enough particularly when Eurostat announced Greece’s budget deficit was 13.6% of the GDP instead of previously disclosed 12.7%.
- On 23rd April, 2010 Greece requested an initial loan of 45 billion euros from the European Union and the International Monetary Fund (IMF).
- On 1 May 2010, the Greek government suggested its third austerity package to secure a three year 110 billion euro loan and on May 4 the plan was put before the Parliament for a vote. Though the austerity measures faced public anguish in the form of mass protests, riots etc.
- The Euro zone created a European Financial Stability Facility (EFSF) with initial capital of 440 billion Euros. Additionally, the European Financial Stabilization Mechanism promised to provide loans up to 60 billion euros and also the IMF assured 250 billion euros. Thus the package totaled 750 billion.
- Consequently in the first four months Greece’s budget deficit decreased by 41.5%. In June Greece parliament witnessed votes in favour of third austerity package following which during the first six months the deficit declined by 41.8% In August, 2010 the troika ( ECB, EU, IMF) impressed by the Austerity measures taken by Greece further provided the country with an aid of 9 billion euros. In September fresh bail out of 2.6 billion Euros was provided to Greece. In June 2011 Greece’s parliament agreed for forth austerity package.
- In July 2011 Euro zone agreed to augment the capital fund of the EFSF to 780 billion Euros. The lending capacity now was of 440 billion Euros. In October 2011 the troika offered a second bail out of 130 billion euros but with a condition that further austerity measures will b e implemented and also the debt will be restructured. In November, 2011 Papendreou resigned and new Prime Minister Papademos was appointed to implement the needed austerity plans which would facilitate in getting a second bail out.
- In February 2012, the troika agreed to provide a second bail out package of 130 billion euros with a condition that Greece would introduce another austerity package by reducing Greek spending by 3.3 billion euros in 2012 and 10 billion euros in 2013 and 2014.
- Also for t he first time the bail out programme included debt restructuring agreement of about 206 billion euros in of Greece’s government bonds. The private holders of the Greek government bonds were offered a bond swap ( the Private sector initiative (PSI) ) with a 53.5% nominal write off that was partially in short term ESFS notes and partially in the form of fresh Greek bonds having lesser interest rates and increased maturity period of 11 to 30 years. As a result greek debt in government bonds in March 2012 declined from around 350 billion euros to 240 billion euros.
- This restructuring was considered as a credit event, where previous Greek bond holders will be now given, for 1000 euros of previous notional, 150 euros in ESFS’s PSI payment notes and 315 euros in new Greek Bonds, issued by the Hellenic Republic.
- Meanwhile Euro zone agreed to the second bail out for Greece worth 130 billion euros jointly with the funds from the IMF. IMF therafter announced 28 biilion Euros for this.
- In late March 2012 Greece feared requirement of a third bail out pack. In view of massive social unrest, increasing unemployment rate, troika’s pressure for austerity in lieu of fresh bail out and concerning political uncertainity all eyes are on its domestic elections. Greece’s parliamentary elections include new parties ( socialists) mostly against austerity deals with the troika. Fear of defaults and Greece’s exit from the Euro zone has started weighing on other debt trapped member countries.
Consequently investors asked for higher yields on high risk associated Greece’s bonds thereby raising the cost of country’s debt burden and resulting in a vicious circle of funds and costly high yield bond. Looking at the high bond yields of Greek bonds, the markets also began driving up bond yields in the other heavily indebted countries in the region, expecting similar problems like Greece.
Causes of Italy’s Debt Crisis
Italy’s debt crisis lies in its extremely high levels of debt as a percentage of GDP and loss of its competitiveness against regional and global competitors.
After Italy adopted the common currency in 1999, interest rates in the country fell to near German levels which were the lowest among the Euro members. The lower fueled consumer spending which in turn supported its economic growth. Initially with high growth levels led by increased consumer spending, the country managed to reduce its deficits and debts. Italy’s debt fell by 10 percent of GDP during 1999 to 2007.
Among the GIIPS, Italy adopted better fiscal management which kept its debt burden relatively smaller. The country kept its expenditure moderate partly by pension reform in the 1990s and increasing revenue through better fiscal measures, which helped it to avoid harsh debt explosion so far. The country’s relatively smaller fiscal deficits in conjunction with higher private sector savings established an external balance. So, during 1993-99, the country’s current account was in surplus.
Italy’s real problem lies in country’s lost competitiveness after joining the Euro. The country’s unit cost of labor rose about 32% during 2000 to 2009, which severely hurt its competitiveness among its stronger regional peers like Germany. The country’s competitiveness deteriorated more severely against other global competitors like the United States, China, and Japan. The main reason behind declining competitiveness of Italy remained its falling productivity.
As per studies, the country’s total factor productivity decline about 1% per annum during 1996-2004, whereas during the same period Germany increased its total factor productivity by 1% per annum. The productivity declined on account of numerous factors including rigid labor markets, excessive regulations, inadequate public services etc.
With lost competitiveness in the regional and global markets, Italy’s exports grew at a slowest pace among the member countries during 1998-2000 and the country lost its market share in its traditional markets.
With the outbreak of the debt crisis in Europe, the country’s declining exports resulted in increase in in debts. In 2010, Italian government debt was around 2.4 trillion US dollars. The country’s debt is projected to be somewhere around 121.4% of the country’s GDP in 2012, which is far higher than normal European standards. Italy borrowed to meet the principal and pay interest on its existing debts.
Considering the public debt of about 115% of GDP in 2009 and interest rates close to 4%, Italy must spend about 4.5% of GDP on interest every year. Even if public revenues grows to cover all expenditures, interest costs will still push the country’s debt to grow faster than its sluggish economy. Hence, the country’s debt burden will grow larger every year unless the primary balance surges strongly into surplus.
Thus the main areas of concern for the country are its high public debt and the country’s relatively low growth potential due to its poor competitiveness within and outside EU. The country’s economic growth has been lower than the EU average in past decade. Thus investors fear Italian bonds are high risk assets.
- On May 25th Italy agreed to a fiscal austerity package of 25 billion Euros in order to reduce its budget deficit to 2.7% by 2012 from about 5.2% in 2009. However protests in Italy compelled the government to reduce its austerity package and on July 15th Italian Parliament passed its first austerity package.
- On September 14th Italy goes for second austerity package with a view to save 124 billion Euros. S&P downgraded Italy’s sovereign debt rating to A- from prior A+.
- On November 11th, 2011, Italy’s 10 year borrowing costs declined substantially from 7.5 to 6.7% as the Italian legislature agreed to further austerity actions. Also an emergency government was formed to replace Prime Minister Silvio Berlusconi.
-Italy’s Prime Minister Silvio Berlusconi resigned and the new Prime Minister Mario Monti was appointed in the hope of restoring investor confidence so as to resolve the country’s sovereign debt crisis. Thereafter 30 billion euros austerity plan gained votes though funding cost remained high marginally below 7% level meaning insolvency.
-The Austerity measures included a pledge to raise 15 billion euros from real estate sector in the coming 3 years, increase in retirement age by two years to 67 years, this to happen by 2026. Also it was decided to open up closed professions within a year and a gradual reduction in government’s ownership of local services.
-In January Italy’s debt cost climbed as 10 year bond yields went up to 7.12%. The ECB came forward to buy Italian debt.
After a 100 billion euros of bail out rescue was made available to Spain’s bank Italy moved to the frontline raising concerns that Italy may succumb to the debt crisis. On June 11, 2012 Italy’s 10 years bond yields grew by 7 basis points to 5.84%.
Ireland – Bust of property bubble
Like other GIIPS countries, the crisis in Ireland is also linked with soaring debts and loss of of competitiveness. Ireland was a very strong economy and was cited as Celtic Tiger even before it became part of the European Union and used the common currency Euro. Its GDP was growing at a faster pace and its inflation and borrowing costs were way below than that of strong economies like Germany. Moreover, the country’s governance and business climate indicators were among the world’s strongest.
The already strong economy of Ireland got an unsustainable boost with the introduction of Euro. During 1995-2000, Ireland’s economy grew in leaps and bounds by an average of 9.1% per year. The interest rates in the country also fell below German levels by 2005. With strong growth in the economy Irish wages grew nearly five times faster than the Euro area during 1997-2007. The speedy growth in the economy and relatively too loose monetary policy by EU as per Ireland’s standard, resulted in huge influx of foreign funds in the country. The supply of credit in the country surpassed 200% of GDP by 2008 after averaging around 40% during 1975-1994.
During 2000-2008 its economy grew at a slower but still exciting CAGR of 4% a year. The GDP of Ireland in 1991 was 66.87 billion Euros and continued to show an increase till the year 2007 when it equaled 177.963 billion Euros. Thereafter GDP started declining and reached 159.906 billion Euros in 2010. However bail outs and Austerity measures have helped the country in reaching a GDP of 161.034 billion euros in 2011.
The decade ending 2007, saw expansion in Irish economy due to major factors like, increase in wage rates, Foreign Direct Investment, low corporate tax rates, investment in higher education and low ECB interest rates. Throughout the course of this boom, the Irish government seemed behaving responsibly as it was running an average budget surplus of 1.6 percent of GDP during this period helped support by burgeoning tax revenues.
Meanwhile, with lower interest rates and easily available credit resulted in an extraordinary large housing bubble. With excessive pumping of money in the sector, the property prices in Ireland skyrocketed. During the span of ten years starting from 1997, the house prices rose about 90% as compared to a mere 28% in Spain and 20% in the United States. During the same period, housing completions grew by about 10% per annum. Looking at the soaring property prices, the money started flowing away from the traditional manufacturing sector to housing sector. Construction sectors share in Ireland’s gross domestic output rose from 7.9 % in 1997 to 10.4% in 2007.
In 2008 the property bubble formed in Ireland over the years burst with the start of credit crisis in Europe. Thereafter serious debts started emerging as property market suffered from global financial crisis of 2007-2010. Ireland’s sovereign debt increased about three times from 50 billion Euros in 2007 to enormous 160 billion euros by around 2011. Further its debt to GDP ratio rose from 25% to above 100% during the same time period. The country’s the GDP growth declined to negative 2.972% as against the growth of 5.182% in 2007, which further fell to negative 0.43% in 2010.
As per the Central Statistics office Ireland was declared as the first state in the Euro zone to enter recession. Irish banks borrowed heavily from foreign destinations to invest in services and property sector and focus appeared shifting from manufacturing or trade sectors. During 2004-2008 Ireland’s borrowings increased from 15 billion Euros to 110 billion euros.
By mid-2008 Irish economy started displaying chances of impending recession. Global financial crisis, domestic oversupply of buildings (residential and commercial), heavy debt on low interest rates, absence of substantial export activity led to closure of many business, collapse of share prices and generation of unemployment in the country. The employment rate between 2000 and 2008 was somewhere around 4% however due to the downturn in economy the unemployment rate reached around 14.5% in 2011.
In September 2008, the Irish Government guaranteed all deposits and borrowings of the six Ireland owned banks, for a period of next one year. The National Asset Management Agency was formed was formed to remove the bad debts of the six banks and renewed the guarantee for another one year it in September 2009.
At the same time seriousness increased as the banks were considered to be illiquid by 4 billion euros however they were not insolvent. The Irish economy started witnessing signs of recession in 2008 consequently the ISEQ plunged to a 14 years low in September 2009.
Meanwhile, the Economic and Social Research Institute forecasted that Ireland’s economy may contract 14% by 2010.
In Q1, 2009 unemployment rose by 8.75% to 11.4% as against similar quarter of 2008. In Q1 and Q3 2011 Irish economy grew by 1.9% and 1.6% respectively however contracted by 1.9% in Q3, 2011.
In December 2009 Irish Government announced a fiscal plan which would save 4 billion Euros, partly by raising retirement age of pensioners from 65 to 66 years.
The money borrowed from the ECB was used to pay the bond holders and thus burden of losses and debts were shifted to taxpayers.
In November 2010 Irish government received a sum of 85 billion euros in the form of bail out loan , of which 67.5 billion euros combined loan was given by the Euro zone, IMF, UK, Denmark and Sweden and 17.5 billion euros came from Ireland own reserves. The deal provided 10 billion euros for bank recapitalisation, 25 billion euros for banking contingencies and 50 billion euros budget financing.
The Federal budget went into a deficit of 32% GDP in 2010 from a surplus seen in 2007.
In July 2011 interest rates on European Union and IMF’s combined bail out loan was reduced from about 6% to 3.5% – 4% and the loan repayment time was increased to 15 years. This was done with a view to save Ireland’s 600 – 700 million Euros per year.
In September 2011 the European Commission slashed interest rate on its 22.5 billion Euro (which was part of bail out of 85 billion euros) to 2.59%. This was the rate which European Union itself paid to borrow from financial markets.
Looking at the severity of Ireland’s worsening economic situation, the International Monetary Fund (IMF) recently urged Europe to help Ireland in refinancing its bank bail out. Also it has requested Europe to consider obtaining stakes in state owned banks with a view to help the country to return to the bond markets and thus avoid an impending second bailout next year.
Ireland after obtaining its first bail out package in the end of 2010 now aims to return to long term debt markets in some time later this year so that it can prepare for ending the first official funding in 2013. Also by doing so it aims to meet its borrowing needs of up to 20 billion euros in 2014.
The International Monetary Fund has slashed its forecast for Ireland’s next year’s Gross Domestic Product to 1.9 % from 2% and has also downgraded its average GDP growth forecast for 2013 – 2017 to 2.6% from 2.8% mainly due to weaker exports and increased unemployment. Thus at the current juncture weaker exports, increased unemployment and decreasing consumption are weighing on Ireland’s economy.
Crisis Situation in Portugal
The Portugese became member of the European Union in 1986 and thus gained investor confidence and its Gross Domestic Product witnessed substantial growth. Portugal’s GDP (constant prices) grew at a CAGR of 2.8% from 1991- 1998. In the year 1999 EU came up with a common currency Euro and Portugal adopted the Euro. Euro being a very strong currency started giving advantages to the weaker nations who were members of the European Union. Consequently, Portugal started witnessing low interest rates thus consumption demand started rising. The funds were not put to industrial growth but were used for domestic consumption.
The low interest rates encouraged more debts which were very freely used for increased governmental overspending, particularly to over bureaucratized civil service. During last three decades before 2010 Portuguese government encouraged over expenditure through unclear government and private partnerships. Also Portuguese Republic governments spent heavily on unnecessary and ineffective external consultancy and advisory firms, which added no value to the economic system of the country and instead burdened the economy. Abnormally high wages, incentives and bonuses were provided to the top notch officials and bureaucrats. Further in private partnerships for public works the government spent heavily on funding the top management and high grade government officials.
When compared to other GIIPS countries, Portugal’s economy’s competitiveness starting losing out as soon as it adopted euro. Soon after the Euro was introduced the compounded annual growth rate of GDP (based on constant prices) started dropped to 2.6% from 1991-1999. The annual GDP growth rate slowed down to 3.916% in 2000 from 4.073% in 1999. During 2009, 2010 when global economies were hurt by subprime issues in the US Portugal’s annual GDP growth slipped into negative territory. Since then there have been hardly any noticeable improvement in the economy, so far. Growth in unemployment, large budget deficits and shoddy budgetary discipline were going against the country’s credibility.
Portugal suffered due to its weak long term growth prospects, acute loss of competitiveness among other EU countries and heavy indebtedness (in both public and private debts).
The situation in Portugal devastated further as exports suffered due to poor economic conditions prevailing in Spain, which is a market for 25% of Portugal’s exports.
In first half of 2011 Portugal requested IMF and the EU to grant a bail out of 78 billion euros so as to stabilize its public finances. On 16 May 2011 Portugal received a bail out loan of 78 billion euros from the euro zone and thus it became the third country after Greece and Ireland to receive a bail out. The bail out money was equally funded by the European Financial Stabilisation Mechanism (EFSM), the European Financial Stability Facility (EFSF), and the International Monetary Fund (IMF).
After the bail out was announced, the Portuguese government was able to implement measures to improve the country’s financial situation. Though unemployment level augmented to 14.8 %, taxes got increased, and civil service lower wages were freezed and higher wages were reduced by 14.3%. The average interest rate on bail out loan was around 5.1%. The country’s government also agreed to abolish its primary share in Portuguese telecom company, the Portugal Telecom to provide way for privatization.
In lieu of the bail out package Portugal also promised to reduce its budget deficit to 5.9% of GDP in 2011 as against 9.8% of GDP in 2010 and to bring down the deficit to 4.5% in 2012 and 3% in 2013.
As the result of bail out loan in 2012 the wages of government employees were cut by average 20% of their relative wages in the year 2010. However wages of those public employees whose monthly earnings were above 1500 euros were reduced by 25%.
This led to a flood of specialized technicians and top officials leaving the public service, many looking for better positions in the private sector or in other European countries.
The sovereign debt crisis in Spain emerged from the same source as those in Greece. A huge mismanagement of resources and loss of competitiveness after adoption of the common currency eventually resulted in debt crisis in Spain.
After joining Euro, interest rates in Spain also plummeted like in other crisis hit Euro member countries. With lower interest rates and increased confidence, the domestic demand surged higher. The monetary policy of EU was relatively loose for Spain; the country witnessed speedy growth and boom after joining the common currency. These sectors like housing, government and services sector got a huge boost as lower interest rate and influx of foreign money find their ways to these sectors With strengthening in domestic demand and growth in the economy, prices of houses and services soared faster as compared to the commodities traded in the global markets. At the same time, labor cost also skyrocketed during this period of high growth as compared to the other EU member countries. This in turn however resulted in loss of competitiveness of Spain in the regional and global markets. Meanwhile, increasing growth in the country kept tax revenues of the government higher which managed to hide the lost competitiveness of the country during boom period. However, once the crisis hit Europe, property bubble in Spain burst and lost competitiveness started to get reflected in countries widening deficits.
Spain’s debt to GDP ratio is relatively lower than other crisis hit countries like Greece, which suggest that the country is in a relatively better position to cope with the crisis. However, its huge deficits and loss of competitiveness over the period suggests that if the country doesn’t take remedial action quickly, the crisis would become severe.
In order bring down its deficit within manageable levels Spain has to restore its competitiveness, and redirect its resources towards manufacturing and other growing tradable sectors. In the absence of option of currency devaluation due to common currency, these reforms can only be materialized if unit labor costs, house prices, and the price of services decline relative to its European competitors.
Spain’s GDP (constant prices) equaled 419.702 billion euros and continued to build up till the year 2008 when it reached 697.693 billion euros. Like Ireland Spain’s economy also boomed till 2008, during this period easy debts continued to build up and housing and construction bubble continued to grow. From 1997 to 2007 housing prices in Spain advanced at an average annual rate of 8%. Construction as a share of Spain’s gross output increased from 9.8 % in 1997 to 13.8 % in 2007 Spain. Spain saw an increase in its domestic spending, deteriorating current account balances and rising private debt.
Spain’s annual GDP growth (at constant prices) slowed down to 3.479% in 2007 when compared to 4.077% in previous year. However it’s GDP (constant prices) continued to increase to 691.533 billion Euros in 2007 when compared with 668.284 billion euros of GDP in 2006. Thus the changes in growth rates of GDP started showing early signs of the crisis. In 2008 the country’s annual GDP growth (at constant price) further slowed down to 0.888% though again its GDP continued to augment to 697.673 billion euros.
In 2009, Spain’s GDP declined to 671.58 billion eoros which further dropped to 671.58 billion eoros in 2010. In 2010 its public debt was USD 820 billion, which approximately equaled to the combined debt of Greece, Portugal, and Ireland.
In January 2010, to reduce the budget deficit Spain resorted to austerity measures like reduction in government spending by 4% of GDP and slashed government employees pay by 4%, this was done with the intention to save country’s 50 billion euros. Further increased pressure from Euro zone and IMF compelled Spain to go for new austerity moves somewhere in the middle of the year. Spanish Parliament approved austerity package of 15 billion euros.
In December 2010 Bad debts of Spain’s banking sector reached 131.9 billion euros, which further raised the economic concerns. The ECB provided three year loans to Spanish banks and Spanish government sold 5.64 billion treasuries ( three and a half year duration) at an average yield of 1.735% as against sales made by the government in November at yields as high as 5.11%. Further in January 2012 Spain sold 9.98 billion euros woth three years treasury notes at a reduced yield of 3.384%. The sale of Spains treasury bonds and notes at a reduced yield helped investor’s confidence to return back. Despite these measures Spain’s national debt equaled 68.5% of its GDP that was highest since 1990 and thus the crisis continued to build up. Increased austerity measures with a view to repay enormous debts and meet the high borrowing costs led to social unrest in the country which occurred in the form of strikes and protests from the public. Despite these Spain had no choice and under the increased pressure from the euro zone it announced to cut 10 billion euros worth of its spending from the education and health sectors.
With adoption of austerity measures Spain reduced its fiscal deficit from 11.2% of GDP in 2009 to 9.2% in 2010 and 8.5% in 2011. Further In 2011 the government of Spain amended the Spanish constitution that public debt can not go above 60% of Spain’s GDP, though exceptions were allowed in case of emergencies like natural calamities, recession etc.
Spain now aims to reduce its deficit to 5.3% and 3% in 2012 and 2013 respectively. Also on June 9, finance ministers of the euro zone offered a bail out of upto 100 billion euros for Spain to recapitalize its insolvent banks. According to the International Monetary Fund (IMF) Spain’s banks require at least 37 billion euros to cope with the ongoing crisis. Spain is the fourth country to receive a bail out package after Greece, Portugal and Ireland. However this is likely to increase another 10% in debt to GDP ratio of Spain which is now expected to move up to 80% in 2012.
In mid June 2012, credit rating agency Moody’s warned that it may have to slash Spain’s credit rating by three notches to Junk with in next three months. Greece’s exit from the euro zone will further weigh on Spain and thus its rating might be slashed.
Earlier, Spain’s prime minister revealed that he was fighting to get the euro zone’s central banks to bring down Spain’s record borrowing costs particularly on fears that the country will need a second bail out.
The latest 100 billion euros worth bail out to Spanish bank will further buildup Spain’s debt burden. The announcement of Spain’s request for bailout was expected to bring back some confidence in Spain’s economy; however the move has instead augmented the worries about the government’s ability to finance itself.
Yields on Spanish 10 year debt climbed to 6.71% from 6.67%. The yield above 6% is considered as unsustainable and Spanish yield is now coming close to the 7% rate that resulted in Greece, Portugal and Ireland to ask for financial rescue packages.
Greek debt crisis appears to be spilling over to Cyprus’s financial system due to high degree of dependence of Cyprus banks in Greece’s financial markets. Greece’s borrowers took a large chunk of loans from Cyprus Popular bank. However with the debt crisis prevailing in Greece, 2 billion euros from this loan were written off during the restructuring of Greece’s bonds. Now the Cyprus popular bank is bearing the brunt and is requesting recapitalization of at least 1.8 billion euros.
The government of Cyprus is thinking of providing support to its banking sector.
Further the economy suffered from the damage caused by a devastating explosion at a naval base main power plant in July. Daily blackouts affected its major sectors that are the financial and tourism industry. The damage from the blast was estimated to be around 1 billion to 3 billion euros and would affect around 20% of the GDP. Cyprus economy was getting the infection from worldwide financial crisis and a series of misfortunes too worsened it.
Cyprus showed all signs of contagion with rising borrowing costs and dropping credit rating. The economy appeared to be in serious trouble and the government feared it might collapse. It became absolutely necessary for Cyprus to implement some structural reforms; otherwise they would fear a bail out.
In summer 2011, Moody’s downgraded Cyprus credit rating by two grades. In October, 2011 Standard & Poor’s also downgraded the long term sovereign credit rating to negative.
In September 2011, yields on Cyprus long term bonds grew to more than 12% which reveals the investor confidence has shaken.
In January 2012, Cyprus revealed its intention of obtaining a loan of 2.5 billion Euros from Russia in order to cover its budget deficit and re finance maturing debt. The loan fetches an interest rate of 4.5% for Russia and is valid for tenure of 4.5 years. However it is also expected with government’s intervention Cyprus come out of the crisis by the first quarter of 2013.
By mid June 2012 market expectations increased that Cyprus will request for an emergency bail out. On June 13, 2012, Moody’s the renowned credit ratings agency downgraded Cyprus’s debt by two grades thus pushed it to the level of Ba3 from Ba1 that is it was pushed deeper into junk rating.
Cyprus GDP is expected to decrease by 1% in 2012 and may expand by 0.8 % in 2013. Inflation might not exceed 2.8 % in 2012 and 2.2% in 2013. The deficit of current account surplus of Cyprus will be about 6 % of the GDP and will remain at the similar level in the year 2013.
Belgium’s GDP (constant prices) have witnessed a constant rise except for the year 2009 when it decreased to 340.398 billion euros as against the GDP of 350.35 billion euros in 2008. The GDP increased marginally to 348.22 billion euros in 2010 and 354.699 billion euros in 2011. Thus GDP (constant prices) moved in a very small band of 354 to 340 billion euros during the past four years or it would not be wrong to say that the GDP somewhat flattened since 2007 (last 4-5 years). The country was hit by the global recession of 2008, 2009.
This depicts economic concerns further the country suffered from the political instability that prevailed for long in the country. Absence of concrete government was raising fears of existential crisis and prohibiting from taking substantial economic policy measures to improve the financial crisis.
The doubts about the financial stability of the banks build up following Belgium’s financial crisis of 2008, 2009.
The country went through a political crisis and for a second time in four years the country remained without a government for more than six months. However after inconclusive elections in June 2010 the country was with a caretaker government till November 2011, as political parties of the two language groups (Flemish and Walloon) could not finalise to an agreement to form a majority government. In Belgium two cultural groups live together Flemings whose language is Dutch and Walloons who speak French and folllow French culture.
The annual growth in GDP showed a slowdown after 2004 and in 2009 the growth in GDP slowed down maximum to reach negative levels. Though, in the year 2010 annual GDP grew to 2.266%.
In 2010 Belgiums public debt was over 100% of its GDP which was third highest in the euro zone following troubled countries Greece and Italy.
Belgium’s borrowing costs were high and fears of it entering into severe financial crisis grew. However the country’s budget deficit was of 5% that was relatively modest. Further in November 20910 Belgian government’s 10 year bond yields were 3.7% that was below than yields of the major troubled economies. Ireland’s yield was 9.2%, Portugal’s 7% and Spanish yields equaled 5.2%. The deficit was financed domestically by the Belgian government which was possible due to the country’s high personal savings rate.
However in November 2011, Standard and Poor downgraded Belgium’s long-term sovereign credit rating to AA from AA+. The country’s 10 year government bond yields increased to 5.66%. Thereafter Belgium’s political parties negotiated to finally reach an agreement and a new government was formed. As per the agreement spending was to be reduced and taxes were to be raised worth 11 billion euros. This would facilitate the country to bring down its budget deficit to 2.8% of the GDP in 2012. Consequently investor’s confidence improved and Belgium’s 10 year bond yields declined to 4.6%.
However, fresh economic concerns rose as on June 5th, 2012 Belgium’s debt agency sold 3.517 billion treasury certificates for three months and six months duration with an average yield of 0.213% and 0.266% respectively.
The contagion continued to spread among European Union’s member countries and reached France as well. In June 2010, France adopted austerity measures and increased its public pension program’s retirement age from 60 years to 62 years, by 2018. On August 24th, 2010 France announced an austerity move to reduce 12 billion euros deficit by raising taxes on the affluent class.
In 2010 France’s public debt was 83% GDP or about 2.1 trillion of US dollars. The country also had a budget deficit of 7% GDP in 2010.
In January 2011 Standard & Poors slashed credit rating of France that was already rated AAA and losing investor confidence. On April 1, 2011 French Bank BNP Paribas announced to return a major portion of the three year loan taken by it from the ECB under its long trem refinancing operation (LTRO).
The bond yields spread between France and Germany grew 4.5% from July to November 2011. Further France’s CDS contract value grew 3% during July – November, 2011.
On December 1st, 2011, French bond yield fell and it auctioned 4.3 billion euros of 10 year bonds at an average yield of 3.18% which was far below the supposed risky level of 7%. By early February 2012, yields on France’s 10 year bonds declined further to 2.84%.
Germany has a smaller economy when compared with the debt crisis struck Euro zone countries Spain and Italy. Germany’s economy enjoyed the greatest strength among contagion hit Euro countries, though if it guarantees payment of sovereign debt to the countries sitting on the verge of default it itself can come under pressure. The country’s debt problem is not created due to the faults of its own economy but due to the risk of it to finance the bail outs of the GIIPS.
In June 2010, Germany agreed to an austerity package worth €80 billion over three years. The measure is designed to serve as a model of fiscal austerity for all of Europe.
The majority of German people objected to country’s guarantying the EU countries debts however political will is to stick with the euro and guarantee the debts. Even before bail out of Italy, Germany faced inflationary risk and it’s debt to GDP ratio was 83.2% thus if Germany could save itself by not extending guarantees on debt payments of the weaker countries.
Policy’s to tackle crisis
Emergency measures adopted by EU
European Financial Stability Facility (EFSF) –
On May 9th, 2010, the 27 members of the European Union agreed to create a special facility to aid in solving the financial crisis and named it as the European Financial Stability Facility (EFSF). The EFSF was formed with a view to provide financial help the financial crisis hit ailing European member countries. The EFSF can raise funds for providing loans to financial crisis hit Euro zone countries, which it does by issuing bonds and other debt instruments with the support from German debt management office. Also EFSF raises funds for restructuring/recapitalizing banks or to buy sovereign debt of EU’s member countries.
Bonds issued by the EFSF are backed by guarantees given by the European Union members in ratio of their respective share in the paid up capital of the European Central Bank (ECB).
The members of the European Union initially funded the EFSF with a capital of 440 billion euros. Additionally the European Financial Stabilization Mechanism (EFSM) guaranteed the EFSF that it will provide loans of up to 60 billion euros and the IMF also pledged to provide 250 billion euros. The net safety allowable or the firepower could thus be reached up to 750 billion Euros.
On January 25th, 2011 the EFSF made an inaugural issue of five years bonds of 5 billion euros, which attracted a record 44.5 billion euros of order book.
On November 29th 2011, EU’s member countries finance ministers decided to expand the EFSF by creating certificates to guarantee up to 30% of the new issues made by troubled European Union’s member countries. Further the Euro zone finance ministers decided that new investment vehicles have to be created to augment the EFSF’s powers to mediate in the troubled countries, bond markets.
Impact Of formation of EFSF on Financial markets
Stock markets witnessed a spike as soon as the European Union announced the creation of EFSF, which would come as a support to the falling crisis hit European economies. Investors confidence improved as fears of Greek debt crisis to spread further (or the contagion effect) eased with the formation of the EFSF.
The European currency Euro gained a push and climbed to register its biggest gain in 18 months. The euro got a further boost from the squaring off of the open short positions earlier made by big hedge funds and a large number of short term traders.
After the announcement of formation of EFSF by the EU the interest rates (dollar LIBOR) also surged to nine months high levels and default guarantee swap rate also showed a decline during this period.
The EFSF provides aid only on request of a European Union’s member country’s need for funds and after a country programe has been negotiated with the European Commission and the IMF. Also this programme has to be unanimously accepted by the Euro zone’s finance ministers and a memorandum of understanding should be signed.
Ireland requested for a rescue pack from the EFSF and on November 2010 it was financed with 17.7 billion euros by the EFSF. The 67.5 billion euros rescue package obtained by the Ireland constituted these 17.7 billions provided by the EFSF and the remaining funds came by way of loans from the IMF, European commission and individual European countries. In May 2011 EFSF contributed one third of the 78 billion euro rescue package designed for Portuguese government.
When Greece requested for a second bail out package, 164 billion euros worth of loan was provided by the EFSF. In January 2012 S&P downgraded the EFSF from a credit rating of AAA to Aa+. Weakening economics of the EFSF’s contributors was quoted as the reason for the ratings downgrade. In March EFSF bonds of 1.5 billion euros for a 20 year paper were sold and the issue was oversubscribed by about three times.
Meanwhile EFSF also tried to obtain funds from China though no agreement was reached Later Japan indicated that it is interested in lending more money to the EFSF. The EFSF was initially formed for three years and was to expire in 2013 but as the crisis continued to grow bigger the EFSF mandate was enlarged and a successor institution with a 500 billion euro funding program was created which was known as the European Stability Mechanism (ESM). The ESM is expected to begin its operations in July 2012 and may benefit the financial crisis facing countries of Europe.
European Financial Stabilization Mechanism (EFSM)
An emergency funding programme called the European Financial Stabilisation Mechanism (EFSM) was created by the European Union on January 5th 2011. The EFSM is supervised by the European Commission and is aimed at maintaining Europe’s financial stability by extending monetary help to the financially weak or the crisis hit EU’s member states. The EFSM mainly relies upon funds raised from the financial markets, which are guaranteed by the European Commission using the EU budget as collateral.
The EFSM can raise a maximum 60 billion euros by way of bonds or other financial instruments. In its inaugural emission the EFSM issued bonds of 5 billion euros in capital markets at a borrowing cost of 2.59%, which formed part of the bailout package provided to Ireland. Subsequently, many other emissions were made by the EFSM which totaled of 22.6 billion euros of bond issues from May 24th 2011 to January 9th 2012.This included a 30 year bond issue worth 3 billion euros. The EFSM fetched a credit rating of AAA by Fitch, Moody’s and Standard & Poor’s.
The EFSM also funded the bailout programmes designed by the European Commission for rescue of Ireland and Portugal. As a part of these programmes the EFSM provided loan of 15.4 billion euros to Ireland in January 2112 and 15.6 billion euros to Portugal in January 2012. Like the EFSF, the EFSM will also be replaced by the permanent rescue funding programme ESM, which is due to be launched in July 2012
On October 26th a summit of the heads of 17 member countries of the European Union was held in Brussels, Belgium. Consequently they agreed on the following: -
- Debt haircut for Athens – to help crisis hit Greece, the Euro zone announced to write off half of the Greece’s vast sovereign debt (held by banks). This would mean a reduction of 100 billion euros of sovereign debt.
- An increase of four times (around 1 trillion euros or $ 1.4 trillion) in bail out funds held under the European Financial Stability Facility (EFSF)
- The EU heads directed the European banks to increase their core capital ratios to 9%. The compulsory level of 9% was aimed to prevent the sovereign debt crisis from turning into a second banking and financial crisis.
- Further, commitments from Italy were also obtained to take actions to reduce its national debt.
- the euro zone also agreed for 100 billion euros as new loans to Greece, this was in addition to the 30 billion euros provided in bond guarantees. Thus 109 billion euros package that was talked about in July was replaced by this 130 billion euros package.
However a couple of days latter in October the Greek Prime Minister George Papandreou announced that looking at the countrymen’s reaction towards the package a referendum would be held so that Greece’s people have a final say on bail out package. This was enough for the financial markets to show a negative reaction later on November 3rd Papandreou directed to withdraw the referendum on the rescue package.
A few European banks were continued to maintain high dividend payout rates and were not getting capital dose from their governments, even though they were required to improve capital ratios.
However a meeting was held in February 2012 to come to a final decision on the second bail out package. The European Union agreed with the International Monetary Fund and the Institute of International Finance on the final conditions of the second bail out package worth 130 billion euros. The lenders agreed to increase the nominal haircut to 53.5% from previously agreed 50%.
The member countries of the European Union agreed to implement an additional decrease in interest rates of the Greek Loan Facility to 150 basis points in premium to the Euribor. This rate was now effective for the previously extended loan as well.
Additionally, the members of European Union holding Greek government bonds in their investment portfolio, agreed to let go future income from Greece’s bonds till the year 2020. This is expected to pull down Greece’s debt to between 117% – 120.5% of GDP by 2020.
The European Central Bank (ECB) and its significant role in cooling European debt crisis
The European Central Bank (ECB) was established by the members of the European Union in the Treaty of Amsterdam in 1998. The bank is headquartered in Frankfurt, Germany. The primary function of the bank is to define and maintain the monetary policy of the Euro zone. European Central Bank is required to maintain low inflation (i.e. around 2%) or price stability in the Euro zone.
Other objectives of ECB are to carry out foreign exchange operations, to watch out the foreign reserves and to promote uninterrupted operation of the financial market infrastructure under the TARGET2 payments system.
The European central bank also has the special right to authorize the issue of euro’s banknotes and euro coins. However member countries are now allowed to issue only euro coins, though the amount has to be pre described and authorised by the ECB.
From time to time the ECB has taken a number of steps to reduce volatility in the financial markets and improve liquidity in the euro economies.
In May 2010 in order to support Greece, the ECB relaxed its policy pertaining to the required credit rating for loan deposits and started accepting all outstanding and new debt instruments issued or guaranteed by the Greek government as collateral notwithstanding the nation’s lower credit rating. Such a move by ECB gave some respite to the Greek government as they could raise money on capital markets despite the downgrade of Greek bonds to junk status.
In November 2011, the European Central Bank along with other banks (including the US Federal Reserve, the Swiss National Bank, the central bank of Canada, Central Bank of Japan and British central bank) injected greater liquidity in financial markets with a view to reduce the European debt crisis and to support the Euro zone economy.
In order to improve liquidity the central banks lowered the cost of dollar currency swaps by 50 basis points or by half a percentage point. They also agreed to provide increased internal liquidity to each other as that would help commercial banks maintain liquidity in other currencies.
European Central Bank’s LTRO’s
In December 2011, the ECB under its Long Term Refinancing Operations (LTRO) provided 489 billion euros by loan to 523 European banks for a period of three years at a minimal rate of just 1%. This enabled euro banks to have cash to pay their own maturing debt of 200 billion euros for the first three months of 2012. Also they would have enough funds for providing loans and for operating businesses so that economic growth takes place. The loan provided at the negligible rates could also help in purchasing government bonds and thus cool of the debt crisis to some extent.
Further on February 29th, 2012, the European central bank under its Long Term Refinancing Operations provided 529.5 billion euros of loans at very low interest rates to 800 European banks.
Restructuring of European banking system
In mid June, 2012 the ECB along with Euro zone member countries drafted plans for the ECB to turn into a bank regulator and to form a deposit insurance program to enhance national programs. In the same meet reforms were proposed for promoting Euro zone’s growth and employment.
European Stability Mechanism (ESM)
While the EFSF was a temporary or a short duration program to fund for the rescue of ailing economies of Europe. The European Stability Mechanism (ESM) is a permanent programme designed for the similar purpose and is thus expected to succeed over European Financial Stability Facility (EFSF) and European Financial Stabilization Mechanism (EFSM) in July 2012. The EFSF and EFSM were short duration programs and were formed to operate till 2013.
In December 2010 the European Council agreed to an amendment in the EU Lisbon Treaty that allowed for establishment of a permanent bail out mechanism. Next year in March, the European Parliament agreed to the amendment following assurances that the European Commission rather than EU countries would be the major authority in administering the ESM. The ESM will be an intergovernmental organization that would come under the public international law and will be headquartered in Luxembourg.
The ESM would serve as a “financial firewall” by protecting investors’ (different nations and banks) interest by guaranteeing some or all the obligations of the issuing countries. So, in this case, any default by one country won’t ripple through the entire interconnected financial system and the single default can be managed while limiting financial contagion.
European Fiscal Compact
There is a structural problem in EU as its members have a monetary union but they are not bound by any fiscal union. So, all the members follow the same monetary policy but the member countries have freedom to decide about public spending and tax rates. So there is no fiscal union among the member countries as having control over fiscal policy is traditionally considered central to national sovereignty. Still, EU has some limited fiscal powers like determination of external trade tarrifs and creating budget of billions of euros.
In order to ensure sensible and effective fiscal policies for all member states the need arised for adopting a form of fiscal union. In the same line in March 2011, European Fiscal Compact was initiated. This Fiscal Compact requires its members to introduce a national requirement to have national budgets that are in balance or in surplus. In case of breaches of either the deficit or the debt rules penalties would be imposed. The European Fiscal Compact was signed by all European Union member countries except the Czech Republic and the United Kingdom on 2 March 2012.
Economic reforms and recovery proposals
Increase investment to rekindle growth
The austerity measures employed by majority of the European countries to cope with the ongoing debt crisis are getting substantial criticism. According to some economic experts, a sudden return to non-Keynesian financial policies will not prove an effective measure to counter the crisis, instead the deflationary policies being adopted by Greece and Spain might further deepen and extend the recession in these countries.
The excessive levels of private indebtedness and a collapse of public confidence in Greece have resulted in decline in spending in an attempt to save up for difficult period ahead. The lower private spending in turn resulted in even lower demand for both products and labor and consequent decline in economic growth. The government revenues in the form of tax declined weakening its ability to tackle public indebtedness.
Most of the credit given to the crisis hit countries to cope with the credit burden is conditional and available only if they do fiscal adjustment and structural reform. However, the recent austerity measures taken by the governments seems not working as almost all spending cuts brought even larger tax rise with them.
Slow economic growth rates generally correspond to sluggish growth in tax revenues and speedy surge in government spending, which in turn widens deficits and results in ballooning debt levels. So, instead of implementing strict austerity measures to tackle the crisis, economists are suggesting increasing investment and cutting income tax in weak economies to rekindle economic growth and boost employment.
In addition to finding ways to boost growth they also have to ensure that they are carrying out structural reforms gradually which may take some time to bear fruit. So the crisis hit countries like Spain and Italy should also resort to some form of structural reforms ranging from tax collection to labor markets apart from supporting economic growth in order to come out of the problem. Against this, if they just resort to mere cutting public spending their unemployment rate would keep increasing eventually hurting the spending capacity of the people which in turn can actually hurt the process of economic recovery.
Increase competitiveness to boost exports
The two major symptoms of the ongoing crisis in Europe seems fiscal problems and widening sovereign spreads, but these symptoms are tightly associated with a deeper problem in the form of the slowdown in productivity and loss of competitiveness in GIIPS. These countries have lost competitiveness against strong economies in northern Europe like Germany as well as against major global counterparts like the United States, China, and Japan. With loss of competitiveness, potential growth rate of these countries have been hampered severely and as a result their creditworthiness have decline sharply. The loss of competitiveness against major global and regional counterparts has been evident for at least five years in the countries like Italy and Portugal, but they managed to hide it due to unsustainable demand and housing boom. Now as their creditworthiness has gone down they are facing difficulty in accumulating public as well as private credit.
In order to improve the situation, these crisis hit countries should find ways to improve their global and regional competitiveness. In normal case where economy has freedom to alter their monetary policy this is done by depreciating the currency. As EU members cannot depreciate their currency by printing money etc., the policy makers of these countries should try to bring back competitiveness through internal depreciation by reducing domestic labor cost, which is a tough and painful economic amendment process.
According to some economists, Europe’s real problem is absence of economic growth. To solve the ongoing crisis, no debt restructuring will work if these economies remain stagnant in the coming years. So, in order to improve the situation, the policy makers would need to find ways to boost economic growth. A combination of improving competitiveness (through reduced labor cost) and gradual injection of foreign capital might help recover these economies. Among the crisis hit European countries, Ireland was the only nation that had taken some steps to reduce wage rates during the last five years. The same has resulted in about 16% decline in its relative price/wage levels. Similar action is needed in Greece too, where wage rates are skyrocketing and nullifying the impact of any external debt support.
So, in order to recover from the crisis these countries should accelerate measures to improve their competitiveness. These countries should now target to gain competitiveness in relation to Germany at the similar pace they have lost it. In order to compete with Germany whose unit labor costs (nominal terms) are almost flat the per unit labor cost in the GIIPS requires to decline by about 6% in the coming three years. This can be attained by either cutting wages modestly or by improving productivity or both. So, some structural reforms would be needed to reduce labor cost and increase competitiveness. Though reforms might take time to give results, but taking some steps towards reform would help improve the market confidence towards these countries.
Against this, some economists opines that despite reducing wages rates, Greece and Portugal could never compete with developing countries like China and India as labor cost in these countries are very low as compared to the western world. So, instead of reducing wages to improve competitiveness, weak European countries should shift their focus towards higher quality products and services, which is a long-term process and may not bear immediate fruite.
Meanwhile, according to a report on 15 November 2011, the indebted eurozone countries facing a severe economic crisis were in the path of rapid reforms and are now progressing towards restoring their fiscal balance and external competitiveness. As per the report, Greece, Spain, Ireland and Portugal were among the top seven reformers out of 17 countries included.
Reducing Current account imbalances:
Another measure to cope with the ongoing crisis in the GIIPS would be reducing the primary balance (the budget balance excluding interest payments) so as to ensure the debt-to-GDP ratio comes back on a downward path gradually. Spain, for example, this means reducing the primary balance by some 8 percent over three years, and in Italy by 4 percent. In both cases, that is more than is currently being contemplated.
A country with a large trade deficit must eventually fill this gap with increased borrowings or lower savings (balance of payments). So, a country with higher imports than exports must either borrow or decrease its savings reserves. Against this, a country with a large trade surplus must either invest its capital by lending money to other countries or increase its savings reserves. In the same line the GIIPS countries with huge trade deficits during the last decade had to resort to external borrowing to bridge the gap between imports and exports. With huge amount of debt and increased interest rates after loss of confidence among the investors eventually resulted in surmounting pressure on these countries to service their debts. In 2009 the combined trade deficits of Italy, Spain, Greece, and Portugal were to the tune of about $180 billion at the same time Germany’s trade surplus was $188.6 billion.
Increase in trade surplus of any country generally results in appreciation in its currency relative to other currencies, which in turn reduces the imbalance as stronger currency makes its exports expensive. The currency of country with trade surplus strengthens as the importing nation sells its currency to buy the exporting country’s currency for purchasing their goods. Against this, a country with trade deficit sees its currency weakening which in turn help adjust its imbalances as weak currency makes its exports attractive. However, as the crisis hit members of EU are on the euro, they don’t have flexibility to adjust their interest rates to manage their trade imbalances.
So, the only solution left with these countries to cope with problem is to reduce budget deficits and to alter its savings and consumption habits. If people of the country starts saving instead of consuming imported goods, the same would result in shrinkage in its trade deficit. Hence, it has been recommended that countries like GIIPS with large trade deficits to limit their consumption and improve their exports by increasing competitiveness. Against this, countries with huge trade surplus like Germany and the Netherlands should support their consumption by shifting their focus more towards services and increase wages.
Proposed long-term solutions
Issuance of Eurobonds
Another measure suggested by increasing number of investors and economists to solve the debt crisis is issuance of Eurobonds. In November 2011, the European Commission also proposed that Eurobonds issued jointly by EU members would be an effective way to cope with the financial crisis. However, any such plan would have to be accompanied by strict fiscal surveillance and policy coordination among the member countries to protect the interest of the members. Thus, introduction of Eurobonds would require changes in EU treaties to ensure tight financial and budgetary coordination among the members. Germany however remains largely against this proposal to a collective takeover of the debt of crisis hit nation that have run huge budget deficits and borrowed heavily to bridge the gap over the past years. The country opines that this could substantially increase its liabilities.
European Monetary Fund
In late 2011, Austrian Institute of Economic Research suggested converting the EFSF into a European Monetary Fund (EMF). The purpose of EMF would be providing governments with fixed interest rate Eurobonds at attractive interest rates. Such bonds could be held by investors with the EMF and liquidated at any time; however they would not be tradable. Backed by all EU members and the European Commercial Bank these bonds would achieve a similar reputation among the financial investors as that of Fed backed government bonds. In the meantime, the EMF would operate as per strict regulations by providing funds to countries that fulfills desired fiscal and macroeconomic criteria, thus ensuring fiscal discipline among the member countries despite lack of market pressure. This would force governments lacking sound financial policies to rely on national governmental bonds with relatively higher interest rates.
Drastic debt write-off through enhanced wealth tax
One way to curtail the growing debt burden on crisis hit European countries is to write-off all the debts of these countries by financing it through wealth tax. As per the Bank for International Settlements, the combined private and public debt of OECD countries grew almost four times during 1980 to 2010 and this trend is likely to continue to grow. According to a study increasing financial burden being imposed by aging population and subdued economic growth suggests these indebted economies are not likely to come out of their debt problem if they meet one of the following three conditions: If government debt is more than 100% of GDP; if its non-financial corporate debt is more than 90% or if the private household debt is greater than 85% of GDP.
So, if the overall debt load of these countries continues to increase briskly than the economy, then large-scale debt write-off would become unavoidable. According to a study, to keep economic growth intact and sustainable, the Eurozone should reduce its overall debt level by 6.1 trillion euros. The same could be financed by a one-time wealth tax of between 11-30% for most countries; however for the crisis hit countries like Ireland, where debt write-off would be much higher, and the tax rate might be way higher. However, such programs would be severe and unpopular and implementing the same would require strong political coordination.
Will Greece leave European Union?
After being in focus since emergence of debt crisis Greece’s again gathered attention in May 2012, this time for political crisis. In the absence of clear majority to any single or combination of parties in the recent elections in the country, the political crisis ignited talks that Greece might have to exit from the European Union. Many economists have been suggesting that Greece along with similar debt troubled countries should quit the European Union. They justifies it by saying that the same would result in Greece to move out of the common currency trap and allow it to bring back its own currency at a lower rate. These economists say that a Greece default is inevitable in long run and delaying this default through pumping more money in the economy would hurt EU lenders badly. Against this, if Greece continues to be in the European Union, huge government deficit led higher interest rates might hamper domestic demand and hurt economic growth.
However, there are other severe implications of debt defaults and national exits. The breakup of Euro with exit of Greece might result in bankruptcy of many Eurozone member nations, as they are interlinked and it will have a domino effect. So, ousting financially weaker nations from European Union is not a solution to this crisis.
Some more issues pertaining to crisis
Maastricht treaty violations
Breach of “Article-123 (TFEU)”
According to the European Union’s Maastricht Treaty, there are some clauses which ensure that the sole duty of repayment of sovereign debt remains with the country itself, this clause can be termed as “no-bail-out” clause. This clause encourages member countries to have sound fiscal policies, so that ill effects of unsound fiscal policies would not spillover to the partner countries. Thus, the recent purchase of crisis hit country’s bonds by ECB can be termed as violation of Article-123 (TFEU) of Maastricht treaty.
Moreover, the formation of EFSF to support countries in crisis can also be regarded as violation of the conditions of the article. Primarily, the regulations of Maastricht treaty were designed to deter EU member countries to carry huge deficits and sovereign debt. These regulations were also meant to prevent excessive spending and loaning activities during the times of economic booms. These rules were also intended to shield the interests of other member countries’ tax payers. Thus providing bailout packages for the countries that have violated norms of EU treaty would encourage unethical practices in future.
Violation of Convergence criteria in EU treaty
In the Maastricht Treaty, there is a convergence criterion according to which, the member countries have approved that the yearly budget deficit of any country should not surpass 3% of its GDP and also the ratio of a country’s to Gross Domestic Product should remain below 60%. Majority of the crisis hit European countries like Italy and Greece have substantially violated these convergence criteria over the period.
Catalysts of the crisis
EU members disappointed with rating agencies
Many international credit rating firms which played a central role during housing bubble and crisis in Island were also involved in controversies during the ongoing European debt crisis. European policy makers have criticized these ratings firms for acting politically and accused them of fueling speculation. These rating firms have been alleged of over rating some countries. At the same time they are accused of acting conservatively while rating a troubled firm or nation. For example, in Greece’s case ratings agencies began to describe the Greek bonds as junk about four five weeks after market started treating them as junk. Further, policy makers from the EU and Portugal reacted furiously after Moody downgraded foreign debt of Portugal to the junk category. France also showed its anger after S & P downgraded the country. If the rating firm downgrades one country like France due to its high debts, the same should also degrade Britain which is also highly indebted in order to be uniform. These rating firms were also alleged of systematically downgrading euro-zone members just prior to important Euro meetings.
Meanwhile, looking at the inconsistency of ratings firms, European regulators got new authorities to supervise them. In order to keep close eye on rating agencies the European Union established European Securities and Markets Authority, which is EU’s only single regulator to supervise credit rating agencies. According to the ESMA, Credit ratings firms have to strictly follow the new regulations otherwise they will be deprived of operation on EU region. Further, European policy makers are said to be considering the prospect of establishing a European ratings firm so that the existing rating firms based in US will have less impact on developments in Europe’s financial markets in the coming years. But all the efforts to regulate credit rating firms in strict manner following the European debt crisis have mostly proved unsuccessful.
Talks of European Union’s breakup
Many economists of criticized the structure of the euro system right from the start as it resulted in monitory union among the member countries but lacked uniformity in fiscal system. Once the sovereign debt crisis spread past Greece, the same economists started continuously recommending that the Eurozone should be sacked. Looking at the crisis in GIIPS countries the same economists started recommending that Greece with other crisis hit countries in the EU should leave the Euro and should default their debts. As per their argument once these countries exits Euro, they can restart their national currencies and get advantage to lower interest rates to kick-start the economic recovery process.
In the same line some economist suggested that Germany should return to its previous currency (Deutsche Mark) or form a new currency union with the Denmark, Norway, Netherlands, Austria, Luxembourg, Sweden, Finland and Switzerland. Such a union would create one of the largest creditors in the world greater than China or Japan as their collective current account surplus would be huge. These economists opined that with the exit of these countries, the remaining euro members will have the opportunity to lower their interest rates which in turn would lead to economic growth in these countries gradually.
In 1992, the European Union was formed after the members signed an agreement known as the Maastricht Treaty. As per Maastricht treaty EU’s Convergence criteria included following measures to limit the deficit spending and debt levels of the member countries:
Low & stable inflation: The potential member country should have low & stable inflation. The inflation should not be more than 1.5% of the average of the 3 best performing EU countries.
Healthy Fiscal condition: The country seeking membership should have healthy fiscal condition. The country’s budget deficit should not be more than 3% of the GDP and total sovereign debts should not be more than 60% of GDP.
Stable currency Exchange rate: The potential member country should have a stable currency exchange rate. Its currency should not have devalued against any other member’s country’s currency for the preceding two years. Also its currency must trade in a range of +/- 2.25% against currencies of other member countries.
Despite agreeing to Maastricht Treaty and members pledging to contain their deficits and borrowing levels, many EU member countries like Italy and Greece, found ways to bypass these regulations and managed to hide their wide deficit and ballooning debts via using complex derivatives.
The actual position of Greece’s deficit came to open in 2009 when the new government revised the budget deficit to 12.7% of GDP from earlier forecast of 6-8%, which was further increased to 15.4 per cent of GDP in 2010. Once the world came to know the actual position about this EU member, a panic button was pressed and that fueled the debt crisis in Greece. Though the main focus remained on debt crisis hit Greece, there have been many cases of EU member countries misreporting their national statistics in order to hide their widening deficits and huge public debts.
Dispute over Collateral for Finland
In the environment where the European Union has been facing request for bailouts by economically weak EU member countries the European countries with better or strong economic conditions are being asked for help in the form of providing funding for bailout packages. However such countries fear default of the loan or interest on loans extended by them to the suffering economies, despite the fact that the loan is provided indirectly in the name of the European Union.
In view of which, Finland laid down a condition of receiving collateral (guarantee) for its contribution to upcoming bail out packages. In 2011 August, it became clear that Finland would be given collateral by Greece as demanded by the Parliament of Finland, so that the country can contribute to the expected 109 billion euros of bailout package for troubled Greece.
Looking at this special treatment other European countries that were providing aid for rescue packages started demanding equal treatment. Netherlands, Austria, Slovakia and Slovenia replied with annoyance on granting of this special assurance to Finland and thus showed the risk involved and demanded a similar assurance from Greece.
The collateral or the guarantee was expected in the form of cash deposit which Greece could provide only through recycling a portion of the loans given as bailout by Finland. Thereafter, numerous negotiations were made to make the collateral available to all euro zone countries however in the beginning of October 2011; a final collateral pact was reached.
Finland only is expected to utilize the collateral facility as it has to provide starting capital to the European Stability Mechanism (ESM) which would be in one cumulative installment rather than five small periodical installments. Finland is has a credit rating of AAA and thus can provide required capital easily.
Later in 2012 February, Greek’s four major banks agreed to give 880 million euros in collateral (as guarantee) to Finland, so that Greece can secure the second bailout pack.
Crisis and Politics
European sovereign debt crisis had a deep political impact on the euro zone countries. It has resulted in a number of untimely elections leading to early end of various European governments or has led to formation of temporary or new governments.
The French presidential elections, 2012 were held in two rounds the first round happened on 22 April 2012 and the second round was held on 6 May. In the first round of elections Nicolas Sarkozy and François Hollande were sent for the second round since none of them received majority votes. Hollande won the runoff with a vote of 51.63%. Sarkozy campaigned making immigration as a major issue and Hollande making euro zone crisis and the state of French economy as his is major issues. In the second round of elections Francois Hollande received 51.62% votes though Nicholas Sarkozy gained only 48.38% of votes. Thus for the time since 1981 an incumbent failed to get a second term that was mainly due to the financial crisis faced by France and the euro zone.
The Finnish presidential elections were held in two rounds first in January and second in February, 2012. In first round Sauli Niinisto received 37% of the votes though Pekka Haavisto got 18.8% of the votes. In the second round held on February 5th Sauli Niinisto won the election and was elected as the President of Finland. The issue for election campaign was again European debt crisis focusing largely on Portuguese bailout and the EFSF.
In Greece, European sovereign debt crisis and Greece’s financial crisis resulted in a political crisis. The Greek legislative elections were held on May 6th 2012. The elections as per the constitution were supposed to be held after four years of the prior election i.e. in late 2013 however in November 2011 an early election was agreed to form a coalition government which would approve and implement decisions taken with other Euro zone nations and the International Monetary Fund .
Greek Prime Minister George Papandreou announced that a referendum have to take place in order to determine whether Greece is ready to accept the next bailout from the Troika (ECB, EU and IMF). Though the referendum never took place instead the opposition and politicians from ruling PASOK (Pan-Hellenic Socialist Movement) demanded elections should occur early. A number of Austerity measures taken by the government resulted in social unrest in the form of strikes and protests, thus showed the anger of people towards the Government.
As a result for the first time in past four decades the bipartisanship (of PASOK and New Democracy parties) lost the votes. The communists and populist parties who were against the strict measures proposed by the foreign lenders and the Troika won the maximum number of votes.
Political conditions in Ireland spoiled on economic crisis related reasons like high budget deficit in 2010, uncertainty about the anticipated bailout from IMF. The Parliament of Ireland collapsed during next year therefore elections were announced to be held in February 2011.
As a result the previous government parties namely Fianna Fail and Green Party collapsed Taoiseach Brian Cowen resigned. Fine Gael party gained strength and formed government in coalition with Labour Party. When the parliament assembled on March 9th 2011, Enda Kenny was elected by 117 of the votes and was the only candidate nominated as Taoiseach (Prime Minister).
The euro fell after the Irish election on fears that new government would revalue the bailout with senior bank bond holders. On 28 February the Irish Stock Exchange‘s the ISEQ index stepped up by about 1% following the election.
In Netherlands, the Prime Minister Mark Rutte’s government collapsed as the talks about the austerity package worth 15 billion euros between Party for Freedom (PVV), VVD, CDA failed. The Prime Minister Mark Rutte resigned on 23 April consequently an early general election will be held on 12th September, 2012.
In Portugal parliament failed to adopt austerity measures consequently Prime Minister Jose Socrates resigned and the government ended. This called for early elections to be held in June 2011.
In Spain, early elections were announced to be held, as Spanish government failed to tackle the economic situation. Spain’s Prime Minister Jose Luis Rodriguez called for early elections to be held in November 2011. After the elections in Spain Mariano Rajoy was appointed as the new Prime Minister of the country.