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Memo on European Sovereign Debt _ 11

Memo on European Sovereign Debt _ 11

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Published by Sean Donovan

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Published by: Sean Donovan on Dec 01, 2010
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Memo On European Sovereign Debt ± 11/29/10
Justin Ciambella, Gardner Davis, Sean Donovan, Kunal Malkani, and Nicholas Paine
1
European Sovereign Debt
 The 2008 global recession exposed weak underlying macro-fundamentals in several peripherycountries of the euro zone, most notably Greece, and more recently Ireland, catalyzing the 2010European sovereign debt crisis. The situations in Greece and Ireland have not only pushed their domestic economies further into recession, but have questioned the feasibility of a commonEuropean currency. This memo progresses in four parts: 1) a discussion on Greek sovereign debt;2) a discussion on Irish sovereign debt; 3) an analysis of how these crises have affected the eurozone as a whole; 4) a look at what is to come as a result of the European sovereign debt crisis andwhat lessons should be learned. Taken together, this memo is intended to highlight the rootcauses of the crisis, analyze the euro zone¶s reactions, and evaluate the implications.
1) Greek Sovereign Debt Crisis
Overview:
Throughout the 1980s and 1990s Greece was viewed as a credit risk and was consequently forcedto pay borrowing rates up to 10% higher than Germany
i
. Greece saw the Euro as an opportunityto receive lower interest rates since they would be backed by other credible European economies.Before being allowed to join the euro zone though, Greece had to prove that they would beresponsible by having a budget deficit of less than 3% and stabilizing inflation
ii
. Rather thanactually meeting these criteria, government officials manipulated the figures to make it seem likeGreece was responsible.After Greece successfully joined the euro zone in 2001, they became eligible for low interest rateloans. The Greek government relied heavily on these foreign loans and increased capital flows tofinance their excessive government spending and current account deficits. Moreover, Greece¶s primary budget deficit continued to grow as expenditure soared and tax evasion continued to berampant.The financial crisis of 2008 caused a ³sudden stop´ of capital inflows and forced the governmentto have deflationary monetary policy to counteract the necessary decreases in wages and prices
iii
.These pressures pushed the economy further into recession and exasperated the government¶sdebt problems. When the new government was elected in 2009, the estimated budget deficit of 6.7% of GDP was revealed to be nearly double that at 13.6% of GDP. In response to this news,Greek credit was downgraded and the euro zone was attacked by widespread speculation.
 
 
Memo On European Sovereign Debt ± 11/29/10
Justin Ciambella, Gardner Davis, Sean Donovan, Kunal Malkani, and Nicholas Paine
2
esponse: Bailout and Austerity
As a result of Greece¶s financial situation, the Greek government found itself unable to financeitself on the markets like it had since joining the euro zone in 2001. With no other source of capital and with fears of contagion in Europe if Greece defaulted, the European Union and theInternational Monetary Fund intervened. The agreement between the EU-IMF and Greeceappropriated a total of ¼110bn ($146.5bn) to the Greek government in exchange for a multi-year austerity plan. The contributions from the Euro member states were proportioned according totheir respective holdings in the European Central Bank's capital.The euro zone loan promises were conditional on Greek reform and austerity measures; anddespite significant social unrest in Athens, the government passed legislation targetingexpenditure cuts, pension reform, tax reform, and labor market reform. Expenditure cuts mainlytook the form of wage freezes for all public sector workers, a cap on bonuses, as well as areduction in government employment. Pension reform was addressed through an increase in theminimum retirement age, a tightening of the requirements for a full pension, and a determinationof the value of the pension by average salary rather than final salary. In addition to these reforms,the value-added tax was increased and the labor market was made more flexible andcompetitive.
iv
 When taken together, these measures were intended to cut the fiscal deficit from the estimated13.6% of GDP to less than 3% of GDP by 2014. Such a reduction would move Greece intocompliance with the Euro Zone Stability and Growth Pact, hopefully calm the markets, and position the country to secure much-needed funds in the future. 
2) Irish Sovereign Debt Crisis
Overview:
Ireland became one of the fastest growing economies in Europe after it cut its corporate tax ratesand other taxes in the 1990¶s, leading to large capital inflows and foreign direct investment.However, during this time, a large housing bubble developed, which was heavily financed bydomestic banks. Meanwhile, the government increased public spending, raising domestic prices,and wages and reducing Ireland¶s competiveness abroad.
v
In 2008 when interest rates rosethroughout Europe, Ireland¶s housing bubble burst, devastating their banks¶ balance sheets andthe country¶s external wealth. The government stepped in to bail out its banks, but this move putthe government further in debt.
 
Memo On European Sovereign Debt ± 11/29/10
Justin Ciambella, Gardner Davis, Sean Donovan, Kunal Malkani, and Nicholas Paine
3
To mitigate the increases in debt, spending cuts and tax increases were implemented, but thisfiscal tightening sunk the economy further into recession, leading to a 7.1% drop in GDP in 2009and 13% unemployment
vi
. The negative shocks of the housing bubble burst and the subsequentfiscal tightening sent Ireland into a downward spiral of recession and increased government debt.This trend scared investors, resulting in the government¶s debt being downgraded in quality bythe S&P.
vii
 
esponse: Bailout and Austerity
To combat this growing pessimism among investors, the EU and the IMF responded similarly asthey did in Greece, providing Ireland with an ¼85bn bailout. ¼50bn is aimed at helping Ireland¶s public finances, while the government implements a ¼15bn austerity package over the next four years. The remaining ¼35bn will go towards recapitalizing Ireland¶s banks, with ¼10bn to be usedin the short term recapitalization, and the rest set up as a contingency fund that can be drawnupon if needed.
viii
 There is a lack of a consensus as to whether the bailout and austerity measures taken will beenough to restore market confidence and prevent default. Ireland has taken a very tough stance onkeeping the Euro and not defaulting, implementing costly austerity measures to do so, which intheory should help fend off some speculative attacks. However, some call for a more completerestructuring of the Irish banks and their loans.
ix
 
3) Crisis¶s Affects to the Euro Zone
Implications for the Euro Zone:
 The debt crises in Greece and Ireland have tested the sixteen-member euro zone¶s commitment toa common currency. Since the euro zone shares a common currency, their economies arenaturally very interdependent, despite asymmetric shocks to some periphery countries. Banks incountries throughout the euro zone, especially in France, and Germany to a lesser extent, werelarge holders of sovereign Greek debt.
x
A default by either Greece or Ireland would have sentnegative shockwaves throughout the financial system and the broader economy of the euro zone;consequently, as an attempt to prevent this fear from materializing, the EU agreed to the bailouts.Although Germany was initially, and still is, reluctant to partake in bailouts, it has helped their economy, with the EU projecting robust 3.7% growth for Germany in 2010, lifting EU growth to1.8%.
xi
 

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