2011

Futures First GHF Group Abhishek Joglekar

[EUROZONE DEBT PROBLEMS]

Our analysts take on the problems and possible solutions for the fiasco everyone is talking about

Eurozone Debt Problems

Introduction

Euro was established through the Maastricht Treaty of 1992. 14 countries adopted the Euro on 31Dec-98. To participate in the currency, member states were meant to meet strict criteria: Budget deficit less than 3% of GDP Debt/GDP ratio of less than 60% Low inflation Interest rates close to EU average However, their inability to meet the strict criteria was the very reason Euro faces problems today. The first two clauses were wildly floundered. Infact, the very beginning of Eurozone Debt crisis was that Greece balance sheet showed that they had a budget deficit of over 13% in Nov-09, more than twice than earlier reported (~6%, which was still higher than the mandate). This crisis spread like forest-fire catching others having high Budget Deficits, namely, Portugal, Italy, Ireland and Spainwho in addition to Greece, are collectively known as PIIGS.

Problems
It was inevitable than the troubled nations required the so called bailouts from EU/IMF. Greece , predictably, was the first one getting 110bn worth support in May-10, followed by Ireland which got 85bn in Nov-10 and Portugal got 78bn in May-11. All countries got bail-outs on strict austerity and other conditions (viz. privatizations etc). Greece, however, failed to meet these conditions and thus had to be given a further 159bn with revised conditions. Lets compare some of the important nations criterion by criterion Country Germany France Italy Spain Ireland Portugal Greece GDP ( Nominal) 3.30tn 2.5tn 2tn 1.4tn 204bn 229bn 305bn GDP Growth (%YoY) 2.7% 1.6% 0.8% 0.7% 0.1% -0.9% -5.7% Debt (% of GDP) 83.2% 81.7% 119% 60.1% 96.2% 93% 142.8% Budget Deficit (% of GDP) 3.3% 7% 4.6% 9.2% 32.4% 9.1% 10.5% CPI (Inflation) (%YoY) 2.4% 1.9% 2.7% 3.1% 2.7% 3.2% 2.4% 10yr Yields 2.15% 2.81% 4.97% 4.98% 9.20% 10.44% 16.38%

Source: Bloomberg, 22-Aug-11

So, we notice that Germany and France seem to be most healthy, whilst the rest seem to be in trouble in one count or the other. Greece, clearly, is the most troubled with high negative growth, high Debt/GDP ratio, high Budget Deficit. As an impact of these adverse conditions, we notice that it has to pay the most on its 10-year borrowings amongst the rest at over 16%. Infact, given the negative growth rate, it has what we call as an inverted yield curve- shorter term yields higher than longer term. To the effect that on its 1-year debt it has to pay over 40%! Now, Ireland, Portugal and Greece are relatively small economies compared to the rest on the list. Infact, the total GDP of all three is half the smallest of the rest (Spain). Hence, it wasnt much of a

Eurozone Debt Problems

trouble bailing them out. However, a contagion to even one of the bigger economies (mainly Italy or Spain) could put the whole existence of Euro-zone at risk.

Possible Solutions
Given that the debt issues have failed to abate in view of low growth (in some cases negative), there are very few avenues which may prove to be a panacea for Euro-zones debt problems. However, amongst the most discussed are the following: 1. Orderly Default- This means that the holders of debt of debt-stricken nation will be asked to take a hair-cut on their holdings (ie entitlement to less than 100% nominal worth of the bonds). Though, this would prove disastrous for the nation in the short run, but it will help offload some of the debt. Thus, it will have more breathing space to try and grow and come out of the situation. 2. Fiscal Union- This is one of the most popular alternative doing rounds. It would mean that member nations, with parliament support, will do away with their fiscal right to an entity which will be common to all governments. Thus, the risk is distributed amongst all nations. More the nations to guarantee the debt, the safer the debt becomes. However, it will lead to rise in costs for the safer and more-creditworthy nations (viz. Germany and France), which are also the stronger members with higher say in the Union. Therefore, its difficult to envision this scenario to take shape in near term. 3. Let go of some nations from the Union- This means that countries finding difficult to meet the Eurozone mandates in short-term and no real chance of meeting them in imaginable future should be allowed to leave eurozone to their previous currencies. Yes, it will lead to massive devaluation of their currency and they would still find tough to pay back their eurodenominated debt. However, in the long run they should be able to export their way back to growth and pay their debts. This is an unpopular choice amongst member as it would mean breaking up of Eurozone and will raise many questions regarding its stability in future.