Eurozone Debt Crisis

GROUP - 14
8/23/2012 Great Lakes Institute of Management

Saket Sharma – FT13468 Sakshi Jalota – FT13469 Sandeep Kumar R – FT13470 Santhosh Kumar S – FT13472 Shantanu Mishra – FT13474 Shreya Ravipati – FT13475 Shubham Agarwal – FT13476 Smriti Saran – FT13477 Sohrab Singh – FT13478

The European debt crisis or European sovereign debt crisis is the financial crisis that started in Eurozone in late 2009 and is still on-going. One after the other, countries in Eurozone is finding it difficult to re-finance their debts (government debt). “From late 2009, fears of a sovereign debt crisis developed among investors as a result of the rising private and government debt levels around the world together with a wave of downgrading of government debt in some European states. Causes of the crisis varied by country. In several countries, private debts arising from a property bubble were transferred to sovereign debt as a result of banking system bailouts and government responses to slowing economies post-bubble. In Greece, unsustainable public sector wage and pension commitments drove the debt increase. The structure of the Eurozone as a monetary union (i.e., one currency) without fiscal union (e.g., different tax and public pension rules) contributed to the crisis and impacted the ability of European leaders to respond. European banks own a significant amount of sovereign debt, such that concerns regarding the solvency of banking systems or sovereigns are negatively reinforcing. Concerns intensified in early 2010 and thereafter, leading Europe's finance ministers on 9 May 2010 to approve a rescue package worth €750 billion aimed at ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF)”(1)

Review of Literature

Need of the study Statement of the problem Objective
The objective of

Results & Discussions
Main Cause The crises resulted from a combination of complex factors and is not the result of a since event. Some of the main causes of the crises were: 1. Rising government debt levels When European Union was formed, all the member countries agreed to limit the total debt to 3 % of their GDP. All the major economies flouted the rule. After the formation of the Eurozone in late 90’s many Eurozone countries with different credit worthiness were borrowing debts on similar and low interest rates. This was the result as Eurozone referred to as one entity and each country in it receiving the backing of Eurozone. So countries like Greece, Spain, Portugal, and Italy were now receiving loans at a cheaper rate in comparison to their credit rating. But when the time came back to repay the money, the countries started defaulting on the debts which lead to the crises.

Now the question arises what debt levels are sustainable by a country. According to a research report when the combined government debt and the banking system gets greater than five times the government revenue it becomes a problem for the country.

Government debt +Banking system > 5X Government revenue
This is because you’re banking system and your government debt becomes too large and if the government have to bail out, they do not have sufficient funds to do so. Current state Country Ireland Japan United States United Kingdom

43X 37X 16X 14X

Spain Portugal Netherlands France Germany Greece Australia Italy

11X 10X 10X 10X 9X 8.5X 8.4X 7.5X

2. Trade Imbalances

Looking at the current levels though Germany has a higher level but why is Greece which has a lower level in doll drums, and on the other hand Germany is doing well. The reasons for this are:  Better health of the Germany’s economy than other European countries which is reflected in the Balance of payment account. Germany is a Trade Surplus country. Germany exports more goods than it imports which in turn helps it to generate surplus money to service off its debt levels.  On the other hand countries like Greece, Portugal , Spain etc. economies are not that good wherein they are importing more than what they are exporting leading to trade deficits which in turn leaves more borrowed money to service their debt levels.  From time to time all the European countries have increased the wages of the labour and employees. Germany is the country where wages changed very less. They remained low.

So due to these reasons Germany was still considered a safe haven to invest in while all the other major countries were considered as a risky option to invest in. 3. Structural Problems There were various structural problems embedded in the Eurozone. Firstly Eurozone has a common monetary policy while a different fiscal policy for each country. In terms of they have a regulatory body to enforce the monetary policy for each country but there is no governing body for fiscal policy. So each country were using their own policies for taxation and expenditure. Secondly as Eurozone is a 17 member nation, decision making was a time consuming process as it was to be passed by each member state. So the lack of quick decision making also acted as a catalyst in the debt crises. 4. Lack of confidence of Investors On seeing the crisis, investors demanded a higher yield for the European countries’ bonds. As when the risk increases, investors demand more yield for the capital they have invested in. Due to the increased interest rates, the debt value for these countries further increased which further increased the pressure on these economies. This is like a vicious circle. Also when US crisis occurred, whole world economy slowed down. Even at that point of time European countries like Greece didn’t changed their fiscal policy. They continued to spend like before. So pressure increased on their economy and these countries faced crisis.

MEASURES TAKEN AT EU Level 1. ESTABLISHMENT OF EFSF At the European Union level the major step taken to tackle the situation by creation of European Financial Stability Facility (EFSF) with an initial investment of £750 billion. The aim of this is to establish financial stability within the Euro-zone by bringing about fiscal responsibility amongst the Eurozone countries. This was supported by banks accepting a

53.5% write-off of Greek Debt owed to private creditors thereby increasing the EFSF to about £1 trillion. This improves the financial position of EFSF which plays the role of a financial regulator within the Euro Zone to prevent the collapse of major economies. 2. INTRODUCTION OF BALANCED BUDGET LAW The balanced Budget law was the first initiative taken by Germany post Euro crisis to handle the issue of lack of fiscal union. The objective of this law is to force the Euro Zone countries to restrict the budgetary expenditure to a value lesser than income thereby bringing down the budgetary deficits by imposing a cap on the new debts and bringing about a fiscal discipline. This has to be achieved by constitutional amendment in every Euro Zone member countries. 3. ESTABLISHMENT OF COMPETITIVENESS ACT In late 2010 steps were taken by German Chancellor Angela Merkel to propose another pact called Competitiveness pact which involves the commitment of Euro Zone countries to bring about a list of political reforms to improve the fiscal strength and competitiveness of each country along with improvement of employment opportunities, contribution to sustainability of public finances and co-ordination in tax policy. The competitiveness aspect stressed in the pact would be addressed by abolishing of Wage Indexation which involved adjusting of wages based on Price Index to keep the purchasing power under control instead the wages would be decided by National Unit labour Costs (ULC) of a particular nation thereby reducing the cost and increasing productivity by deregulating the industries and improving on infrastructure and education. Employment opportunities would be improved by adopting a policy called “flexicurity” involves adoption of flexible contractual agreements in the interest of the labour along with comprehensive lifelong learning strategies for the labour community to equip themselves better for future besides these the labour policies must be updated to attract foreign investments and finally the social security systems must be effective in providing adequate income support during employment transitions. This is done in an environment where the minimum wage is maintained at a rate higher than average wage and a clear progressive taxation policy. Public Finance will be strengthened by reducing the burden of pension funds by limiting early retirement by providing incentives to firm to employ older workers. Harmonizing tax rates across the Euro Zone nations by establishing a corporate base and unifying tax rates and member countries will apply their tax rates on the corporate base to arrive at their country’s tax rates which will reduce the administrative burden and compliance costs which was earlier significantly high due to maintenance of 27 different rule sets involved for corporate book keeping. 4.EUROPEAN FINANCIAL STABILISATION MECHANISM This programme was set up on 5th January 2011 and was aimed at creation of emergency fund through financial markets using European Commission as guarantee and EU’s budget as collateral. It has the authority to raise up to €60 billion. It is monitored by European Commission and is responsible for providing the financial stability in Euro Zone by providing financial assistance to countries in financial and economic distress. EFSM would be replaced by ESM by July 2012.

5. SIGNING OF EUROPEAN FISCAL COMPACT The emergence of European Fiscal Compact which is a treaty signed by all the Euro zone members except Czech Republic on 2nd March 2012 to address the issue of lack of fiscal union by every country in the zone adopting a balanced budget approach to keep the general budget deficit to less than 3% of GDP and Structural deficit to a range of 0.5% to 1% of GDP depending on the Debt-GDP ratio of each nation. The balanced budget approach involves 2 aspects – Primary balance and Structural balance. The treaty also makes it a legal obligation for Euro zone countries coming under the jurisdiction of European Court of Justice to comply to their budgetary obligations stated in the treaty and any breach would lead to fines up to 0.1% of GDP. 6. MEASURES TAKEN BY ECB a. Supporting Open Market Operations buying government and private debt securities worth €219.5 billion and simultaneously absorbing liquidity to control inflation. b. Opening currency swap lines with Federal Reserve. c. Acceptance of all debt instruments irrespective of the country’s credit rating as collaterals for loans which was advantageous to Greece since its sovereign bonds have been downgraded as Junk Bonds post the dent crisis. d. Lowering of Dollar currency swaps by 50 points based on the initiative of ECB to open the swap lines leading to additional liquidity e. Long term refinancing operations to the amount of 365 billion pounds taken by Spain,281 billion pounds by Italy leading to increase in liquidity leading to prevention of credit crunch and infusion of economic growth. COUNTRY SPECIFIC MEASURES GREECE: Greece was a country where a fast growing economy was plagued with a huge structural deficit predominantly due to fiscal irresponsibility. The other reason being the cyclical nature of their shipping and tourism industries which were the major revenue generators for the economy. The country’s revenue expenditure was pretty high leading to low growth. To stimulate the economy and to usher growth a stimulus of €45 billion from EU and IMF was provided to cover the financial needs of the country. This had a repercussion in terms of S&P’s downgrade of the sovereign debt rating to BB+ leading to a stir in the stock markets due to fear of investors losing their money. On May 1st 2010 Greece Government introduced austerity measures amidst massive social unrest to secure a second bailout of 3 year €110 billion loan to honour the country’s financial commitments. During October 2011 the consortium of EU, ECB ANDIMF (TROIKA) offered a loan of €130 billion but with a clause that Greek must adopt more austerity measures and must accept a Debt Restructuring Agreement. All these measures brought down the primary deficit (Fiscal deficit before interest payments) from €24.7 billion which is approximately 10.6% of GDP in 2009 to €5.2 billion which is 2.4% of GDP in 2011. BRUSSELS AGREEMENT:

The Brussels agreement was signed by Euro Zone members on 26th October 2011 to handle the Greek Debt Crisis by having a 50% write off of Greek’s sovereign debt held by Banks. Bailout amounting close to €1 trillion through EFSF and bank capitalisation to 9% along with a €35 billion as a credit enhancement package to absorb the losses suffered by European Banks. The austerity measures had its own disadvantages as it paralysed growth by harming private firms with a huge tax burden and reducing their capital expenditure. This in turn impacted the Industrial Output and high unemployment rates among youth. This also had an impact in terms of the increase in Gini Index for Greece To handle this crisis and prevent it from worsening into a political crisis involving military coup etc. the Troika offered the 130 billion loan proposed by it in October 2011 where the debt restructuring involved  Private holders of Greek Government bonds were made to agree to a 53.5% nominal write off with a bond swap which will reduce the debt burden for the nation by reducing the interest payments. Payments during buyback of Sovereign Bonds involved partly in short term EFSF notes, partly in Greek Bonds with lower interest rates and maturity prolonged to 11-30 years thereby providing the cushion for repayment by Government.

Debt restructuring lead to the Greek Debt level falling from €350 billion in 2011 to €240 billion in March 2012.This lead to the Debt-GDP ratio to fall below the target level of 120.5% of GDP by 2020. IRELAND: Ireland crisis was mainly due to lack of fiscal responsibility from the 6 major Irish banks in financing the Property bubble. The first step towards handling this issue was taken on 29TH September 2008 by the then Finance minister Brian Lenihan ,Jnr issued a one year guarantee to bank depositors and bond holders. This was followed up with the launch of National Asset Management Agency (NAMA) which was aimed at removal of Bad loans from six banks thereby reducing the bank’s NPA and improving the bank’s performance. Ireland lost €100 billion due to defaulting property developers during the property bubble leading to a number of macro-economic effects like increase in unemployment, budget steering away from surplus in 2007 to a deficit amounting to 32% of GDP in 2010. The bailout package provided to Ireland by the Troika along with UK, Denmark and Sweden amounting to €67.5 billion on 29th November 2010 along with €17.5 billion coming from country’s own pension reserves totalling to €85 billion. Out of the Bailout package received €34 billion was used for recovery of the country’s financial sector. Post bailout Ireland has its objective as reducing the budgetary deficit to 3% by 2015. European Leaders have agreed to take cut in the interest rates to be paid for the bailout loan from 6% to 3.5%-4% and double the repayment time to 15 years to improve the financial stability of the nation. This reduced the risk of Sovereign bonds thereby reducing the interest rates from 12% in July 2011 to 6.3% in 2012 thereby encouraging FII and improving the Forex reserves of the nation by improving the investor sentiments. This lead to an increase in the demand for 5 year and 8 year government bonds offering sustainable interest rates of 5.9% and 6.1% respectively.

PORTUGAL: The cause of crisis in Portugal lies in governmental overspending and an over bureaucratised civil service leading to delay in decision making leading to difficulties in crisis handling. The over expenditure in terms of funding inefficient projects coupled with unclear PPP agreements. This was inflated with hefty top management bonuses and wages leading to delay in developmental activities. The bailout provided in May 2011 was split amongst European Financial Stabilisation Mechanism and IMF due to this the interest rate was nominal around 5.1%.. This lead to acceptance from Government to cut the budgetary deficit in a staged manner from 9.8% of GDP in 2010 to 5.9% in 2011 ,4.5% in 2012 and finally achieving the target of deficit of 3% of GDP in 2013. In return for bailout Portuguese government introduced some austerity measures in terms of reducing its share in Telecom industry and public servants taking a wage cut around 20-25% leading to people moving to private sectors. The target of budgetary deficit of 3% was achieved earlier than expected due to one-off transfer of pension funds thereby reducing the government’s liability to interest payments leading to increase in the capital investments generating robust economic growth. SPAIN: The country had a relatively low debt ratio but it was mainly due to the huge tax revenues emerging out of property bubble supported by private mortgage debt which was not sustainable in the long run although it supported increased government spending with minimum debt accumulation in the short run. Spain tackled the situation by adopting austerity measures to curb the budgetary deficit at the cost of economic growth. Deficit although has been reduced from 11.2% of GDP in 2009 to 9.2% of GDP in 2010 and further reducing to 8.5% in 2011. This was followed by Spanish government adopting a constitutional amendment as a part of the compliance to balance budget law. A bailout package of 40 to 100 billion pounds which would be transferred directly to Spanish Banks to reduce Spain’s Sovereign Debt. The government was forced to accept the bailout due to spiralling of interest rate on sovereign bonds to 7% making it difficult to be traded. The country is currently plagued by high unemployment coupled with negative growth rates and a budgetary deficit of 5.4% which is higher than the threshold level. IMPACT ON REST OF WORLD Reduction of FDI Inflows hampering growth in infrastructure and other critical sectors which can hamper the economic growth of nations. Resurgence of Dollar as the only global reserve due to decline of Euro will make our exports cheaper and imports like fuel traded in USD costlier leading to higher Trade deficit. The increase in the Input costs will fuel inflation leading to lower capital expenditure which in turn leads to growth paralysis. In case of China has been limited impact due to Euro Crisis unless Euro zone crumbles. This is due to its reducing reliance on trade surplus generated by its huge exports, as the growth driver due to increase in domestic consumption.

The contribution of China towards helping Euro zone countries has increased by China holding its investments in Greek’s Sovereign bonds to propel Greece economy. The slow growth of Chinese economy at 8% has a negative impact on the Asian Economies leading to a lack of credit facilities and poor job creation leading to economic stagnation leading to poor purchasing power. The slow Chinese growth means reduced spending leading to reduction in exports of South-East Asian countries leading to increase in their Trade Deficits. The demand for Australian coal in China has reduced leading to a drop in its coal exports by 19% and iron ore exports by 11%. The path for future is recovery of the growth engine in terms of Europe moving in growth path along with resurgence of Chinese economy.

There are various schools of thoughts on the future of EURO crisis. Some financial experts think that all the 17 member nations should continue as the Eurozone, while some believe that it will be a difficult task. They predict that eventually the Eurozone will fall apart into different segments. These segments can be associated nations of small numbers, or each country will print its currency on its own. Some believe that powerful nations should try to rescue the weak nations in all ways possible, while others believe that weaker nations should themselves leave the Eurozone for the greater good of others. The below mentioned are few possible scenarios which could surface for ending the Eurozone debt crisis. Again this is not an exhaustive list; there can be many other alternatives which may take shape in the future. Nothing Changes the Eurozone remains intact – This scenario is possible only when the stronger nations like Germany and France would support the other member nations. This solution is most favoured by politicians, who hope that by this the weak nation will get the time to administer their finances. European Central Bank who has been buying out the government debts of troubled countries like Portugal, Ireland, Greece and Italy, will have to major role and would need the assistance of stronger nations of Eurozone and of international financing bodies. Limited disintegration of Eurozone – This scenario is possible when the weaker nations like Greece, Portugal would leave the Eurozone or they would be pushed out by other member nations out of the group. These countries will then start printing their own currencies. The danger with this scenario is that these weakened countries will be on the greater verge of economic collapse, and the other European banks who collectively own their debt will subsequently also collapse. Substantial disintegration of Eurozone – In this scenario not only the weaker nations will leave the group, but other members like Belgium and Italy would also leave. This will leave only the strongest nation in the group. Complete disintegration of Eurozone – In this scenario every member country will go on its separate way to re-issue its old currency. This will create a scenario of panic among the

whole Europe, which has not been seen since the Second World War. In this case one after the other the governments will start defaulting on their debts, which will ultimately lead to the collapse of the whole banking sector not only in Europe, but also in the rest of the world. Most of the leaders in the Eurozone are of the view that the group should remain intact. For them it is much more than a single currency. It took years to create Eurozone. It is much more than EURO, it is about an ideology which will ensure peace and joint prosperity among the whole of the continent of Europe. Although all members of the Eurozone are meant to be equal, some are more equal than others. Germany and France have, by far, the largest economies in the Eurozone and they wield the most influence; while countries like Malta and Estonia have very small populations and economies, and therefore have little influence on events.