European Debt Crisis

Background:

The Euro’s introduction in 1999 came along with unified interest rates in the nations that share the currency. These unified interest rates allowed members to borrow heavily. The result was that the bonds that were issued by the nations of south Europe were taken at par with the bonds that were issued by strong economies such as Germany. The result was that money flowed into Greece, Spain and Ireland. The large inflow of money had realty booms in these countries.

In 2007, the housing bubble busted in US and Europe. This was the first blow to the credibility of the Euro zone. In 2009, when the Government changed in Greece, the new Government found that its predecessor made wrong statements about its borrowings and had run up huge debts, the revelation provoked a drastic loss in investor confidence that spread across the currency bloc spread today in 17 countries.

After this, the nervous investors started to pull their money out of the country and started demanding punitive interest rates on the debt. This lead to a situation where the sovereign government’s borrowing from domestic and external markets is in excess of its capacity to repay, resulting in loan defaults requiring rescheduling of loans or bailout packages from other countries or multilateral institutions such as IMF. It was called the “Sovereign Debt Crisis“.

Greece was not in a situation to meet its repayment obligations to its external creditors. The budget deficit of Greece was in the range of 13.6% of its gross domestic product. The stock of debt was equivalent to 115% of the gross domestic product. The debt problem was further compounded by the fact that nearly three-fourths of the government debt was held by foreign institutions, particularly foreign banks. Not only was the high fiscal deficit a problem, it was also camouflaged by derivative hedging. Reportedly, investment banks misled investors into investing in government bonds of Greece by being secretive about the actual state of affairs. The rating agencies played accomplice and allegedly ‘failed’ to assess the correct fiscal position.

Larger Eurozone economies and the IMF extended Athens an emergency credit line in May 2010, but by then Greece’s finances had destroyed the illusion that all Eurozone members were equal. Investors quickly turned on the weaker economies of Portugal and Spain, driving up borrowing costs. This was followed by massive losses at the banks in Irelands stemming from the housing bubble forced Ireland to take a bailout six months after Greece; uncompetitive Portugal then followed in May 2011.

The lack of political foresight in Eurozone missed another chance to reassure markets. Germany has been reluctant to fully commit to helping member states meant the rescues did not constitute an effective firewall—markets continue to be difficult for Spain and Italy, which have a combined debt of about 2.5 trillion euros.

Impact:

The most visible impact was the hyperinflation on Greek banks. There was an array of problems such as violence, economic depression; international isolation and investor panic spreading to Italy and Spain make up the worst-case scenario if Greece were to default on its 370 billion euro debts.

European banks that lent to Greece at the height of the borrowing binge would certainly be hit; French banks have been particularly under pressure in recent days for their Greek exposure.

Since investors would no longer believe the euro zone protects its own members, they would sell off Spanish and Italian paper, possibly sparking more defaults. Banks and governments around the world holding euro assets would take major losses.

Possible outcomes:

Currently, the Euro zone leaders are adamant that Greece will not default. But if there is a default, Greece would likely be forced to devalue by leaving the euro and taking back the old drachma, making imports prohibitive. Credit would dry up, demand would shrivel and the country would be plunged into a prolonged depression.

Idea of Eurozone Bonds

Some European politicians and economists say that euro zone states should consider issuing bonds jointly underwritten by all countries in the bloc —Euro Zone bonds. The bonds would create a common interest rate for the bloc and allow weaker states to access markets at reasonable rates. However, implementation of such an idea could take years and there is fierce opposition to the idea in Germany and some other nations. However, the risk of a collapse of the euro or even of the European Union itself could eventually force Germany, to do whatever it takes to back weaker Eurozone nations, whether it be with the ECB intervening in markets to buy riskier debt or providing more funding to recapitalize European banks. But for now, European politicians seem more divided than ever, particularly on issues such as budget sovereignty.

Month: Current Affairs - November, 2011