European Debt Crisis: The Way Forward

Tue, Sep 14, 2010

Biz Arena

The European debt crisis may seem as far away as Iceland and as complicated as the spelling of its famous volcano. The recent crisis in the European banking system was followed by an even more serious crisis: some European governments’ perceived lack of creditworthiness. These two crises combined to create the present situation in which banks and countries face the risk of being shut out of the debt markets, once again constraining liquidity. Greece’s economy has been in the balance for months, but the seeds of the crisis were sown a decade ago. The country was clearly not ready for euro membership and now faces some hard choices: make savage budget cuts and plunge into a deep recession; default on its debts and lose its credit rating for a generation; plead for a bailout from its European Union partners; or quit the euro.

The adoption of the euro as a common currency has been the initiation point of the present scenario. The intent of the creators of the common currency was partly economic (to facilitate commerce in the European region) and partly political (to bind the economies of the member states more closely so as to avoid repeating the wars that ravaged Europe and the rest of the world during the 20th century). The agreement that established the euro imposed certain economic constraints on the member states. The principal requirements were as follows:

1. The ratio of debt to GDP could not exceed 60%.

2. Budget deficits could not exceed 3% of GDP

However, it became obvious early on that the mechanisms backing the euro were quite stringent and that individual member states would feel free to breach the treaty restrictions when they pleased, especially those having to do with debt limitations. Close scrutiny of Greece’s budget figures shows that the country has not actually met the conditions to join the eurozone. Greek government admitted in 2004 that its deficit has never been below 3% since 1999, as EU rules demand.

Things worsened as the debt liability increased after hosting the Athens Olympics. New Democracy party, in 2005 imposed an austerity budget to try to slash Greece’s deficit and get the public finances back on track after the cost of hosting the 2004 Olympics. Things seemed to run smoothly for some time but after the German crisis, the spotlight quickly turned to Greece, the weakest member of the euro area .For a long time, Greek debt had traded at only a modestly higher yield to that of its larger neighbors, reflecting a general market sentiment that did not distinguish among euro participants to any great degree. The crisis saw this assumption challenged, and Greek debt began to feel the strain. Then the implosion came. A new government came to power in Greece and confessed that the country’s finances were in even worse shape than had been disclosed. In short, the previous government had lied.

The government owes 300 billion euro and its debt is 115.1% of its GDP. The budget deficit is 13.6% of GDP, much above the Eurozone prescribed limit which says that its member states must not exceed deficits of 3% of GDP. According to the IMF’s latest report on Greece (IMF Country Report No. 10/217), published in July, non-performing loans (NPLs) have increased from 7.7% of the total in December 2009 to 8.2% in March 2010. What’s more, the system-wide capital adequacy ratio has declined from 13.2% to 12.9% over the same period. The current crisis shows that sometimes external borrowings attain unmanageable proportions that may adversely affect the process of growth.

In May, IMF and other Eurozone countries reached a loan agreement through which Greece would get a 110 billion Euro loan with 45 billion Euros available immediately. In lieu, the government agreed to introduce a number of austerity measures including introduction and increase of taxes and spending cuts. The government also announced Stability and Growth Program (SGP) through which it planned to reduce fiscal deficit to 2% and debt to 113% of GDP in 2013. Expenditure is expected to reduce to 47% from 52% and revenue is expected to increase to 45% from 39% of GDP in 2013.

Impact on the US economy

The Eurozone accounts for about 15% of US exports (and Greece only 0.2%) and the UK accounts for an additional 4%. The Canadian economy has been quite strong, and Canada accounts for about 20% of US exports on its own, and key US trading partners among the emerging market economies are also doing relatively well. Continued growth in these economies is expected to lead to increased demand for US exports. As long as that is the case, the direct trade impact on the US from the crisis will be muted. There will also be an indirect impact, though, that will take an additional toll – the exchange rate moves also mean that the US has lost competitiveness against the European countries in exporting to other countries, particularly the emerging economies of Asia, and may lose some export share to Europe.

Is the worst of Europe’s debt crisis over?

Investors seem to have regained their confidence in the euro: Europe’s common currency has largely stabilized at around $1.27 per dollar, after falling to a four-year low of $1.1876 in early June. At the same time, other parts of the European financial architecture are flashing red, signaling more trouble to come for the highly-indebted countries on Europe’s periphery. Renewed fears about Ireland’s banks and Greece’s economy have pushed their credit-default swaps closer toward record levels. (Investors buy these swaps to protect themselves against government defaults.) So, how will these conflicting signals be resolved? A lot depends on the U.S. economy’s ability to keep chugging along. If the recovery continues at a reasonable pace, the euro zone — especially countries closely tied to the U.S. through trade like Ireland — could actually benefit by comparison. But if the U.S. slides back into the doldrums, Europe’s recovery could be hindered, putting the likes of Ireland and Greece in jeopardy.

Conclusion:

We find that rich world policies (like Conservative Fiscal and Monetary policies) cannot be grafted into emerging market economies unless the latter have high level of institutional support for this sort of fiscal and monetary policy.

Also, the credit rating agencies took a long time to describe Greek bonds as junk although the bonds had started trading at junk levels several weeks before the downgrading of the bonds. It’s high time to review the operations and credibility of credit rating agencies.

Author : Manupriya Agarwal

MBA, Narsee Monjee Institute of Management Studies

(Batch of 2009 – 11)

3 Responses to “European Debt Crisis: The Way Forward”

  1. Nitin Jagga Says:

    Rich World policies (like Conservative Fiscal and Monetary policies)? At one end you yourself have reported the fiscal deficits to be so high, and at the other end, in Conclusion, you’re referring to “Conservative Fiscal” policies of the Rich World. That’s contradictory. In fact, the alarming levels of debt itself says how much the governments have been spending which implies they have been following “Expansionary” Fiscal policies to keep their economies running.
    I’d have loved to see a point on view if this is correct, whether spending money Keynesian way does really adjust the economy to it’s producing potential, or whether expansionary fiscal policies are sustainable or not.
    Really disappointed, the conclusion doesn’t make sense about anything.

  2. antropont Says:

    This occurs because of imperfections in the organizational structure of the European community. But I hope that is just a matter of time.

  3. Bona Says:

    It probably is just a matter of time. I hope they will fix this before it really gets out of hands.


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