Background
Roots of European sovereign debt crisis had been sowed well before the 2008 crisis.
The formation of European Union (EU) and single currency EURO (€) allowed the European peripheral countries to borrow money at lower interest rates. Countries like Greece borrowed at interest rate even lower than the Inflation rate. This helped peripheral countries to rack up huge amount of debts (in the case of Greece, debt is 160% of GDP).
Now the question arises is why these countries needed to borrow so much and why have they not defaulted yet?
It’s a bit complicated. Take the example of Greece government. It issued Greek Bond (now rated as junk bonds) to keep their voters happy by paying higher wages and pensions. In case on any sign of default, the European Central Bank (ECB) helps out with a bailout against collateral of Greek government bonds which virtually had a zero value.
What has been the impact so far?
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Fall of Eurozone: With lack of growth in the economies of the European periphery and limited bail-out capabilities, the debt burden becomes unsustainable.
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The sources of funding European banks are getting shut one after the other. In November, we saw failure of German bond auction causing a drop in bond prices.
This might lead to a credit crunch leaving businesses unable to get loans and invest (Austria’s central bank instructed the country’s banks to limit cross-border lending.)
So far, only one large European bank Dexia has collapsed due to funding shortage, but there could be a few others following soon as sources of funding (long term bonds, deposits from customers and short term funding through money market) are getting shut. -
European banks may try to raise cash by selling assets. This will also help these banks to meet high capital adequacy ratio targets. As capital moves out of emerging markets, the real value of their currencies could tumble leading to economic activity getting disrupted and inflation rates going up due to a rise in import prices. Hungary is the most affected among the emerging markets in Europe and we can also see similar effect in India.
Measures taken to resolve
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Rescue packages of €80 billion were given in May, 2010 to Greece and the European Union countries agreed on a €500 billion credit line for other distressed countries. The International Monetary Fund added a further €280 billion.
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Portugal received a €78 bailout in May in return for working towards a deficit reduction plan. Ireland was given €85bn in bailout cash in November, 2011.
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European Central Bank has also been buying government bonds of over-indebted countries.
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Immediate Budget cuts and modifying tax brackets to reduce the current account deficit.
These measures have, however, failed to resolve or even reduce the impact of this debt crisis. Failure of these measures was imminent as European economy as a whole and individual European countries economy are facing downturns which gets even worse with austerity measure like cuts in government spending, making it even harder to service their debts. Unless these economies bounce back to growth phase, it is hard to see any kind of external help working to resolve the issue of peak high Debt/GDP, current account deficits. Besides these economic issues, these countries face several political issues. For example, promises made by Greek government for huge pensions, early retirement schemes are causing them problems in cutting down budget. Greek citizens are protesting against the government measures to bring about austerity measures.
Possible outcomes if not resolved
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Disintegration of the euro:
We cannot predict what will lead to disintegration of euro but events like disagreement between debt laden countries and their rescuers over conditions of bail out, downgrade of France AAA rating, bankruptcy of banks could be a few reasons of disintegration. Disintegration can be disastrous as countries which separate out from euro will see depreciation in the value of their currency. This will lead to investors to divert their money to other countries offering better prospects, leading to collapse of the bank system in these countries. -
Greece, Portugal and Ireland could also be removed out of the European Union to prevent contagion effect but such an event in very unlikely as default and bankruptcy of these nations could worsen the debt crisis and also reduce confidence level of investors in nations like Italy and France.
The economy of the 17 countries in the euro currency union is almost stagnant, growing just 0.2 percent in the third quarter, with unemployment at 10.3 percent. Economists expect the euro zone economy to slip into recession early next year - if it has not happened already. Declining output makes the debt crisis even worse by cutting tax receipts.
EU summit held on 9, Dec 2011 has brought some relief by reaching an agreement to provide €200 billion to the International Monetary Fund to fight crisis and help cover Italy and Spain but failed to form a 27 nation pact on fiscal coordination as United Kingdom and Hungary refused to go along. Importantly all 17 members that use euro and six other countries agreed on the new treaty. The permanent 500 billion euro European Stability Mechanism would be put in effect a year early by July 2012 and for a year would run alongside the existing and temporary EFSF.
Khozema Dhanerawala,Affiliate Member,CFA Institute.