euro zone crisis_aayush saxena

7/30/2019 Euro Zone Crisis_Aayush Saxena

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Executive Summary

With each passing week, the Eurozone edges closer to a full blown banking or sovereign debt

crisis. Liquidity in the interbank markets is tightening, and debt spreads for peripheral countries

are widening!

PIGS (Portugal, Ireland, Greek & Spain) became over-indebted despite the supposed self-

imposed discipline adopted by the euro zone of prohibiting fiscal deficits; 3 percent of GDP.

That discipline was violated by almost all euro zone members, beginning with France and

Germany, but more egregiously by the PIGS.

To make matters worse, however, the PIGS were also running increasingly large current account

deficits (with Germany, France, China). Though countries like France (and to a lesser extent)

Germany were fiscal sinners, they were at least running current account surpluses.

PIGS had access to excessively cheap public and private money available on terms totally

inappropriate to their economic circumstances. Given their inherent risks, which markets

mispriced completely, their borrowing costs should have been 300-500 bp higher than

Germanys.

Such expenditures became almost wholly dependent on access to increasing amounts of cheap

public borrowing from capital markets. In response to access to excessively cheap money, wages

in the PIGS rose across the board as did growth in public sector employment.

Although Greece's troubles were the most extreme, they highlight problems in the euro zone that

also apply to other economies.

Many other southern European countries ran up huge debts - government debts as well as

household mortgage debts - during the past 10 years. They also enjoyed rapidly rising wage

levels.

But meltdown is not yet inevitable. Under pressure from the IMF and others, and faced with the

possibility of financial implosion, solutions are being sought in European capitals.

Austerity is contradictory because it leads to recession thus worsening the burden of debt and

further imperiling banks and the monetary union itself.

The bigger questions are: can Euro survive, will UK continue to be a part of EU, will the new

Fiscal cord bring out the EU from recession & a full or partial breakup of the Euro is inevitable.


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Will EU survive the second decade of the

new millennium?

By : Aa yush Saxena

What will be the future of EU? Will it survive as we know it? Or will the 'PIGS' pull it

down?

As the euro-zone crisis spooks governments,

opinions are diverging dramatically about what

the union is for?? Does the E.U. still make sense

in its current form?

As long as that question remains unanswered,

uncertainty is bound to continue. Short-term

measures, like the propping up of Spanish and Italian bonds by the European Central Bank "are

quick fixes that smooth things over the short term," says Stephen King, chief economist at HSBC

in London. "But they don't answer the questions the markets are asking: What are the political

and fiscal arrangements that would create stability in the future?"1

Europe is at a crossroads. It is a moment of choice for both the 17 countries of the Euro zone and

the 27 countries of the European Union. The Euro zone needs to decide whether it will move in

the direction of a more comprehensive fiscal and economic union or risk a breakup that would

put in danger the whole European integration.

The European Union needs to decide whether to promote growth, speak with a common voice on

global issues and play a significant global role in the 21st century or accept that the world will

move on without us. Not making a decision and taking action on these fundamental questions

will weaken Europe as a whole and its member states individually, including the larger ones.


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9 Dec: U.K has opted out of the new treaty that would create more EU integration for members

using the EURO. By refusing to join the fiscal accord, UK strengthened the fact that it wants to

leave EU.2

9 Dec: Angela Merkal & Sarkozy are taking different measures to protect Eurozone from falling.

In a European Union summit on 9 Dec, which ended with up to 26 member states agreeing to

move forward in economic integration around the euro zone, and Britain alone in staying out.

The Franco-German plan would slap automatic penalties on countries that overshoot deficit

targets and make countries anchor a balanced budget rule in their constitutions.3

Have we seen the bottom of the sovereign debt crisis iceberg yet? Or is it just the

beginning?

09Dec: Moody's said Monday it will review the credit ratings of all EU countries in the first

quarter of next year after a summit of European leaders last week failed to deliver "decisive

policy measures."4.

The same was followed by S&P.5

"The absence of measures to stabilize credit markets over the short term means that the euro

areas, and the wider EU, remain prone to further shocks and the cohesion of the euro area under

continued threat," the ratings agency said in a statement.

The entire eurozone banking systems

credibility/stability/solvency is in

doubt. Today an outstanding portfolio

of about 11-12 trillion euro in

eurozone debtof which about 80

percent is held by EU firmsis

souring relentlessly.6

About 7 trillion euro of that portfolio

is sufficiently affected by contagion to

require provisioning (France and Belgium may soon be added).


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About 5 trillion euro of eurozone high-risk-debt is currently held by EU banks, insurance

companies, pension funds and individuals.

That sovereign debt, which is supposed to constitute the safest component of any asset

portfolio, now constitutes perhaps the riskiest element. That reality inverts the whole basis of

banking/financial system soundness and stability across Europe (including the UK). It

compounds the problem of calculating capital adequacy requirements for these banking systems

and puts regulators in a quandary.7

As per Euromoney, France has been on the edge of losing its triple-A status, as its banks hold a

large amount of sovereign debt and the country suffers from an ailing economy and government

bond market. Germany has a higher debt than Spain.

Germany fails to draw in buyers in its debt sale and market participants are crying out. Stark and

Juncker didn't help. Germany's Bundesbank revealed that it had only sold 3.644 billion in new

2% 10- year bonds at an average yield of 1.98%.8

The Eurozone crisis is not a debt crisis. The current sovereign debt concerns are symptoms of the

problem, namely the fragility of the European banking system. And that fragility is the result of a

transformation in the role of financial instititutions, what we can call financialization and this is

just a beginning!

Will it further slowdown the global economy or will it wither away?

Fiscal austerity in Europe demanded by markets and exacted by Germany as the price for saving

the euro currency is taking its toll on the world economy. A global slowdown is spreading!

The major advanced economies will see growth slow to 1.3% in 2011 and remain weak at 1.2%

in 2012, followed by only a modest acceleration to 1.9% in 2013, forecasts Fitch Ratings.8

Fitch expects growth in the eurozone to weaken further to just 0.4% in 2012 owing to increased

fiscal austerity measures and deteriorating financial market conditions feeding into tighter credit

conditions for the broader economy. 9

Much of Europe is widely seen as already in recession, Even in Germany, the euro zone's

powerhouse, the central bank slashed its 2012 growth forecast last week to 0.6 percent from 1.8


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percent. Neither the European Central Bank, the European bailout fund nor the International

Monetary Fund has sufficient resources to backstop the euro zone.10

Emerging markets are facing a credit squeeze as Europe's banks sell assets and bring money back

home to strengthen their balance sheets. This looks set to worsen after the European Banking

authority last week said the region's banks must raise 115 billion Euros in extra capital.

Fitch expects the economic growth of BRIC countries will remain robust over the forecast

horizon, at 6.3% in 2012 and 6.6% in 2013, well above global growth rates.

Fitch says downside risks dominate. In particular, financial tensions may intensify further in the

eurozone, and progress on U.S. fiscal consolidation or global imbalances could unwind in a

disorderly fashion.11

Policymakers must simultaneously tackle three broad challenges if confidence in the long-term

future of the euro area is to be restored.

First, they must address worrying dynamics of public debt in some member states.

Second, they must confront fragilities in the regions banking system.

Third, they must implement bold structural reforms to improve economic flexibility, while also

correcting the institutional weaknesses that allowed the crisis to take root in the first place.

Which countries will do better and which will suffer the most? Will it affect more

countries?

Almost all the European countries are bleeding, the condition of some countries is visible and for

some invisible though they are bleeding from Inside. S&P and Moodys have put the entire Euro

Zone at a risk of rating downgrade.

As discussed above, all the major advanced economies will suffer from slow & weak growth.


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On 16 May 2011 the Eurozone leaders officially approved a78 billion bailout packagefor Portugal.

On 6 July2011 it was confirmed that the ratings agency Moody's had cut Portugal'scredit rating to junk status, Moody's also launched speculation that Portugal may follow

Greece in requesting a second bailout.18

Spain:

Oct. 19, 2011:Spains credit rating was cut for the third time in 13 months by MoodysInvestors Service, cutting it by two levels to A1 from Aa2, with the outlook remaining

negative.19

22 Nov: Spain's short-term borrowing costs hit a 14-year high, despite the landslideelection victory on Sunday of a conservative party committed to budget cuts

Dec. 1: Sold 8.1 billion euros ($10.9billion) of bonds, sending yields

lower across Europe, a day after six

central banks jointly moved to reduce

financing costs to banks.20

13 Dec: The Spanish 10year bondyield was 31 basis points higher at

5.02%. Bond auctions in the coming

days will be challenging.21

13 Dec: Credit rating agency Moody's placed CaixaBank, Banco Sabadell, Bankia andother Spanish banks on review for possible downgrade late on Monday, citing exposure

to real estate and reduced earnings capacity. "Significant doubts persist regarding real-

estate valuations and the adequacy of impairments and provisions taken so far by many

banks," Moody's added.22

Italy:

Italy's debt has increased to almost 120 percent of GDP (U.S. $2.4 trillion in 2010) andeconomic growth was lower than the EU average for over a decade.

This has led investors to view Italian bonds more and more as a risky asset
http://economictimes.indiatimes.com/topic/Bankiahttp://economictimes.indiatimes.com/topic/Bankia


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12 Dec: The yield on the benchmarkItalian bond rose by 40 basis points to

around 6.74%. The five year Italian

bond yield rose by 34 basis points to

psychologically crucial level of 7%.23

France

As per Euromoney, France has beenon the edge of losing its triple-A

status, as its banks hold a large

amount of sovereign debt and the

country suffers from an ailing

economy and government bond

market.24

13 Dec:The Moodys rating agencydowngraded three leading French

banks: BNP Paribas, Societe

Generale and Credit Agricole SA.

Moodys said that the spiraling debt

crisis in Europe was making it hard

for them to get loans and that the situation may get worse.25

13 Dec:The banks long-term debt ratings were also downgraded, saying they wereaffected by the fragile operating environment for European banks.

Germany:

Credit ratings agency S&P indicated that the triple-A rating under review. President of the EuroGroup, highlighted Germanys debt concerns. 23 Nov: disastrous bond auction after the Bundesbankrevealed that it had sold only

3.644 billion in new 2% 10-year bonds at an average yield of 1.98%.


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What will be the impact of various austerity measures proposed?

Removing obstacles to economic growth, whatever they may be.

Depending on past inflation dynamics, a nationwide wage cut might be a difficult but necessary

step or a restructuring of private debt or banks or freeing up professions currently closed tocompetition and innovation, and removing harmful regulation.

Impacts:

1. Lower Growth:

Spending cuts lead to lower domestic

demand and higher unemployment,

contributing to decline in growth prospects

for Europe. As a result of austerity measures

in 2011, the OECD now forecast negative

growth of -0.8% for the Eurozone in 2012.

With less profit to tax and more dole

cheques to write, weak growth makes it

even harder for governments to cut their

borrowing and repay their debts.26

(This graph suggests a strong correlation between fiscal tightening (meaning higher tax, lower spending)and lower rates of economic growth)

2. Lack of Flexibility in Euro:

There is no scope for devaluation to restore competitiveness. In 2011, the ECB have still been concerned about inflation (leading to increase in interest

rates). There has been no quantitative easing.

There is hope that supply side reforms will enable improved productivity andcompetitiveness, but this will take time and could involve several years of high

unemployment and low growth.

This fiscal austerity is made more damaging because of the general slowdown ineconomic activity.27


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Will it bring down governments? Or will it make the union even stronger?

Euro zone crisis has brought the government of Italy & Spain down. 26 member states have

agreed to join the Franco-German plan at the European Summit. The same is aimed at

strengthening the union.

What will the EU need to do to survive in the second decade of the new millennium?

1. Only allow nationals to buy sovereign bonds: As per Nomura's Richard Koo, eurozone

countries are in crisis because the savings

rate shot through the roof, but private sector

savings are often invested outside the

country. Restricting investors' sovereign

bond purchases to their own countries would

funnel money into struggling sovereigns like

Italy and Spain, keeping borrowing costs

there under control.28

2. The need for radical changes in national economic policy-making:

In a monetary union fiscal and supervisory authorities have to adopt policies thatcounteract the emergence of private financial imbalances at the national level. Private

debts denominated in euros cannot be inflated away.29

Fiscal and other national macroeconomic policies have to ensure competitiveness byresisting increases in nominal trends. This is the implication of sharing an exchange rate;

devaluation cannot be used as a tool for any one country to regain competitiveness.

Benchmarking against other euro area countries is unavoidable.29

Fiscal authorities have to build up sufficient buffers in good times to withstand adverseconditions. 29

3. Monetary expansion: A concerted programme of monetary expansion by the ECB, with

support from the European Financial Stability Facility (EFSF), boosts nominal growth to

contain the crisis.30


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4. Orderly defaults. Vulnerable economies restructure debt through voluntary defaults to

bring debt levels under control.30

5. Greek exit. Greece exits the currency union and the rest of the Eurozone commits to

protecting the remaining members.30

6. New currency bloc. Core countries propose a new-euro bloc with integrated fiscal and

monetary institutions. Vulnerable economies exit the euro.30

7. Allow countries such as Greece and Portugal that cannot meet their debt obligations and

minimum criteria of the euro to take a sabbatical from the monetary union and rejoin

once the requisite economic corrections are made. This idea has been proposed by

PIMCOs Mohamed el-Erian. El-Erian acknowledges that the economic logic of such a

plan contradicts the political logic of ever-greater advance toward union.31

8. Brady Debt Restructuring Plan of the type then US Secretary of the Treasury Nicolas

Brady developed during the Latin America debt crisis of the late 1980s that would allow

the writing down of debt. This idea has been proposed by Nouriel Roubini.31


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