The Eurozone Crisis – Origins, Impact and Role of G20

Raveesh, Saurabh, Deepak, Neha, Kulraj

Presented by

Outline

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The Genesis of the Crisis

PIIGS

Impacts

The Possible Alternatives

Role of G20

Euro Crisis: The GenesisThe roots of the crisis lie in the Credit Crunch originating in the US, Financial contagion spread the crisis across Europe

The Credit Crisis in the US

Housing Price Bubble Formation

Low Interest Rates Lax Regulation of MortgagesSecuritization

Housing Bubble Burst Rise in Interest Rates Fall in Housing Prices Mortgage Default

Financial System Collapse in the US

Freddie Mac, Fannie Mae taken over by US Government Default of Lehmann Brothers in September ‘08 International Credit Markets froze with collapse of subprime based hedge funds

The Crisis in EuropeSubprime Debt obligations made in the US held around the worldHousing Bubble burst in the UK, Spain and IrelandStress on Banks around the world

BNP Paribas closed funds in August ’07Northern Rock taken over by UK Govt.German state banks IKB, WestLB, BayernLB and SachsenLB bailed out by governmentIrish banks given government deposit guarantees, Iceland’s banks defaulted

Fall in US demand, decrease in exports of other countries

Euro Crisis: The GenesisThe policy response of the Governments and Financial Institutions exacerbated the problem The response of the ECB

ECB injected liquidity into European banks unable to obtain short-term funds in marketFederal Reserve used Euro-dollar swaps to make dollars available to ECB to lend to banksECB did not lower interest rates until October 2008 because of its focus on inflationEuro fell against the dollar due to “safe haven” flight to US Treasury securitiesRole of the Euro in CrisisPrevious economic crises in Europe have led to large devaluations of currenciesWithin eurozone, single currency prevents devaluationMoney supply and Currency Revaluation controlled by ECB

Euro Crisis: The GenesisThe curious case of Greece

CausesGreece has had higher inflation than other Eurozone members.Increase in debt to finance generous public sector pay, welfare, and retirement benefits, while lower share in taxes due to widespread tax evasion.Greek goods became increasingly expensive and uncompetitive, causing loss of market share and further reducing revenues.

OutcomesDebt/GDP ratio ≈ 113% and Deficit/GDP ratio ≈12.7% in 2009.Foreign bondholders became doubtful that Greece could continue to roll over its increasing debt, forced interest rates higher.EU faced choice between Greek default and bailout with tough conditions.IMF and EU agreed to lend Greece up to $146 billion over three years.Greece to increase sales taxes, reduce public sector salaries, pensions, eliminate bonuses.

Euro Crisis: PortugalIrresponsible spending & Banking crisis triggers collapse

PortugalIn the period between the Carnation Revolution in 1974 and 2010, governments encouraged over-expenditure and investment bubbles through unclear public-private partnerships. Government funds mismanaged for almost four decades .Risky credits and accounting frauds destabilize banks2009: Two major Portuguese banks, BPN and BPP bailed out at government expense.July 2010 : Unemployment at 11%. Moody’s downgrades Portuguese sovereign debt to A1Nov 2010: Portuguese 10 year bond yield at 7%.

23 Mar 2011: Jose Socrates ejected in no confidence vote. Announces that Portugal will request aid from IMF, EFSF3 May 2011: Portugal receives bailout of euro 78 billion. Agrees to austerity conditions. 6 July 2011 : Ratings agency Moody's cuts Portugal's credit rating to junk status

Repercussions

Euro Crisis: IrelandProperty Bubble leads to banking crisis

IrelandLow corporate tax rate, low ECB interest rates lead to an expansion of credit fuel a property bubbleIreland hit hard by recession in September 2008 as the property bubble burstsIrish banks over-exposed to the Irish property market come under severe pressure29th Sep 2008: Government guarantees all deposits and borrowings for the six Irish-owned banks for the next two years to save economy. Loans money from ECBApril 2009: National Asset Management Agency (NAMA) formed in to take over loans of major banks28 Nov 2010: EU, IMF agree to 85 billion euro rescue deal in the form of loans.

Feb 2011: Govt loses elections. In April 2011, Moody’s downgrades Irish bonds to junk status

Repercussions

Euro Crisis: ItalyExcessive Debt

ItalyEconomy shrinks by 6.76% from 2007 – 2011 with seven consecutive quarters of recession.Late 2010: Govt. debt reaches 118% of GDPAutumn 2011: Standard & Poor's and Moody's downgraded Italian sovereign debt rating because of "Italy's weakening economic growth prospects." A weak coalition government which would "limit the government's ability to respond decisively" to events. 8 Nov 2011: Italian 10 yr bond yields cross 7%.

11 Nov 2011: Berlusconi ousted. Emergency govt agrees to further austerity measures.Relatively high levels of private savings and low levels of private indebtedness make it the safest among Europe's struggling economies

Repercussions

Euro Crisis: SpainHousing Bubble ?

SpainHuge domestic and foreign demand for Spanish homes. Plus difficult to evict renters.Result: Immense property bubble – House prices rise by over 200% by 2007.Banks offering 40-year and 50-year mortgages start to crash€ 651trillion is the current mortgage debt (second quarter 2005) of Spanish families

Oct 2011: Moody’s cuts Spanish bond ratings to A1 with outlook remaining negative. Dec 2011: As fallout of credit crisis, unemployment reaches 22.1%.

Repercussions

€ Collapses

€ survives

Inflation

Phoenix from the Ashes

UnionDivorce

Unraveling

Meltdown

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Depression

Best Outcomes for EuroWorst Outcomes for Euro

Good Economic Outcome

Bad Economic Outcome

Euro Crisis: Why should G20 Bother-ImpactsThe possible scenarios depending on economic outcomes and currency survival

Best Outcome, Everything goes according to plan

All Eurozone governments agree to new borrowing rules

Financial Markets willing to lend to Eurozone governments

European Union turns into political federation

Central Democratically elected government

UK and other non euro EU members exit

ECB Prints money, Prices rise

Euro plummets, import prices rise

Wages rise in Germany, Southern Economies regain edge to some extent

Governments cut spending, causing deep recession

Consumers, business lose confidence in economy

Makes it difficult to cut spending, many banks and business go bust

Members feel break-up is the only option

Southern Economies abandon, want to avoid austerity measures

Northern Economies avoid bailing out, want to avoid moral hazard

Weaker Economies leave one by one

Greek Govt. Falls; exits Euro, Italy follows suit

Germany, France and other Northern Economies remain

2008 again, but without bailouts

Economic solutions; politically unacceptable, Political solutions; Economically non-sensical

Investors stop lending to euro banks, stock markets and euro plummet

Greek Prime Minister George Papandreou has said restructuring the nation's debt would be "catastrophic" for the country's credibility and its economy

Though some economists argue that an organized restructuring of debt that would reduce the amount of money troubled countries owed, especially in conjunction with a financial aid package, might provide a quicker path to recovery and avoid the trauma of a forced default down the road

The idea is The people who provided the funds to these banks should take the consequences

Proponents of a default say that Argentina and Russia, in 2002 and 1998, found life after a debt restructuring. Both reneged on their foreign loans and, after devaluing their currencies, were able to recover.

The Possible Alternatives Debt Restructuring1

Complicating matters is that, unlike Argentina and Russia, Ireland and other troubled European countries that use the Euro as a common currency cannot devalue their currencies

But imposing bond haircuts can make future market access expensive and can create serious contagion effects

“There is just no escaping debt restructuring for Greece and Ireland,” said Kenneth S. Rogoff, a Harvard professor and expert on sovereign debt crises.

Then why not do it now?

IMF has expressed views against it.

Most of the debt is held by Germany and France and investor panic will be felt throughout Europe and ignite systemic risk

The Possible Alternatives Debt Restructuring1

The Possible Alternatives Innovative Fiscal Strategy: Osborne Plan of Britain

Following the example of other European nations, Britain is also implementing its own set of austerity measures led by George Osborne

The Osborne plan includes extensive spending cuts and significant reform of welfare programs.

Tenets of the plan include new limits on benefits for the poor, an increase of the retirement age for millions, a rise in college tuition rates and transportation fees, and a reduction of public payrolls

Excessive austerity without a plan to stimulate growth could damage the already slow global economic recovery

“The economy will contract and tax revenues will fall," Soros said. "So the debt burden will actually rise, requiring further budget cuts and setting in motion a vicious cycle

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China also has expressed its commitment to the Eurozone recovery and promised to invest in Greek bonds as they became available and create of a $5 billion fund to assist Greece’s shipping industry

China has advocated a relaxation of EU restrictions on high-tech exports

George Soros recommended that in addition to fiscal discipline, the should provide more stimulus and share the eurozone debt burden in the form of euro bonds

Public financing from the EU and IMF might assuage the debt crisis but it will not resolve the crisis comprehensively. Its like trying to cure liquidity when the problem is that of solvency

NOT SUSTAINABLE!

The Possible Alternatives Foreign Investment and Stimulus 3

Fiscally troubled member states could potentially drag down the entire Eurozone, exit from the EMU may be welcomed by other states as a means to halt further damage to the union

Dismissal from the EMU would require that departing nations issue their own national currency at great expense and economic uncertainty

On the other hand, such an action would allow highly indebted nations to exercise their own monetary policy. Through currency devaluation, these nations could assuage fiscal austerity measures and stimulate the economy through more price-competitive exports

This would undermine the credibility of Euro forever and would incur great costs for not just the exiting economy but even the remaining economies.

Remains a possible but extremely unlikely option

The Possible Alternatives Exit from European Monetary Union4

The Possible Alternatives Compact Fiscal Union

This is a Long Term Solution although it signals a political commitment to the Euro

Not an amendment to the current Lisbon treaty but a separate deal

Intergovernmental pact which represents a common commitment to sort out the problems of economic governance

Key features include a move toward a more rules-based approach to fiscal discipline, introduction of the new ESM

Alone it is only likely to hasten the demise of the euro, not save it.

NOT THE RIGHT MEDICINE UNDER STRESS!!

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The Possible Alternatives ECB as Lender of Last Resort

Kathleen R. McNamara, “the eurozone will only reassure markets if it takes bolder political steps including the issuing of eurozone bonds and focuses on growth over austerity”

Markets will only be reassured in the short term if the ECB plays a greater role in shoring up the high-yielding bond markets

Only by pooling together the strength of the eurozone in a collective debt instrument while offering a process of real improvements will the monetary union survive

ECB’s move to inject liquidity on Dec. 21 was seen as a kind of backdoor way of supporting government bonds

As a result, the yields on Italian six-month bills fell to 3.25 percent from a record 6.5 percent yield a month earlier

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Financial analyst Simon Johnson asserted, “a lingering flaw of the European Commission is its inability to address problems until they become crises”

If only when crisis erupts can the EU can come together to develop solutions. If so, the question now is how the EU can succeed in the long-term if it does not have the capacity to address problems early? Perhaps, the most important lesson of this episode was the realization that public policy challenges can no longer be postponed as they used to be.

The Possible Alternatives Concluding Remarks

“We face the greatest challenge to the world economy in modern times; a crisis which has deepened since we last met, which affects the lives of women, men and children, in every country and which all countries must join together to resolve. A global crisis requires a global solution”

“We believe that the only sure foundation for sustainable and rising global prosperity for all is an open world economy based on market principles, effective regulation, and strong global institutions”

G20 London Summit, 2009The Tone

Financial Stability boardInternational cooperationPrudential regulation

Tax heavens Accounting StandardsCredit rating agencies

The final communique of the London summit, 2009

“The agreements we have reached today, to treble resources available to the IMF to $750 billion, to support a new SDR allocation of $250 billion, to support at least $100 billion of additional lending by the MDBs, to ensure $250 billion of support for trade finance, and to use the additional resources from agreed IMF gold sales for concessional finance for the poorest countries, constitute an additional $1.1 trillion programme of support to restore credit, growth and jobs in the world economy.”

G20 London Summit, 2009Steps Taken

“G20 tells euro zone to fix debt crisis in eight days”

“The risk of a global recession would be dramatically higher if next Sunday's European summit failed to deliver.”

“This meeting takes place in a context where the absolute priority for the success of the G20 is to find the elements for the stability of the euro zone.”

"We have said this before and have conveyed this again, that if emerging economies and the BRICS are called upon to contribute, we can do it via the IMF”

G20 Paris Meeting, Oct 2011The Rhetoric

Opposition to increased funding via the IMF was spearheaded by the US and Britain.

David Cameroon – “The job of the IMF is to help countries in distress, not support currency systems.”

Amid talk of the need for “big bazooka” to resolve the euro financial crisis, the EFSF has been characterised as a “water pistol.”

Efforts to secure additional funding for the EFSF at the G20 meeting, either through a contribution via the International Monetary Fund or directly, were a dismal failure.

G20 Paris Meeting, Oct 2011The Reality

Brazil’s president - “I have not the slightest intention of contributing directly to the EFSF; if they are not willing to do it, why should I?”

Canada FM – “ We oppose the idea of a co-ordinated G20 action because many members of the group are poorer than the European countries they would be asked to bail out.”

“Most of the countries around the G20 table agreed that Europe needs to take control of its own destiny.”

“They will be there with support but they are not going to shovel money into Europe to support the difficulties there, à la Greece and a la Italy.”

G20 Paris Meeting, Oct 2011The Reality

Interests of all G20 nations not aligned to helping the Eurozone out of this crisis

Most G20 countries facing troubled economic scenarios at their domestic front

Little headroom after the 2008 fiscal stimulus for more fund injection to recovery

Developing nations themselves dealing with issue of inflation, against fiscal expansion

Steps taken by Eurozone do not inspire confidence that they are serious about the issue

Summits keep on happening without any concrete decision on austerity or fiscal union

Our Analysis of G20’s Stand on Euro CrisisPresenting our Viewpoint

Euro debt crisis in existence mainly due to monetary union without any fiscal union. A structural problem, any outside funding is only short term measure.

There is lack of political will and economic capacity of G20 countries to provide funds for Eurozone bailout. Political opposition in USA & U.K. and huge fiscal deficit in India.

G20 should continue its efforts of strengthening the institutions like IMF and World Bank to play more constructive role in global economy as a whole.

Greater cooperation on issues like effective Regulatory Mechanisms, Adequate Capital Requirement for banks as suggested by BASEL committee, uniform accounting standards etc. can be achieved easily and these steps can be effective in mitigating the consequences of another financial crisis to some extent

Direct support to Eurozone can be provided by China separately but G20 should not commit to infusion of capital.

What Should be G20’s stand on Euro Crisis

Thank You !!

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