memo on european sovereign debt

8/8/2019 Memo on European Sovereign Debt

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Memo On European Sovereign Debt 11/29/10

Justin Ciambella, Gardner Davis, Sean Donovan, Kunal Malkani, and Nicholas Paine

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European Sovereign Debt

The 2008 global recession exposed weak underlying macro-fundamentals in several periphery

countries of the euro zone, most notably Greece, and more recently Ireland, catalyzing the 2010

European sovereign debt crisis. The situations in Greece and Ireland have not only pushed their

domestic economies further into recession, but have questioned the feasibility of a common

European currency. This memo progresses in four parts: 1) a discussion on Greek sovereign debt;

2) a discussion on Irish sovereign debt; 3) an analysis of how these crises have affected the euro

zone as a whole; 4) a look at the ways the European sovereign debt crisis may evolve and what

lessons should be learned. Taken together, this memo is intended to highlight the root causes of

the crisis, analyze the euro zones reactions, and evaluate the implications.

1) Greek Sovereign Debt Crisis

Overview:

Throughout the 1980s and 1990s Greece was viewed as a credit risk and was consequently forced

to pay borrowing rates up to 10% higher than Germany.i Greece saw the Euro as an opportunity

to receive lower interest rates since they would be backed by other credible European economies

and have a stable currency. Before being allowed to join the euro zone though, Greece had to

prove that they would be responsible by having a budget deficit of less than 3% and stabilizing

inflation. ii Rather than actually meeting these criteria, government officials manipulated the

figures to make it seem like Greece was responsible.

After Greece successfully joined the euro zone in 2001, they became eligible for low interest rate

loans. The Greek government relied heavily on these foreign loans and increased capital flows to

finance their excessive government spending and current account deficits. Moreover, Greeces

primary budget deficit continued to grow as expenditure soared and tax evasion continued to be

rampant.

The financial crisis of 2008 caused a sudden stop of capital inflows and, without the ability to

depreciate its currency, Greece has been forced to bear the painful and slow process of decreases

in wages and prices. iii These pressures pushed the economy further into recession and exacerbated

the governments debt problems. When the new government was elected in 2009, the estimated

budget deficit of 6.7% of GDP was revealed to be nearly double that at 13.6% of GDP. In

response to this news, Greek credit was downgraded and the euro zone was attacked by

widespread speculation.


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Response: Bailout and Austerity

As a result of Greeces financial situation, the Greek government found itself unable to finance

itself on the markets like it had since joining the euro zone in 2001. With no other source of

capital and with fears of contagion in Europe if Greece defaulted, the European Union and the

International Monetary Fund intervened. The agreement between the EU-IMF and Greece

appropriated a total of 110bn ($146.5bn) to the Greek government in exchange for a multi-year

austerity plan. The contributions from the Euro member states were proportioned according to

their respective holdings in the European Central Bank's capital.

The euro zone loan promises were conditional on Greek reform and austerity measures; and

despite significant social unrest in Athens, the government passed legislation targeting

expenditure cuts, pension reform, tax reform, and labor market reform. Expenditure cuts mainlytook the form of wage freezes for all public sector workers, a cap on bonuses, as well as a

reduction in government employment. Pension reform was addressed through an increase in the

minimum retirement age, a tightening of the requirements for a full pension, and a determination

of the value of the pension by average salary rather than final salary. In addition to these reforms,

the value-added tax was increased and the labor market was made more flexible and

competitive. iv

When taken together, these measures were intended to cut the fiscal deficit from the estimated

13.6% of GDP to less than 3% of GDP by 2014. Such a reduction would move Greece into

compliance with the Euro Zone Stability and Growth Pact, hopefully calm the markets, and

position the country to secure much-needed funds in the future.

2) Irish Sovereign Debt Crisis

Overview:

Ireland became one of the fastest growing economies in Europe after it cut its corporate tax rates

and other taxes in the 1990s, leading to large capital inflows and foreign direct investment.

However, during this time, a large housing bubble developed, which was heavily financed by

domestic banks. Meanwhile, the government increased public spending, raising domestic prices

and wages, and reducing Irelands competiveness abroad.v In 2008 when interest rates rose

throughout Europe, Irelands housing bubble burst, devastating their banks balance sheets and

the countrys external wealth. The government stepped in to bail out its banks, but this move put

the government further in debt.


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To mitigate the increases in debt, spending cuts and tax increases were implemented, but this

fiscal tightening sunk the economy further into recession, leading to a 7.1% drop in GDP in 2009

and 13% unemploymentvi. The negative shocks of the housing bubble burst and the subsequent

fiscal tightening sent Ireland into a downward spiral of recession and increased government debt.This trend scared investors, resulting in the governments debt being downgraded in quality by

the S&P.vii

Response: Bailout and Austerity

To combat this growing pessimism among investors, the EU and the IMF responded similarly as

they did in Greece, providing Ireland with an 85bn bailout. 50bn is aimed at helping Irelands

public finances, while the government implements a 15bn austerity package over the next four

years. The remaining 35bn will go towards recapitalizing Irelands banks, with 10bn to be used

in the short term recapitalization, and the rest set up as a contingency fund that can be drawn

upon if needed.viii

There is a lack of a consensus as to whether the bailout and austerity measures taken will be

enough to restore market confidence and prevent default. Ireland has taken a very tough stance on

keeping the Euro and not defaulting, implementing costly austerity measures to do so, which in

theory should help fend off some speculative attacks. However, some call for a more complete

restructuring of the Irish banks and their loans. ix

3) Crisiss Affects to the Euro Zone

Implications for the Euro Zone:

The debt crises in Greece and Ireland have tested the sixteen-member euro zones commitment to

a common currency. Since the euro zone shares a common currency, their economies are

naturally very interdependent, despite asymmetric shocks to some periphery countries. Banks in

countries throughout the euro zone, especially in France, and Germany to a lesser extent, were

large holders of sovereign Greek debt.x

A default by either Greece or Ireland would have sent

negative shockwaves throughout the financial system and the broader economy of the euro zone;

consequently, as an attempt to prevent this fear from materializing, the EU agreed to the bailouts.

Although Germany was initially, and still is, reluctant to partake in bailouts, it has helped their

economy, with the EU projecting robust 3.7% growth for Germany in 2010, lifting EU growth to

1.8%.xi


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Effects to the Value of the Euro:

Throughout the debt crisis, two major factors have influenced the value of the Euro. The first was

fear, which greatly depreciated the value of the Euro. When the debt crisis struck, the potential

risk of default on euro zone assets led to a sharp depreciation of the Euro as investors sold Euros

in search of safer returns in other currencies. This fear of potential default was enhanced by

Germanys initial unwillingness to agree to terms on a rescue package. Even after the Greek

rescue package was announced, the Euro depreciated farther as fears of contagion circulated and

investors continued to sell Euros. Once this fear gradually subsided, the second factor, monetary

policy, led to an appreciation of the Euro. Because the ECB has pursued tighter monetary policy

than the Fed and other central banks, the Euro has erased most of the initial losses stemming from

a lack of faith.xii With that said, these fears have reappeared recently due to the crisis in Ireland.

The appreciation of the Euro has made it difficult for Germanys export-oriented economy to

compete hence their reluctance to run to the aid of Greece and Ireland. The appreciation caused

their exports to fall for consecutive months in July and August of this year. Unless the ECB

begins to loosen monetary policy at the rate of other central banks, this will continue to be a

problem for Germany, a country that relies on a large current accounts surplus, and is being relied

on to prop up weaker European economies such as Greece and Ireland. xiii

4) Appraisal of the European Sovereign Debt Crisis

Beyond Greece and Ireland

The sovereign debt problems that we have discussed so far focus around Greece and Ireland, two

countries with particularly acute fiscal problems. Greece, for example, has run persistently high

fiscal deficits for years and has failed to reform its economy such that the private sector can be

competitive and drive economic growth.xiv The crisis, however, has not been constrained to just

those two countries and has had significant impact on government policies and bond markets

across the euro zone. Bond rating agencies have downgraded the debt of a number of Euro

countries, including Spain and Portugal, and the yields that the market has demanded on the

weaker European countries debt has increased markedly.xv Despite the efforts of European

officials to use the example of Ireland to restore confidence to the markets, many investors worry

that Spain and Portugal are the next to face a debt crisis.


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Rather than reassuring the markets, the Irish bailout has caused bond yields to increase in

Portugal, Spain, and Greece. This is partially due to the recent German rumblings that

accompanied the bailout suggesting that, in the future, bond holders may have to pay a portion of

the cost.xvi Further, markets may be concerned that the appetite within Germany and other

sponsoring Euro countries for future, potentially costly bailouts, may be waningand that if they

occur, they will result in harsher terms for bond holders.xvii

Across Europe, policymakers and governments have to reckon with uneasy bond markets as they

decide their fiscal policies. This has resulted in a reluctance to engage in expansionary fiscal

policyand in the United Kingdom has prompted fiscal tightening despite the economic

recession and the fact that British bonds have not seen an increase in risk premium. In the event

of future weaknesses in the financial system, some euro zone members may have to weigh the

costs of not supporting their banks against the cost of losing bond market confidence, and thuspotentially a sovereign debt crisis. This problem is exacerbated by the fact that many euro zone

countries have large debt-to-GDP ratios: Italy at 116%; Greece at 113%; Belgium at 101%;

France at 78%; Portugal at 77%; and Germany at 73%.xviii Further, euro zone countries issue

short-term debt meaning that they are required to rollover their debt more frequently-- $1.3

trillion worth over the next year.xix At these levels, an increase in bond yields can result in a major

increase in government borrowing costs, decrease private sector investment, and lower overall

GDP growth, potentially putting the economy into recession.

Future Dangers and Impact:

When the euro zone first came into being, critics suggested that it would face serious problems

primarily due to the fact that it was attempting to establish a monetary union without a political

union. According to these critics, conditions could vary significantly across countries and with a

common currency, each country would lose the shock absorber of its own floating exchange rate.

With the euro zones initial successes, many European economists confidently viewed these

concerns as overblown.xx However, these potential problems have surfaced in the recent financial

crisis and have only become worse as euro zone members experience different recoveries and

government responses to the crisis and recession. In the third quarter of 2010, Germanys GDP

growth was 0.7%, whereas Greeces growth was -4.7% and Portugals growth was -0.1% for the

quarter.xxi

These numbers are indicative of dramatically different economic outlooks that will likely only

become divergent in the future. Greece and the other euro zone countries facing difficult bond


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markets will have to continue austerity measures for years, which will constrain GDP growth and

prolong their recession. On the other hand, Germany, France, and the other stronger European

economies have already emerged from the recession and will likely see continued and possibly

accelerating growth. In this environment, the European Central Bank will have to set a monetary

policy that attempts to balance between the requirements of the two groupsand will not be able

to fully meet either.

The euro zone will also face further stress if the indebted countries have trouble in meeting their

strict targets for austerity, fiscal reductions, and economic reforms. Greece, for one, already has

said it will not be able to meet its 8.1% deficit target this year.xxii If this continues, Germany may

tire of its role as creditor for all of the euro zones debt. Struggling countries may find it attractive

to leave the Euro and devalue their currency to combat their fiscal position rather than to struggle

through fiscal austerity.

xxiii

We did not focus on the question of the Euro as a viable currencyunion, so we cannot discuss its outlook in detail. However, our understanding suggest that while a

total collapse of the Euro is unlikely, it is possible that the euro zone gradually shrinks to just

those countries with workable fundamentals and growing economies.

i Lewis, MIchael. "Beware of Greeks Bearing Bonds." Vanity Fair. 01 Oct 2010.ii Ibid.iii Krugman, Paul. "The Euro Trap." The New York Times. N.p., 30 Apr 2010. Web..iv "Greek Parliament Approves Crucial Austerity Package as Global Markets Reel." IHS Global Insight. Web.

.v FitzFerald, Garret. Dublin is paying the price of three follies. Financial Times . FT, 22 Nov. 2010.vi Ireland. The New York Times. NYT, 23 Nov. 2010. vii Brown, John Murray. S&P Downgrades Ireland on Debt Worries.Financial Times . 29 Nov. 2010.viii Tait, Nikki, Joshua Chaffin, Quentin Peel, and John Murray Brown. EU Agrees 85bn Irish Bail-Out. Financial Times . 29 Nov.2010.ix Europe has not yet rescued Ireland. Financial Times . 22 Nov. 2010.x Kirkegaard, Jacob F. "The Biggest Losers: Who Gets Hurt from a Greek Default or Restructuring." Peter G. Peterson Institute forInternational Economics. 27 Apr. 2010. Web. 25 Nov. 2010.xi Wishart, Ian. "EU Predicts Economic Growth." European Voice | An Independent Voice on EU News and Affairs. Web. 27 Nov.2010.xii "How to Run the Euro: Fixing Europe's Single Currency." The Economist 23 Sept. 2010.xiii Junga, Katharina. "Germany: Export Prospects With a Strengthening Euro." Roubini Global Economics. 22 Oct. 2010. Web. 24

Nov. 2010.xivJerome Cukier, OECD,Deepening Debt, March 23, 2010.

https://community.oecd.org/community/factblog/blog/2010/03/23/deepening-debtOECD, Greece at a Glance: Policies for a Sustainable Recovery. http://www.oecd.org/dataoecd/6/39/44785912.pdf.xv Reuters,Key staging posts in spread of euro zone debt crisis, November 29, 2010.

http://www.reuters.com/article/idUSTRE6AS34V20101129.xvi

The Economist,A Contagious Irish Disease?, November 25, 2010.xvii Bild,First the Greeks, then the Irish, thenwill we end up having to pay for everyone in Europe?, via The Economist (ibid).xviii CIA, World Factbook: Public Debt Country Comparison. https://www.cia.gov/library/publications/the-world-factbook/rankorder/2186rank.html.xix Sujata Rao and Sebastian Tong, Reuters,Emerging Markets Can Weather Global Rollover Risks, May 25, 2010.

http://uk.reuters.com/article/idUKLNE64O00520100525.xx Lars Jonung and Eoin Drea,It Cant Happen, Its a Bad Idea, It Wont Last: U.S. Economists on the EMU and the Euro, 1989-2002,Economics in Practice, January 2010. Via Paul Krugman.xxi Jana Randow and Jeff Black, Bloomberg BusinessWeek, Germanys Economic Growth Slows from Record Pace, November 12,2010.xxii Charles Forelle, Wall Street Journal, Greece, Germany Grapple Over Debt, November 16, 2010.xxiiiA Portuguese Minister has already speculated that it may have to leave the Euro due to its acute crisis. Forelle, ibid.

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