The European Financial Tragedy

Following the trends of my previous posts, I will try to analyze the Eurozone Crisis.

The Eurozone Crisis is also known as the Sovereign Debt Crisis.

Let us first understand the meaning of Sovereign Debt. When a nation’s government issues bonds in a foreign currency to be sold to foreign investors in order to finance the issuing country’s growth, this debt raised by the government is known as Sovereign Debt.  Sovereign debt is a riskier investment when it comes from a developing nation and a safer investment when it comes from a developed country. The stability of the issuing government is an important factor to consider, when assessing the risk of investing in sovereign debt, and sovereign credit ratings help investors weigh this risk.

When a country fails to repay its debt it is known as Sovereign Default. Countries are often hesitant to default on their debts, since it will be difficult and expensive to borrow funds after a default event. However, sovereign countries are not subject to normal bankruptcy laws and have the potential to escape responsibility for debts without legal consequences. Sovereign defaults are relatively rare, and are often precipitated by an economic crisis affecting the defaulting nation. Investors in sovereign debt closely study the financial status and political temperament of sovereign borrowers in order to determine the risk of sovereign default.

Since the intensification of the financial crisis in September 2008 after the collapse of Lehman, long-term government bond yields relative to the German Bund have been rising after ten years of stability at very low levels. In the first phase, the associated global uncertainty and in the euro area the rescue of the largest Irish banks by the Irish government might have played a key role in the developments of the euro area sovereign spreads. The situation started to improve in the course of the spring and the summer 2009 as global uncertainty receded and after the announcement of stringent fiscal stabilization measures by the Irish government on 22 February 2009. On 16 October 2009, the Greek Prime Minister George Papandreou in his first parliamentary speech disclosed the country’s severe fiscal problems and immediately after on 5 November 2009 the Greek government revealed a revised budget deficit of 12.7% of GDP for 2009, which was the double of the previous estimate. Since then, the sovereign spreads rose sharply for most of the euro area countries, causing the biggest challenge for the European monetary union since its creation.

The Eurozone crisis resulted from a combination of complex factors,

  • the Globalization of finance;
  • easy credit conditions during the 2002–2008 period that encouraged high-risk lending and borrowing practices;
  • the financial crisis of 2007–08;
  • international trade imbalances;
  • real estate bubbles that have since burst;
  • the Great Recession of 2008–2012;
  • Fiscal policy choices related to government revenues and expenses;
  • Approaches used by states to bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

In 1992, members of the European Union signed the Maastricht Treaty, under which they pledged to limit their deficit spending and debt levels. However, in the early 2000s, some EU member states were failing to stay within the confines of the Maastricht criteria and turned to securitizing future government revenues to reduce their debts and/or deficits, sidestepping best practice and ignoring international standards.

This allowed the sovereigns to mask their deficit and debt levels through a combination of techniques, including inconsistent accounting, off-balance-sheet transactions, and the use of complex currency and credit derivatives structures.

From late 2009 on, after Greece’s newly elected government stopped masking its true indebtedness and budget deficit, fears of sovereign defaults in certain European states developed in the public, and the government debt of several states was downgraded. The crisis subsequently spread to Ireland and Portugal, while raising concerns about Italy, Spain, and the European banking system, and more fundamental imbalances within the Eurozone.

The under-reporting was exposed through a revision of the forecast for the 2009 budget deficit from “6–8%” of GDP (no greater than 3% of GDP was a rule of the Maastricht Treaty) to 12.7%, almost immediately after PASOK won the October 2009 national elections. Large upwards revision of budget deficit forecasts due to the international financial crisis were not limited to Greece: for example, in the United States forecast for the 2009 budget deficit was raised from $407 billion projected in the 2009 fiscal year budget, to $1.4 trillion, while in the United Kingdom there was a final forecast more than 4 times higher than the original. In Greece the low (“6–8 %”) forecast was reported until very late in the year (September 2009), clearly not corresponding to the actual situation.

The fact that the Greek debt exceeded $400 billion (over 120% of GDP) and France owned 10% of that debt, struck terror into investors at the word “default”. Although market reaction was rather slow—Greek 10-year government bond yield only exceeded 7% in April 2010—they coincided with a large number of negative articles, leading to arguments about the role of international news media and other actors fuelling the crisis.

Greece

In the early mid-2000s, Greece’s economy was one of the fastest growing in the eurozone and was associated with a large structural deficit. As the world economy was hit by the financial crisis of 2007–08, Greece was hit especially hard because its main industries—shipping and tourism—were especially sensitive to changes in the business cycle. The government spent heavily to keep the economy functioning and the country’s debt increased accordingly.

Despite the drastic upwards revision of the forecast for the 2009 budget deficit in October 2009, Greek borrowing rates initially rose rather slowly. By April 2010 it was apparent that the country was becoming unable to borrow from the markets; on 23 April 2010, the Greek government requested an initial loan of €45 billion from the EU and International Monetary Fund (IMF), to cover its financial needs for the remaining part of 2010. This eventually led to slashing of Greece’s sovereign debt rating by S&P.

As a counter measure to curb this growing crisis the Greek government announced a series of austerity measures. The third austerity package was announced to secure a 3 year 110 billion Euros loan. After this another bailout was agreed upon for Greece worth 130 billion Euros. Then, in March 2012, the Greek government did finally default on its debt, which was the largest default in history by a government, about twice as big as Russia’s 1918 default. Of all €252bn in bailouts between 2010 and 2015, just 10% has found its way into financing continued public deficit spending on the Greek government accounts. Much of the rest, went straight into refinancing the old stock of Greek government debt (originating mainly from the high general government deficits being ran in previous years), which was mainly held by private banks and hedge funds by the end of 2009.

So, basically as we can see the causes and consequences of the Eurozone Crisis were pretty similar to any of the previous crises. First there is a rapid increase in asset prices and the there is a credit boom which helps investors in investing in those assets and then the bubble bursts.

Same was the case with Ireland, Portugal, Spain and Cyprus.

Ireland

The Irish sovereign debt crisis was not based on government over-spending, but from the state guaranteeing the six main Irish-based banks who had financed a property bubble.

Irish banks had lost an estimated 100 billion euros, much of it related to defaulted loans to property developers and homeowners made in the midst of the property bubble, which burst around 2007. The economy collapsed during 2008. Unemployment rose from 4% in 2006 to 14% by 2010, while the national budget went from a surplus in 2007 to a deficit of 32% GDP in 2010, the highest in the history of the Eurozone, despite austerity measures.

Similar to Greece Ireland was also bailed out by the EU and the IMF.

Portugal

Portugal had allowed considerable slippage in state-managed public works and inflated top management and head officer bonuses and wages in the period between the Carnation Revolution in 1974 and 2010. Persistent and lasting recruitment policies boosted the number of redundant public servants. Risky credit, public debt creation, and European structural and cohesion funds were mismanaged across almost four decades. When the global crisis disrupted the markets and the world economy, together with the US subprime mortgage crisis and the Eurozone crisis, Portugal was one of the first and most affected economies to succumb.

During the crisis Portugal’s government debt increased from 93 to 139 percent of GDP.

Spain

Spain had a comparatively low debt level among advanced economies prior to the crisis. Its public debt relative to GDP in 2010 was only 60%, more than 20 points less than Germany, France or the US, and more than 60 points less than Italy, Ireland or Greece. Debt was largely avoided by the ballooning tax revenue from the housing bubble, which helped accommodate a decade of increased government spending without debt accumulation. When the bubble burst, Spain spent large amounts of money on bank bailouts. In May 2012, Bankia received a 19 billion euro bailout, on top of the previous 4.5 billion euros to prop up Bankia. Questionable accounting methods disguised bank losses. During September 2012, regulators indicated that Spanish banks required €59 billion (US$77 billion) in additional capital to offset losses from real estate investments.

Again we can see a similar pattern of the bursting of the bubble leading to a crisis.

Cyprus

The economy of the small island of Cyprus with 840,000 people was hit by several huge blows in and around 2012 including, amongst other things, the €22 billion exposure of Cypriot banks to the Greek debt haircut, the downgrading of the Cypriot economy into junk status by international rating agencies and the inability of the government to refund its state expenses

So all these European countries were involved in the Sovereign Debt Crisis either because of the very similar reasons that lead to a financial crisis or because of the fact that they are dependent on each other and failure of one of them means failure of all of them.

 

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