european credit crisis

8/7/2019 European Credit Crisis

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Europeancredit crisis


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y In early 2010, fears of a sovereign debt crisis, the 2010 Euro Crisis

developed concerning some European states, including European

Union members Portugal, Ireland, Italy, Greece,Spain, and Belgium.

This led to a crisis of confidence as well as the widening ofbond yield

spreads and risk insurance on credit default swapsbetween these

countries and other EU members, most importantly Germany

y In 2010 the debt crisis was mostly centred on events in Greece,

where there was concern about the rising cost of financing

government debt. On 2 May 2010, the Eurozone countries and the

International Monetary Fund agreed to a 110 billion loan for

Greece, conditional on the implementation of harsh Greek austerity

measures. On 9 May 2010, Europe's Finance Ministers approved acomprehensive rescue package worth almost a trillion dollars aimed

at ensuring financial stability across Europe by creating the European

Financial Stability Facility


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Causes :Greek epicenter of the event

y The Greek economy was one of the fastest growing in the eurozoneduring the 2000s; from 2000 to 2007 it grew at an annual rate of 4.2%as foreign capital flooded the country. A strong economy and fallingbond yields allowed the government of Greece to run large structuraldeficits. According to an editorial published by the Greek newspaper

Kathimerini, large public deficits are one of the features that havemarked the Greek social model since the restoration of democracy in1974. After the removal of the right leaning military junta, thegovernment wanted to bring disenfranchised left leaning portions ofthe population into the economic mainstream. In order to do so,

successive Greek governments have, among other things, run largedeficits to finance public sector jobs, pensions, and other socialbenefits.[14] Since 1993 debt to GDP has remained above 100%.


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y Initially currency devaluation helped finance the borrowing. After theintroduction of the euro in Jan 2001, Greece was initially able toborrow due to the lower interest rates government bonds couldcommand. The global financial crisis that began in 2008 had aparticularly large effect on Greece. Two of the country's largestindustries are tourism and shipping, and both were badly affected bythe downturn with revenues falling 15% in 2009.

y To keep within the monetary union guidelines, the government of

Greece has been found to have consistently and deliberatelymisreported the country's official economic statistics. In the beginningof 2010, it was discovered that Greece had paid Goldman Sachs andother banks hundreds of millions of dollars in fees since 2001 forarranging transactions that hid the actual level of borrowing. Thepurpose of these deals made by several subsequent Greek governments

was to enable them to spend beyond their means, while hiding theactual deficit from the EU overseers. The emphasis on the Greek casehas tended to overshadow similar irregularities, usage of derivativesand "massaging" of statistics (to cope with monetary union guidelines)that have also been observed in cases of other EU countries, especiallyItaly,however Greece was seen as the worst case.


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y In 2009, the government ofGeorge Papandreou revised its deficit from

an estimated 6% (8% if a special tax for building irregularities were not

to be applied) to 12.7%.In May 2010, the Greek government deficit was

estimated to be 13.6%which is one of the highest in the world relative to

GDP.Greek government debt was estimated at 216 billion in January

2010.Accumulated government debt is forecast, according to some

estimates, to hit 120% of GDP in 2010.The Greek government bond

market is reliant on foreign investors, with some estimates suggestingthat up to 70% of Greek government bonds are held externally.

y Estimated tax evasion costs the Greek government over $20 billion per

year. Despite the crisis, Greek government bond auctions have all been

over-subscribed in 2010 (as of 26 January).

y According to the Financial Times on 25 January 2010, "Investors placed

about 20bn ($28bn, 17bn) in orders for the five-year, fixed-rate bond,

four times more than the (Greek) government had reckoned on." In

March, again according to the Financial Times, "Athens sold 5bn (4.5bn)

in 10-year bonds and received orders for three times that amount.


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Downgrading of debty On 27 April 2010, the Greek debt rating was decreased to the first levels

of 'junk' status by Standard & Poor's amidst fears of default by the Greekgovernment. Yields on Greek government two-year bonds rose to 15.3%following the downgrading. Some analysts question Greece's ability torefinance its debt. Standard & Poor's estimates that in the event of defaultinvestors would lose 3050% of their money. Stock markets worldwide

declined in response to this announcement.y On 3 May 2010, the European Central Bank suspended its minimum

threshold for Greek debt "until further notice",meaning the bonds willremain eligible as collateral even with junk status. The decision willguarantee Greek banks' access to cheap central bank funding, and analysts

said it should also help increase Greek bonds' attractiveness to investors.Following the introduction of these measures the yield on Greek 10-yearbonds fell to 8.5%, 550 basis points above German yields, down from 800basis points earlier. As of 26 November 2010, Greek 10-year bonds weretrading at an effective yield of 11.77%.


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Austerity and loan agreement

y

On 5 March 2010, the Greek parliament passed the EconomyProtection Bill, expected to save 4.8 billionthrough a number of

measures including public sector wage reductions.

y On 23 April 2010, the Greek government requested that the

EU/IMF bailout package be activated.The IMF had said it was"prepared to move expeditiously on this request".Greece needed

money before 19 May, or it would face a debt roll over of $11.3bn.

y On 2 May 2010, a loan agreement was reached between Greece, the

other Eurozone countries, and the International Monetary Fund. Thedeal consisted of an immediate 45 billion in loans to be provided in

2010, with more funds available later. A total of 110 billion has

been agreed. The interest for the Eurozone loans is 5%, considered

to be a rather high level for any bailout loan.


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4TH Austerity measures taken by Greece

y Public sector limit of 1,000 introduced to bi-annual bonus, abolished entirely

for those earning over 3,000 a month.y An 8% cut on public sector allowances and a 3% pay cut for DEKO (public

sector utilities) employees.

y Limit of 800 per month to 13th and 14th month pension installments;abolished for pensioners receiving over 2,500 a month.

y

Return of a special tax on high pensions.y Changes were planned to the laws governing lay-offs and overtime pay.

y Extraordinary taxes imposed on company profits.

y Increases in VAT to 23%, 11% and 5.5%.

y 10% rise in luxury taxes and taxes on alcohol, cigarettes, and fuel.

y

Equalization of men's and women's pension age limits.y General pension age has not changed, but a mechanism has been introduced to

scale them to life expectancy changes.

y A financial stability fund has been created.

y Average retirement age for public sector workers has increased from 61 to 65.

y

Public-owned companies to be reduced from 6,000 to 2,000.


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Spread beyond Greece.


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Ireland, Italy, Portugal, and Spain

y The crisis has reduced confidence in other European economies.

Ireland, with a government deficit of 14.3% of GDP, the U.K. with

12.6%, Italy with 12.0%, Spain with 11.2%, and Portugal at 9.4% are

most at risk.

y In April 2010, following a marked increase in Irish 2-year bond yields,

Ireland's NTMA state debt agency said that it had "no majorrefinancing obligations" in 2010. Its requirement for 20 billion in

2010 was matched by a 23 billion cash balance, and it remarked:

"We're very comfortably circumstanced".On 18 May the NTMA

tested the market and sold a 1.5 billion issue that was three timesoversubscribed


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y Shortly after the announcement of the EU's new "emergency fund" foreurozone countries in early May 2010, Spain's government announced newausterity measures designed to further reduce the country's budget

deficit.The socialist government had hoped to avoid such deep cuts, butweak economic growth as well as domestic and international pressureforced the government to expand on cuts already announced in January. Asone of the largest eurozone economies the condition of Spain's economy isof particular concern to international observers, and faced pressure from

the United States, the IMF, other European countries and the EuropeanCommission to cut its deficit more aggressively

y Niall Ferguson writes that "the sovereign debt crisis that is unfolding ... is afiscal crisis of the western world". Financing needs for the Eurozone in2010 come to a total of 1.6 trillion, while the US is expected to issue

US$1.7 trillion moreTreasury securities in this period,and Japan has 213trillion of government bonds to roll over. The countries most at risk arethose that rely on foreign investors to fund their government sector.According to Ferguson similarities between the U.S. and Greece should notbe dismissed


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Iceland

yIceland had to suffer the failure of its banking system and asubsequent economic crisis.

y Before the crash of the three largest banks in Iceland, with Glitnir,

Landsbanki and Kaupthing, jointly owing about 14 billion ($19

billion)or 6 times Iceland's GDP. In October 2008, the Icelandicparliament passed emergency legislation to minimise the impact of

the financial crisis.

y The Financial Supervisory Authority of Iceland used permission

granted by the emergency legislation to take over the domesticoperations of the three largest banks.On 28 October 2008, the

Icelandic government raised interest rates to 18%, (as of August

2010, it was 7%) a move which was forced in part by the terms of

acquiring a loan from the IMF.


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Sloveniay On June the 4th, 2009, several Slovene companies and banks were

planning to issue bonds that year to get fresh funding at more

favourable credit terms. The issuing of corporate bonds had been rare

in Slovenia until then, but the largest fuel retailer Petrol (PETG.LJ)

planned to issue a 50 million ($70,920,000) 5 year auction bond

later in June 2009.y In May 2010 Slovenia went heavily into debt paying for its part of the

110 billion ($145 billion) rescue package for Greece. Slovenia had

scrapped its International Bond Sale Plan as the economy returned to

positive growth in the October of 2010.y The government had planned to borrow as much as 4.39 billion

($5.6 billion), compared with 4 billion in 2009. Slovenia also sold

1.5 billion worth of 10-year bonds in January and 1 billion of five-

year securities in March


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UK

y On Friday 14 September 2007, the first day branches opened

following the news (that Northern Rock has called on emergencyfunding from the Bank of England to help it through the creditmarket crisis), many Northern Rock customers queued outside

branches to withdraw their savings (a run on the bank).

y

This bank run was not the traditional form, where depositorswithdraw money in a snowball effect, leading to a liquidity crisis;instead, it occurred in the aftermath of the liquidity crisis. It wasestimated that 1 billion was withdrawn by customers that day, about5% of the total bank deposits held by Northern Rock. This became

emblematic of the level of economic panic in the UK at the time.y During 2010 the eurozone debt crisis was widely seen (in the UK

media) as vindication of the decision to not join the eurozone.

y Despite not being in the eurozone the UK contributed 7 Bn to the

Irish bailout in Dec 2010.


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Latvia, Lithuania, and Estonia

y The Baltic States have been amongst the worst hit by the

global financial crisis. In December 2008, the Latvian

unemployment rate stood at 7%. By December 2009, the

figure had risen to 22.8%.

y The number of unemployed has more than tripled since the

onset of the crisis, giving Latvia the highest rate of

unemployment growth in the EU.


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Belgiumy

In 2010, Belgium's public debt was 100% of its GDP - the thirdhighest in the Euro zone after Greece and Italy and there weredoubts about the financial stability of the banks.

y After inconclusive elections in June, by November the countrystill had no government and no budget for 2011 as parties from

the two main language groups in the country (Flemish andWalloon) were unable reach agreement on how to deal with theeconomy.

y Financial analysts forecast that Belgium would be next country

to be hit by the financial crisis as Belgium's borrowing costsrose. However the government deficit of 5% was relativelymodest and Belgian government 10-year bond yields inNovember 2010 of 3.7% were still below those of Ireland(9.2%), Portugal (7%) and Spain (5.2%).


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Controversies

y Credit rating agencies

y Media

y Role of speculators


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EU emergency measuresy On 9 May 2010 the 27 member states of the European Union agree to

create the European Financial Stability Facility (EFSF), a legalinstrument[156] aiming at preserving financial stability in Europe byproviding financial assistance to eurozone states in difficulty.

y In order to reach these goals the Facility is devised in the form of a specialpurpose vehicle (SPV) that will sellbonds and use the money it raises to

make loans up to a maximum of 440 billion to eurozone nations in need.The bonds will be backed by guarantees given by the EuropeanCommission representing the whole EU, the eurozone member states, andthe IMF. The new entity will sell debt only after an aid request is made by acountry

y The EFSF will be combined to a 60 billion loan coming from theEuropean financial stabilisation mechanism (reliant on guarantees given bythe European Commission using the EU budget as collateral) and to a 250 billion loan backed by the IMF in order to obtain a financial safety netup to 750 billions. The agreement allows the European Central Bank tostart buying government debt which is expected to reduce bond yields.


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Measures taken by ECB

y First, it began open market operationsbuying government and private

debt securities.y Second, it announced two 3-month and one 6-month full allotment of

Long Term Refinancing Operations (LTRO's).

y Thirdly, it reactivated the dollar swap lines with Federal Reservesupport.

y Subsequently, the member banks of the European System of CentralBanks started buying government debt.

y Stocks worldwide surged after this announcement as fears that theGreek debt crisis would spread subsided, some rose the most in a yearor more. The Euro made its biggest gain in 18 months, before falling to

a new four-year low a week later.y Commodity prices also rose following the announcement. The dollar

Libor held at a nine-month high. Default swaps also fell. The VIX closeddown a record almost 30%, after a record weekly rise the precedingweek that prompted the bailout.


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y Stephen Roach, chairman ofMorgan Stanley Asia, warned about

this threat saying "When you have a vulnerable post-crisis

economic recovery and crises reverberating in the aftermath of

that, you have some very serious risks to the global business cycle.

y After initially falling to a four-year low early in the week following

the announcement of the EU guarantee packages, the euro rose as

hedge funds and other short-term traders unwound short

positions and carry trades in the currency.

y While the aid package has so far averted a financial panic,

international credit rating agencies consider that Eurozone

countries such as Portugal continue to have economic difficulties.


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LONG TERMSOLUTION

y European Union leaders have made two major proposals for ensuring fiscal

stability in the long term.

y The first proposal is the creation of the European Financial Stability Facility.

y The second is a single authority responsible for tax policy oversight and

government spending coordination of EU member countries, temporarily

called the European Treasury.

y The stability facility is financially backed by the EU and the IMF. The European

Parliament, the European Council, and especially the European Commission,

can all provide some support for the treasury while it is still being built.

However, strong European Commission oversight in the fields of taxation andbudgetary policy and the enforcement mechanisms that go with it have been

described as infringements on the sovereignty of euro zone member states and

are opposed by key EU nations such as France and Spain, which could

jeopardise the establishment of a European Treasury


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y Capital controls that restrict or penalize the flow of capital across

borders is another method that can reduce trade imbalances.

Interest rates can also be raised to encourage domestic saving,

although this benefit is offset by slowing down an economy and

increasing government interest payments.

y Over 23 million EU workers have become unemployed as a

consequence of the global economic crisis of 2007-2010, whilst

thousands of bankers across the EU have become millionaires

despite collapse or nationalisation (ultimately paid for by

taxpayers) of institutions they worked for during the crisis, a fact

that has lead many to call for additional regulation of the banking

sector across not only Europe, but the entire world.

european credit crisis

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