final euro crises
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European crises
In 1958, an organisation called European Coal and Steel Community was formed. This
evolved into the European Union (EU) which was established by the Maastricht Treaty in
1993. The European Union introduced the euro on January 1, 1999. On this day, 11 member
countries of the EU started using euro as their currency. It benefited countries such as
Portugal, Italy, Ireland, Greece and Spain (together now known as the PIIGS).
"Before these countries started to use the euro as a currency, they had to borrow money at
interest rates much higher than the rates at which a country like Germany borrowed. When
these countries started to use the euro they could borrow money at interest rates close to
that of Germany, which was economically the best managed country in the EU, and this was
a benefit to them.
The rest of Europe, in effect, used Germany's credit rating to indulge its material desires.
They borrowed as cheaply as Germans could to buy stuff they couldn't afford, They kept
buying stuff they cannot really afford.
Also other than the low interest rates, the inflation in the PIIGS countries was higher than
the rate of interest. And the European peripheral countries (PIIGS) racked up enormous
amount of debt in euros.
While the sovereign debt increases have been most pronounced in only a few eurozone
countries they have become a perceived problem for the area as a whole.In May 2011, the
crisis resurfaced, concerning mostly the refinancing of Greek public debts.In late June 2011,
the crisis situation was again brought under control with the Greek government managingto pass a package of new austerity measures and EU leaders pledging funds to support the
country.
Concern about rising government deficits and debt levels across the globe together with a
wave of downgrading of European government debt created alarm in financial markets. On
9 May 2010, Europe's Finance Ministers approved a comprehensive rescue package worth
750 Billion (then almost a trillion dollars) aimed at ensuring financial stability across Europe
by creating the European Financial Stability Facility (EFSF).
In 2010 the debt crisis was mostly centered on events in Greece, where the cost of financing
government debt was rising. On 2 May 2010, the eurozone countries and the InternationalMonetary Fund agreed to a 110 billion loan for Greece, conditional on the implementation
of harsh austerity measures. The Greek bail-out was followed by a 85 billion rescue
package for Ireland in November, a 78 billion bail-out for Portugal in May 2011, then
continuing efforts to meet the continuing crisis in Greece and other countries.
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Eurozone sovereign debt concerns
Greek debt in comparison to Eurozone average
The Greek economy was one of the fastest growing in the eurozone from 2000 to 2007;
during that period, it grew at an annual rate of 4.2% as foreign capital flooded the
country.[24]
A strong economy and falling bond yields allowed the government of Greece to
run large structural deficits. After the removal of the right-wing military junta, the
government wanted to bring disenfranchised left-leaning portions of the population into the
economic mainstream.[25]
In order to do so, successive Greek governments have, among
other things, customarily run large deficits to finance public sector jobs, pensions, and other
social benefits.[26]
Since 1993 debt to GDP has remained above 100%.[27]
Initially currency devaluation helped finance the borrowing. After the introduction of the
euro in Jan 2001, Greece was initially able to borrow due to the lower interest rates
government bonds could command. The late-2000s financial crisis that began in 2007 had a
particularly large effect on Greece. Two of the country's largest industries are tourism and
shipping, and both were badly affected by the downturn with revenues falling 15% in
2009.[27]
To keep within the monetary union guidelines, the government of Greece had misreported
the country's official economic statistics.[28][29]
In the beginning of 2010, it was discovered
that Greece had paid Goldman Sachs and other banks hundreds of millions of dollars in fees
since 2001 for arranging transactions that hid the actual level of borrowing.[30]
The purpose
of these deals made by several subsequent Greek governments was to enable them to
continue spending while hiding the actual deficit from the EU.
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 was forecast, according to some estimates,
to hit 120% of GDP in 2010. The Greek government bond market relies on foreign investors,
with some estimates suggesting that up to 70% of Greek government bonds are held
externally.
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On 27 April 2010, the Greek debt rating was decreased to the upper levels of'junk' status by
Standard & Poor's amidst hints of default by the Greek government.[41]
Yields on Greek
government two-year bonds rose to 15.3% following the downgrading. Standard & Poor's
estimates that in the event of default investors would fail to get 3050% of their money
back.
Danger of default
Without a bailout agreement, there was a possibility that Greece would prefer to default on
some of its debt. The premiums on Greek debt had risen to a level that reflected a high
chance of a default or restructuring. Analysts gave a wide range of default probabilities,
estimating a 25% to 90% chance of a default or restructuring.[65][66]
A default would most
likely have taken the form of a restructuring where Greece would pay creditors, whichinclude the up to 110 billion 2010 Greece bailout participants i.e. Eurozone governments
and IMF, only a portion of what they were owed, perhaps 50 or 25 percent.[67]
It has been
claimed that this could destabilise the Euro Interbank Offered Rate, which is backed by
government securities.
Greece represents only 2.5% of the eurozone economy.[72]
Despite its size, the danger is that
a default by Greece will cause investors to lose faith in other eurozone countries. This
concern is focused on Portugal and Ireland, both of whom have high debt and deficit
issues.[73]
Italy also has a high debt, but its budget position is better than the European
average, and it is not considered among the countries most at risk.
EU emergency measures
On 9 May 2010, the 27 member states of the European Union agreed to create the EFSF, a
legal instrument[122]
aiming at preserving financial stability in Europe by providing financial
assistance to eurozone states in difficulty. The facility is jointly and severally guaranteed by
the Eurozone countries' governments.[123]
In order to reach these goals the Facility is devised in the form of a special purpose vehicle
(SPV) that will sell bonds and use the money it raises to make loans up to a maximum of
440 billion to eurozone nations in need. The new entity will sell debt only after an aid
request is made by a country.[124]
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The EFSF loans would complement loans backed by the lender of last resort International
Monetary Fund, and in selected cases loans by the European Financial Stabilisation
Mechanism.
The ECB has announced a series measures aimed at reducing volatility in the financial
markets and at improving liquidity:[130]
First, it began open market operations buying government and private debtsecurities.
Second, it announced two 3-month and one 6-month full allotment of Long TermRefinancing Operations (LTRO's).
Thirdly, it reactivated the dollar swap lines[131]with Federal Reserve support.[132]
Subsequently, the member banks of the European System of Central Banks started buying
government debt.
Reform and recovery
In November, as concerns started to resurface about the fiscal health of Ireland, Greece and
Portugal, EU President Herman Van Rompuy said "If we dont survive with the eurozone we
will not survive with the European Union."[167]
In March 2011 a new reform of the Stability and Growth Pact was initiated, aiming at
straightening the rules by adopting an automatic procedure for imposing of penalties in case
of breaches of either the deficit or the debt rules.[168][169]
Subsequently, the proposed European treasury was implemented as the temporary
European Financial Stability Facility, which will function until the permanent European
Stability Mechanism is established following ratification of its treaty. In July 2011, it was
agreed during the EU summit that the EFSF will be given more powers to intervene in the
secondary markets, thus dramatically socializing risk in the eurozone, which ends the
crisis.[170]
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How European crisis could impact India?
A crisis in an economy impacts other economies via three channels:
Trade Channel:When an economy falls into a recession, it impacts the affected countrys
trading partners too. Falling household and business demand in the slump-hit economy hitsthe exports/imports of its trading partners.
The share of exports to EU (excluding UK) and imports from EU has fallen over the years. In
1987-88, exports to EU constituted about 18.6% of total exports. This has declined to 17.5%
by 2008-09. The decline of imports is higher from 25% in 1987-88 to 12% in 2008-09. Hence,
total trade between India and EMU is about 29.5% and could be impacted due to the crisis.
(Source:RBI)
However, trade channel can impact Indian external sector indirectly as well. When the
recent crisis gripped the world 2008, most policymakers, economists and experts put forththe view that India would be only marginally affected. Two reasons were cited for th
First, India was a virtual non-entity in global trade as its share was less than 0.5%-0.7% of the total global trade volumes. Hence, it was assumed that its economy was
largely insulated from the turmoil.
Second, share of developed economies in trade had declined. In 1987-88 developedeconomies contributed 59% of exports and in 2008-09 their share has declined to
37%. The share of developing economies has increased from 14% in 1987-88 to 37%
in 2008-09. In case of imports developed economies share has again fallen from 60%
in 1987-88 to 32% in 2008-09 while developing economies has risen from17% to32%. (Source:RBI)
Because of this shift it was felt that impact of global crisis on Indian economy would be
limited. As crisis originated in US and developed economies with developing economies still
growing, it was felt Indian trade will continue to grow. However once the crisis struck in
September 2008, Indian trade sector declined sharply and growth was negative for 13
straight months from Oct-08 to Oct-09.
Financial Channel: The current crisis has shown the power offinance channel(though trade
channel was also very strong as above analysis points). The impact of turmoil in one
economys financial markets is not merely transmitted to other markets, the quantum and
direction of the movement is also more or less similar (decline in equity markets, rise in
corporate bond spreads and depreciation in currency). This is because cross border financial
linkages have increased substantially over the years. Besides, the correlation between assets
too has been rising across the world. If you plot the BSE Sensex with other advanced
economy stock indices, you more or less see the same trend. So much so, one can
determine the trend in the Indian equity market by just looking at movements in other
global indices.
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Foreign Institutional Investment: Unlike FDI, it is difficult to pinpoint the origin of FIIinvestment. However, the linkage here is pretty direct. With a turmoil in global
financial markets, FII inflows will decline. We have a large number of global financial
firms which operate across the world and in case of a decline in one major market,
there is a pull out from other markets as well.
commmercial Borrowings: External commercial borrowings could also decline if theEuropean crisis spreads to other economies. ECBs declined in the first stage of the
crisis as well.
Confidencechannel
This channel shows confidence declines in business and households seeing the global
uncertainty. So even if an economys macroeconomic conditions and outlook look favorable,
the decline in confidence can disrupt the economic conditions. Decline in confidence is also
one of the reasons for decline in business investments which led to decline in overall Indian
GDP growth. Credit growth also declined because of decline in business investments.