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Euro Zone Crisis

Name of students PG Roll No.

Anu Goyal PG 20111087

Arun kaushal PG20111140

Kamesh Yadav PG20111111

Mukesh Verma PG20112168

Mukul Mansinghkha PG20111092

Rahul Sharma PG20111148

Tekchand Bhardwaz PG20112190

Submitted to Mrs. Shivani

Submitted on 18th

sept,2012

Subject Bank Lending

Marks Allotted

Remarks(if any)


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Table of content:-

1. Executive Summary

1.1 Purpose of the study

1.2 Scope of the Study

1.3 Method of the Study

1.4 Limitations of the study

1.5 Background

2. Eurozone crisis

2.1 What is EuroZone?

2.2 ECB

2.3 Entry rules in Eurozone

2.4 Countries who broke the rules

2.5 Borrowing cost

2.6 Public and Private Debt

2.7 Trade Deficit

2.8 Major factors worsening Euro crisis

2.8.1 Labour Cost

2.8.2 Credit Rating Agency

2.8.3 Credit Default Swaps

2.9 ECB Support

2.10 Learning

2.11 Recommendations


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1.EXECUTIVE SUMMARY: -

1.1 Purpose of the study: -The purpose of this study was to analyse the

eurozone crisis and how it affect the whole eurozone area and also

analysing the role of ECB in the crisis. We also studied what can be done

in order to get rid of this crisis.

1.2 SCOPE: - Scope of the study limited to PIIGS and two major countries

of Eurozone.

1.3 Method: - All the information that is used in the project is gathered

from secondary data available on internet.

1.4 Limitations: - Eurozone crisis is not only affecting the euro countries

but also the entire world. The World today is interlinked so economic

conditions of countries are also interlinked. But this study is limited to

eurozone crisis effect on eurozone only.

1.5 Background: -Debt crisis in Greece which started in late 2009 has

evolved into a broader economic and political crisis in the Eurozone. The

Eurozone faces four major challenges:

High debt levels and public deficits in some Eurozone countries Weaknesses in the European banking system Economic recession and high unemployment in some countries Persistent trade imbalances within the Eurozone.

Additionally, the Eurozone is facing a political crisis. Disagreements

among Germany, France and the European Central Bank (ECB) over the

appropriate crisis response also affected the market sentiments.

Governments in several European countries have also fallen as a direct or

indirect result of the crisis. The main members that were very muchaffected were Portugal, Italy, Ireland, Greece and Spain (PIIGS).


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2. EURO ZONE CRISIS

2.1 What is Euro zone????

The euro zone officially called the euro area, is an economic and monetary union (EMU) of

17 European Union(EU) member states that have adopted the euro () as their common

currency and sole legal tender. It currently consists of Austria, Belgium, Cyprus, Estonia,

Finland, France, Germany, Greece, Ireland, Luxemburg, Malta, Netherlands, Portugal,

Slovakia, Slovenia and Spain. Most other EU states are obliged to join once they meet the

criteria to do so. If EU states do not meet the criteria after joining EU there are no certain

guideline exists pertaining to it. Since, no state has left and as such there are no provisions to

do so or to be expelled.

2.2 European central Bank:-

The European Central Bank (ECB) is the institution of the European Union (EU) thatadministers the monetary policy of the 17 EU Eurozone member states .

It comprises the ECB and the central banks of the EU states who have joined the eurozone which is governed by a president and a board of the heads of national central

banks.

The principal task of the ECB is to keep inflation under control. Though there is nocommon representation, governance official for the currency union, some co-

operation does take place through the Euro Group, which makes political decisions

regarding the euro zone and the euro.

The Euro Group is composed of the finance ministers of euro zone states, however inemergencies; national leaders also form the Euro.

Since the late-2000s financial crisis, the euro zone has established and used provisionsfor granting emergency loans to member states in return for the enactment of

economic reforms.
http://en.wikipedia.org/wiki/Economic_and_monetary_unionhttp://en.wikipedia.org/wiki/European_Unionhttp://en.wikipedia.org/wiki/Member_state_of_the_European_Unionhttp://en.wikipedia.org/wiki/Eurohttp://en.wikipedia.org/wiki/Legal_tenderhttp://en.wikipedia.org/wiki/Institutions_of_the_European_Unionhttp://en.wikipedia.org/wiki/European_Unionhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Eurozonehttp://en.wikipedia.org/wiki/Member_State_of_the_European_Unionhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Currency_unionhttp://en.wikipedia.org/wiki/Euro_Grouphttp://en.wikipedia.org/wiki/Late-2000s_financial_crisishttp://en.wikipedia.org/wiki/Late-2000s_financial_crisishttp://en.wikipedia.org/wiki/Euro_Grouphttp://en.wikipedia.org/wiki/Currency_unionhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Member_State_of_the_European_Unionhttp://en.wikipedia.org/wiki/Eurozonehttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/European_Unionhttp://en.wikipedia.org/wiki/Institutions_of_the_European_Unionhttp://en.wikipedia.org/wiki/Legal_tenderhttp://en.wikipedia.org/wiki/Eurohttp://en.wikipedia.org/wiki/Member_state_of_the_European_Unionhttp://en.wikipedia.org/wiki/European_Unionhttp://en.wikipedia.org/wiki/Economic_and_monetary_union


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2.3 Euro zone common set of entry rules in euro

countries(Maastricht Treaty,1993):-

Inflation rates: -

Cannot exceed 1.5 percentage points above average of the three member states withthe lowest inflation rates

Government Finance: -

Annual government deficit: Deficit-to-GDP must be close to or be under 3% exceptfor exceptional cases

Government debt: Gross debt-to-GDP ratio cannot exceed 60%. If not achieved, thenthe ratio must be diminishing and approaching the reference value.

Exchange Rates: -

Joined the exchange-rate mechanism (ERM) under the European Monetary System(EMS) for two consecutive years and cannot devalue currency during the period

Long-term Interest Rates: -

Nominal long-term interest rate cannot exceed 2 percentage points above average ofthe three member states with lowest inflation.

Note: - The purpose behind Maastricht treaty was to maintain the price stability within

the Eurozone.

In 1997, SGP (Stability and Growth Pact) came into picture with emphasising on these rules:-

Deficit-to-GDP must be close to or be under 3% except for exceptional cases Gross debt-to-GDP ratio cannot exceed 60%.


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2.4 Countries who broke the rules

In Eurozone only France, Ireland, Luxembourg, Portugal and Finland satisfied the debt-to-

GDP reference ratio of 60%. For the remaining countries, debt levels were considered to have

been sufficiently declining and did not prevent their accession to the single currency.

Then who broke the rules:-

3/9 Italy

Worst offender

5/9 Germany

First to break rules

6/9 France

Offender

9/9 Spain

Top of the Class

Italy was the worst offender. It regularly broke the 3% annual borrowing limit. Actually Germany along with Italy - was the first big country to break the 3% rule.

After that, France followed.

Of the big economies, only Spain kept and didnt follow the same route until the 2008financial crisis.

Spain's government has the smallest debts relative to the size of its economy. Greece, by the way, was in a class of its own. It never stuck to the 3% target; it also

manipulated its borrowing statistics to look good, which allowed it to get into the euro

in the first place. Its waywardness was uncovered two years ago.

2.5 Government Borrowing Cost

So surely Germany, France and Italy should be in trouble with all that reckless borrowing,

but Spain is also facing the same problem. Actually Germany is the "safe haven" as it is a

export oriented economy - markets have been willing to lend to it at historically low interest

rates since the crisis began. Spain on the other hand is seen by markets as almost as risky as

Italy as it is a import oriented economy with a little hope to recover soon.


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2.6 Public and Private debt

There was a big build-up of debts in Spain and Italy before 2008, but it had nothing to do

with governments. Instead it was the private sector - companies and mortgage borrowers -

who were taking out loans. Interest rates had fallen to unprecedented lows in southern

European countries when they joined the euro. And that encouraged a debt-fuelled boom.


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Public debt As % of GDP:-

2.7 Trade Deficits

All that debt helped finance more and more imports by Spain, Italy and even France.

Meanwhile, Germany became an export power-house after the euro zone was set up in 1999,

selling far more to the rest of the world (including southern Europeans) than it was buying as

imports. That meant Germany was earning a lot of surplus cash on its exports and most ofthat cash ended up being lent to southern Europe.


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Fiscal Deficit as % of GDP:-

2.8 Major Factor worsning Eurozone crisis

2.8.1 Labour Costs

Debts are only part of the problem in Italy and Spain. During the boom years, wages rose and

rose in the south (and in France). But German unions agreed to hold their wages steady. So

Italian and Spanish workers now face a huge competitive price disadvantage. Indeed, this loss

of competitiveness is the main reason why southern Europeans have been finding it difficult

to export than Germany.


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So to recap, government borrowing - which has ballooned since the 2008 global financial

crisis - had very little to do with creating the current euro zone crisis in the first place,

especially in Spain (Greece's government is the big exception here). So even if governments

don't break the borrowing rules this time, that won't necessarily stop a similar crisis from

happening all over again.

Spain and Italy are now facing nasty recessions, because no-one wants to spend. Companies

and mortgage borrowers are too busy repaying their debts to spend more. Exports are

uncompetitive. And now governments - whose borrowing has exploded since the 2008

financial crisis savaged their economies - have agreed to drastically cut their spending back

as well.

2.8.2 Credit rating agency role in crisis:-

Credit rating agencies plays an important role in buying behaviour of investors. In case of

EMU, there was a spill over effect from lower rated countries to higher rated countries that

participated in the EMU (Economic and monetary union) during the sovereign debt crisis.

Even when countries were issued warnings by the EU, for example Portugal in 2002, France,

and Germany in 2004, the effect on credit ratings was negligible. In fact, Greece maintained

an A rating from all three ratings agencies until late 2009, despite reaching a deficit level of9.8% of GDP and a debt level at 113% of GDP in the previous year, with limited signs of

recovery.

2.8.3 Role of CDS :-

What is CDS????

A credit default swap (CDS) is an agreement that the seller of the CDS will compensate the

buyer in the event of a loan default. The buyer of the CDS pays fees or a spread to the

seller and, in exchange, receives a payoff if the country in question fails to make payments or

we can say it is type of insurance against risk associated with bonds.

Prior to 2008, since the probability of default was deemed to be small, particularly forAA and AAA-rated countries in Europe, credit default swaps (CDS) were not widely

traded.


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Prior to 2008, European sovereign bonds were widely perceived to be relatively safeinvestments, since they were highly rated and backed by governments that used the

common currency.

Prior to 2008, interest rates in eurozone fell substantially as investors sought low-riskinvestments.

Greek borrowing costs, although higher than the average for the Euro zone, weremuch lower than prior to the countrys entry into the euro. Investors went after high-

return and low-risk investments, and thus Greek bonds became attractive, especially

for large European financial institutions. However, when the sovereign debt crisis

began, it became clear that a restructuring was possible and that default cannot be

completely ruled out.

After 2008, Changes in CDS became much more sensitive to ratings downgrades. Interest rates for Greece, Portugal, Italy, and Ireland increased substantially with the

sovereign debt crisis.

Rapidly rising borrowing costs have in all likelihood made meeting the SGPthresholds even more difficult, as seen with the remarkable increases in debt for

Ireland and Greece since the sovereign debt crisis.

2.9 ECB Support : -

The ECB significantly increased its role in the crisis response in December 2011 andFebruary 2012, when it introduced long-term refinancing operations (LTRO).

The LTRO resulted in loans to more than 800 Euro zone banks, totalling more than 1trillion (about $1.3 trillion), and is the biggest infusion of cash into the banking

system since the euro wasintroduced.

The LTRO aimed to address the liquidity crunch in the Euro zone banking system andto encourage banks to continue buying Spanish and Italian government bonds.

Previously, in May 2010, the ECB began buying government bonds on secondarymarkets for the first time in an attempt to stabilize bond yields, and the ECB is now

believed to be the biggest holder of Greek bonds.


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The ECB has also provided unusual flexibility in its short-term refinancingoperations throughout the crisis, in particular by agreeing to accept securities,

including government bonds, with lower credit ratings on collateral in its refinancing

operations

Recently, The European Central Bank agreed to launch a new and potentiallyunlimited bond-buying programme to lower struggling euro zone countries' borrowing

costs and draw a line under the debt crisis.

The new scheme, would focus on bonds maturing within three years and was strictlywithin the ECB's mandate, ECB would only help countries that signed up to and

implemented strict policy conditions, with the euro zone's rescue fund also buying

their bonds, and preferably with the IMF involved in designing and monitoring the

conditions.

2.10 LEARNING:-

One of the major learning has been the limitation of a single currency system. It lacks thecentral Treasury mechanism which can control the inherent trade imbalances which result in

huge budget deficits, much like the gold standard era.

The eurozone fiscal crisis showed that monetary integration without fiscal integration wouldnot work and that it would ultimately lead to a dead end

Living beyond your means year after year can lead to bankruptcy. This is especially true ifborrowed money is not used for productive purposes. Greece wrongly believed that it could

continue to milk the EU for subsidies and fiscal transfers. With fiscal transfers not linked to

productivity, wages raced ahead of productivity growth, thereby eroding competitiveness

and also raising inflationary pressures.

Trust is everything. Once you lose investors' trust due to a poor track record, immediate anddrastic action is demanded and needs to be complied with.


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2.11 Recommendation

Euro crises can overcome this crisis by reducing their sovereign debt and by maintainthese factors:

Political stability Better monetary policy

There should be penalties for countries who will be violating the rule. Eurozone spends a lot of money on public welfare so they should cut on those

spending so they can cut government expenses

Eurozone countries normally pay money to its citizen as compensation if a person isget unemployed so that a person can survive in bad times. Although this is a good

cause to run but it resulted in high unemployment rate in euro countries. So govt.

should put a time cap for such type of financial aid to cut on their spending.

Banks in euro countries can also play a major role in stabilising the economies as theycan provide interest at lower rates so that industries can grow which will directly

impact on employment and financial inclusion will take place in the country. This all

will ultimately help the countries to come out of the cycle of debt crisis.

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