European Debt Crisis - How it All Started??? (FRIDAY, NOVEMBER 18, 2011)

“EUROPEAN DEBT CRISIS”, THE MOST COMMONLY DISCUSSED MATTER TODAY IN FINANCIAL WORLD AS WELL IN JOB MARKETS. WHAT IS IT EXACTLY? AND HOW IT STARTED? IS IT THE RESULTANT EFFECT OF A COUPLE OF YEARS PROBLEM OR A LONG STRETCHED PROBLEM?

All these queries will be cleared in this Article. Hold your breath this Crisis is not a couple of years old, in fact it was spreading its roots tight since the Year 2000, yes MORE THAN A DECADE!!!

Meaning of Some Terms before we Start what is EUROPEAN DEBT CRISIS AND HOW IT ALL STARTED

Bailout: As a person is when arrested and seeks a Bail to come out from that arrest for some time. In the same way when a Company or a Country is when provided with an emergency financial help so that they keep running and working as before is called a Bailout. In India, Kingfisher Airlines is the recent example of this.

Austerity Measures / Plans: Austerity is a policy of deficit-cutting, lower spending, and a reduction in the amount of benefits and public services provided. Austerity policies are often used by governments to reduce their deficit spending while sometimes coupled with increases in taxes to pay back creditors to reduce debt.

European Financial Stability Facility (EFSF): It is a special purpose vehicle financed by members of the eurozone to fight the European sovereign debt crisis. It was agreed by the 27 member states of the European Union on 9 May 2010, aiming at preserving financial stability in Europe by providing financial assistance to eurozone states in economic difficulty.

Contagion: The likelihood that significant economic changes in one country will spread to other countries. Contagion can refer to the spread of either economic booms or economic crises throughout a geographic region. Contagion has become a more prominent phenomenon as the global economy has grown and economies within certain geographic regions have become more correlated with one another.

HOW IT ALL STARTED?

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.

OVERBURDENED DEBT

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.

Also other than the low interest rates, the inflation in the PIIGS countries was higher than the rate of interest. It means that if the borrowing rate is 3 per cent while inflation is 4 per cent you're effectively borrowing for 1 per cent less than inflation. You're being paid to borrow.

And the European peripheral countries (PIIGS) racked up enormous amount of debt in euros. Taking the case of Greece, their debt currently amounts to around 160 per cent of their GDP. With low interest rates these countries went on a borrowing spree and since they borrowed much more than their repayment capacity is, they are in a mess. Greece is the smallest of these countries and is in the biggest mess.

Other than the citizens, the governments also started to borrow. This helped politicians keep their constituency of voters happy.

GREECE

Taking the case of Greece, a job which now pays 55,000 euros in Germany, pays 70,000 euros in Greece, even with the fact that Germany is a more productive nation. To get around pay restraints in the calendar year the Greek government simply paid employees a 13th and even 14th monthly salary -- months that didn't exist.

The Greek government categorizes certain jobs as arduous. These jobs have a retirement age of 55 for men and 50 for women. As this is also the moment when the state begins to shovel out generous pensions, more than 600 Greek professions somehow managed to get themselves classified as arduous: hairdressers, radio announcers, musicians.

It means more and more borrowing by the government, when they already have so much debt.

SPAIN

Taking the case of Spain, it had the biggest housing bubble in the world. To put things in perspective, Spain now has as many unsold homes as the United States, even though the US is six times bigger. Most of these new homes were financed with capital from abroad. Spain's real estate debt comes to around 50 per cent of its GDP.

Every time there are default threats to the Countries, the European Central Bank (ECB), helps out with a bailout. Since the start of the financial crisis ECB has bought around $80 billion of Greek and Irish and Portuguese government bonds, and lent another $450 billion or so to various European governments and European banks, accepting virtually any collateral, including Greek government bonds. Of the 126 countries with rated debt, Greece now ranked 126th: the Greeks were officially regarded as the least likely people on the planet to repay their debts.

Germany keeps contributing the ECB rescue fund. The German government gives money to the rescue fund so that it can give money to the Irish government so that the Irish government can give money to Irish banks so the Irish banks can repay their loans to the German banks. In case of Greece, a lot of German and French banks which have lent money will be in trouble if Greece defaults.

HUNGARY

In 2004, interest rates in Hungary were at 12.5 per cent. This meant borrowing money was extremely expensive.

In Austria, the banks had started to offer loans and mortgages to their customers in Swiss francs. Rates in Austria, at 2 per cent, may have been lower than in Hungary, but in Switzerland, they were even lower at around 0.5 per cent. Why would Austrians borrow at 2 per cent when they could just as easily borrow at 0.5% per cent?

The same question applied to Hungarians, except that the difference was much bigger. So the Austrian banks, many of which also had branches in Hungary began to engage in the same business there, lending to Hungarian borrowers.

Now Austrian banks have lent 140 per cent of their GDP to countries like Hungary. Even though Hungary has put in austerity measures and is trying to repay, if there was a blow up, the Austrian government wouldn't be able to save the banks and ECB might have to step in.

Similarly, Swedish banks have also lent a lot of money to Estonia, Lithuania and Latvia, countries which aspire to have Euro as their currency some day.

ITALY

Using the example of Italy, Households and firms, anticipating that domestic deposits would be redenominated into the lira (Italy's currency before it started using the euro), which would then lose value against the euro, would shift their deposits to other euro-area banks. A system-wide bank run would follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments, leading to a bond market crisis . . . this would be the mother of all financial crises.

WHAT IS EXACTLY EUROPEAN DEBT DEAL?

Euro as a currency started operating on January 1, 1999. Before that the German currency -- Deutschemark -- used to be the premier currency of Europe. The Euro inherited the strength of the deutschemark. The world looked at the Euro as the new Deutschemark.

The Greek government over the years borrowed a lot of money to finance its fiscal deficit, which is the difference between what a government earns and what a government spends. A lot of this borrowing was from private investors like German banks to whom the Greek government currently owes Euro 8.6 billion.

So these private creditors of the Greek government have now agreed to take a 50 per cent haircut. It basically means is that for every 100 Euro owed to them, they have agreed to accept 50 Euro as repayment, primarily in the hope that Greece at least repays 50 per cent of what it owes to them.

So Greece is defaulting, though technically and we call it a haircut. The hope is that by doing this, Greek debt will come down to manageable proportions. Experts who have come up with this plan expect Greek debt to come down to around 120 per cent of its gross domestic product (GDP) in 2020, because of this plan. Otherwise it would have ballooned to around 180 per cent of its GDP.

If the German banks take a 50 per cent haircut on their outstanding debt of Euro 8.6 billion they lose around Euro 4.3 billion. A lot of money has been lent to the private sector in Greece. And if the government of a country is defaulting, how could one expect the private sector to pay up?

Greece is not the only country which owes money to Germany. Spain owes around $238 billion to Germany. Italy, Ireland and Portugal owe $190 billion, $184 billion and $47 billion, respectively.

These countries might turn around and say why we don’t get a haircut on our debt as well. And then there will be a bigger problem given that these countries are bigger and the money they owe to Germany is considerably larger.

Angela Merkel, the German Chancellor is supporting this policy due to an economic reason. Before Euro became a common currency across Europe, German exports stood at around $487 billion in 1995. In 1999, the first year of the Euro being used as a currency the exports were at Euro 469 billion. Next year they increased to Euro 548 billion. And now they stand at Euro 1 trillion. And all this was because of Euro being used as a currency.

Using Euro as a common currency took away the cost of dealing with multiple currencies and thus helped Germany expand its exports to its European neighbours big time. Also with a common currency at play, exchange rate fluctuations which play an important part in the export game, no longer mattered and what really mattered was the cost of production.

Since the beginning of the Euro in 1999, Germany has become some 30 per cent more productive than Greece. Very roughly, that means it costs 30 per cent more to produce the same amount of goods in Greece than in Germany. That is why Greece imports $64 billion and exports only $21 billion.

So the way it works is that German banks lend to other countries in Europe at low interest rates and they, in turn, buy German goods and services which are extremely competitively priced as well as of good quality.

And that is why Germany is interested in rescuing these countries or at least showing that it is trying to do something about it. Because if these countries in Europe collapse, then German exports will collapse as well.

One solution bandied around is that these countries which are in severe debt to Germany should be asked to stop using the Euro as its currency. But if they stop using the Euro as a currency, then the huge export advantage which Germany has had because of the Euro will also end. So Germany is jammed in from both sides.

A DILEMMA

The euro zone is a hybrid: a single currency with 17 national fiscal and economic policies. It has no common treasury, no tax-raising powers, no joint bonds and no central bank acting as lender of last resort. In good times, this did not matter. But in the worst financial crisis in decades, the flaws are glaring.

Countries cannot quit the euro without extreme economic pain, but nor is it easy to fix. Vetoes may be needed to maintain democratic consent, even if they make for poor crisis management. A blockage in one country endangers all. The markets are testing the ambiguities to destruction. Vague promises to “do whatever it takes” to save the euro are not enough. Will the ECB deploy its full resources to stop the crisis? How much intrusion into national policies are Greece and Italy ready to accept? How far is Germany willing to extend its credit? Will the euro zone’s states hang together or hang separately?

These are big questions, affecting the nature of the state, sovereignty and democracy.

OLD DEBTS DOG EUROPE’s BANKS

European banks are sitting on heaps of exotic mortgage products and other risky assets that predate the financial crisis, adding to pressure on lenders that also are holding large quantities of euro-zone government debt.

Four years after instruments like "collateralized debt obligations" and "leveraged loans" became dirty words because of the massive losses they inflicted on holders, European banks still own tens of billions of euros of such assets. They also have sizable portfolios of U.S. commercial real-estate loans and subprime mortgages that could remain under pressure until the global economy recovers.

While the assets largely originated in the U.S. financial system, top American banks have moved faster than their European counterparts to rid themselves of the majority of such detritus.

Sixteen top European banks are holding a total of about €386 billion ($532 billion) of potentially suspect credit-market and real-estate assets. That's more than the €339 billion of Greek, Irish, Italian, Portuguese and Spanish government debt that those same banks were holding at the end of last year, according to European "stress test" data.

The old credit-market assets might turn out to be harmless for the banks. If real-estate markets hold steady or strengthen, for example, instruments made up of home loans could gain value and generate a steady stream of cash payments for their holders.

Still, the hefty holdings of debt from before the 2008 financial crisis compound the challenge facing the Continent's banks.

Many are holding tens of billions of euros of bonds issued by financially shaky countries. They are holding hundreds of billions more in loans to customers in those same countries, which are likely to go bad at an increasing clip if Europe's economy continues to struggle.

The situation is heightening fears that the banks lack enough capital to absorb potential losses and could require government support.

The banks generally have been holding the assets since before the financial crisis got under way four years ago, a time when real-estate assets in general had much higher prices. Some banks haven't fully written down these loans to reflect their current market values.

European banks, on average, have roughly halved their stockpiles of the legacy assets since 2007. Meanwhile, the top three U.S. banks—Bank of America Corp., Citigroup Inc. and J.P. Morgan Chase & Co.—have slashed such assets by well over 80% over a similar period. It will be another drag on the banks' capital and returns on equity.

France's BNP Paribas SA is sitting on €12.5 billion of asset-backed securities and collateralized debt obligations tied to real-estate markets. The assets are liquid and "priced very conservatively."

French banks in particular have pointed to such sales as a key part of their plan to address a cumulative €8.8 billion capital shortfall.

The assets could lose value due to a wave of selling by the banks. If the banks sell the assets at a loss, it erodes their profits and can dent their capital bases. But if they don't sell them, they're stuck with assets that consume significant quantities of capital.

Banks in the U.K., France and Germany are the biggest holders of such assets, even after chipping away at their exposures. The four biggest British banks reduced their holdings by more than half since 2007, while four French banks trimmed theirs by less than 30%.

Barclays PLC is sitting on about £17.9 billion as of Sept. 30, down from £23.9 billion at the start of the year. The assets, which landed on the giant U.K. bank's books before mid-2007, include collateralized debt obligations, composed of securities backed by assets like mortgages, commercial real-estate loans and leveraged loans that helped finance boom-era corporate buyout deals.

At roughly €28 billion, Crédit Agricole SA has the biggest portfolio of such assets among French banks. The bank's June 30 financial report includes €8.6 billion of CDOs backed by U.S. residential mortgages. On top of that, Crédit Agricole also has at least €1 billion of U.S. mortgage-backed securities, some composed of subprime loans. With the U.S. real-estate market still hurting, further losses are possible in all these securities.

Legacy assets are also haunting Deutsche Bank AG. The bank is holding €2.9 billion in U.S. residential mortgage assets, including subprime loans. It has an additional €20.2 billion tied up in commercial mortgages and whole loans. The bank says it has hedged nearly all of its residential mortgage exposure. Deutsche's exposure to such assets amounts to more than 150% of its tangible equity—a key measure of its ability to absorb unexpected losses.

Compared with European banks, U.S. lenders have moved faster to dump such assets. Citigroup, which required $45 billion of government aid in 2008, faced intense pressure from regulators to rid itself of risky assets, many linked to mortgages that got the New York bank in trouble. Its stockpile of such assets was down by 86% to $45 billion at Sept. 30.

EXPOSURE OF U.S. BANKS

    Goldman Sachs Group Inc., the fifth- biggest U.S. bank by assets, had $2.32 billion of “funded” credit exposure to Italy’s government, financial institutions and companies as of Sept. 30.

-          Morgan Stanley’s net funded exposure tied to Italy was $1.79 billion at the end of September, accounting for most of the $2.11 billion total from the five countries. 

-          Citigroup Inc.’s “net current funded exposure” tied to the PIIGS countries was $7.2 billion at the end of September, more than three times the exposure to Belgium and France. Total cross-border claims linked to Italy were $14.5 billion.

-          JPMorgan Chase & Co.’s exposure to Italy from trading, lending and securities available for sale was $11.3 billion as of Sept. 30.

-          Bank of America Corp.’s non-U.S. exposure linked to Italy was $6.54 billion at the end of September, almost 45 percent of the total linked to the five European countries.

PROBABLE CONSEQUENCES:

The Eurozone is Over

If Greece did its own thing and Germany its own, you need to have separate currencies. If Maharashtra borrowed as much as the government of India on the assumption that it is a sovereign power, the Indian rupee would collapse, too. The rupee holds only because India limits the fiscal sovereignty of its states.

One can see the eurozone being restricted to Germany, France and the Benelux countries, or the emergence of two eurozones – with northern Europe being the stronger half with a stronger euro and southern Europe – assuming it sticks together – having a weaker euro. The southern euro, or successor national currencies, have to depreciate against the northern ones, assuming the euro itself stays.

As the western world goes into recession, it is the less externally-vulnerable countries that will benefit most.

America will benefit, because it imports more than it exports and it retains sovereignty over the dollar. A global slowdown will bring down the price of its imports faster than the slowdown in its export earnings.

India will benefit for the same reason – and for the fact that it will still be growing faster than many other countries. 

The oil-producers (including Russia) will gain because oil priced in dollars will not fall too much.

The biggest losers will be the highly export-driven economies of Germany and China

These Countries will now have to find markets in new areas. Or they will have to grow their internal consumption markets through a painful process of saving less and spending more. All of them will slow down dramatically – if not slip into recession.

LESSONS FROM THIS ALL

Globalisation and absolute sovereignty are inimical to one another. 

One or the other has to dominate. If we want free trade, we cannot have political barriers to trade – and by trade here means not only the export of goods and services, but also capital and labour. Globalisation will work perfectly only if all the factors of production move freely – and markets adjust constantly to this flow.

But this is an impossibility when political power remains national. The euro experiment is failing because Europe tried to graft a political project (to achieve a peaceful continent) based on economic interdependence. It would have worked if Europe also had a sovereign government which redistributed resources from the rich to the poor. In such a scenario, Germany would subsidise Greece and the other PIIGs to improve their economic conditions and competitive abilities. Eurozone is failing because this did not happen – and Germany hogged the benefits as long as it could.

Countries running excess fiscal and current account deficits over long periods of times will get into serious trouble. 

But the reverse is also true. Countries running external surpluses for long periods of time are equally the cause of the problem. This has been the world’s blind spot so far where exporters and surplus countries were hailed as heroes and the rest castigated as zeroes and wasteful. The latter characterisation is rubbish: borrowers need lenders, and if borrowers keep on borrowing, it is because the lenders benefit from it.

Put another way, it means when countries run prolonged deficits, both parties – the surplus economies and the deficit ones – must do opposite things. The adjustment cannot be done by the deficit people alone. By wrongly categorising Germany, China and Japan as surplus heroes a lopsided world is created in which they were being eulogised for being “virtuous savers” when the “profligate” spenders were actually responsible for their growth.

The world’s problems will be solved today only if the saver economies now agree to spend lavishly (instead of lending) to right the balance. They will have to do this by sacrificing some of their old firepower and growth.

Welfarism has serious limits 

Both the US and Europe are capitalist economies that took on excessive burdens on social security – Europe more than the US – which cannot be sustained by economic activity. The US economy is sinking under the weight of its unaffordable social security (mainly medical benefits) and pensions. Europe – where the welfare state is even worse. Till recently, Europe’s inflexible economy was willing to tolerate high unemployment by doling out more by way of state benefits. This is unsustainable.