Posted in Finance Articles, Total Reads: 13199
, Published on 26 March 2012
European Union (EU), established by the Maastricht Treaty in 1993, introduced the common currency ‘Euro’ on January 1, 1999. On this day, 11 member nations of the European Union started using Euro as their currency. It benefited countries such as Portugal, Ireland, Greece and Spain (together now known as the PIGS) that could now borrow money at interest rates applicable for economically stronger nations like Germany.
The other nations in Europe started using Germany's credit rating to finance their expenditures; in effect, borrowing as cheaply as the Germans and buying stuff they couldn't afford otherwise. Consequently, the PIGS nations and other smaller economies of Europe racked up enormous debt in Euros. In addition to the low interest rates, the inflation in the PIGS nations was higher than the rate of interest. A job which pays 55,000 Euros in Germany pays 70,000 Euros in Greece, even with the fact that Germany is a more productive nation.
To make matters worse, certain sections of the society decided to cash in on the social security schemes. Take the case of Greece which categorises 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 roll out pensions, above 600 Greek professions somehow managed to get themselves classified as arduous. So how does the Greek government support this kind of extravagance? By debt financing, obviously. Spain, another PIGS nation, has had its share of trouble as well. Housing bubbles are not new but considering the fact that Spain had the biggest housing bubble in the world makes you notice the enormity of the crisis at hand. 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 debt in real estate is around 50 per cent of its GDP.
And now, with the clouds of sovereign debt default looming large over Europe, the European Central Bank (ECB) readily helps out with a bailout to avert a contagion. Since the start of the financial crisis ECB has bought, outright, something like $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. All this, keeping in consideration, out of the126 nations with rated debt, Greece is ranked 126th.
The situation is pretty messy because it is interlinked. Take the case of Germany, which keeps contributing to 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.
And Austrian banks have lent 140 per cent of their GDP to nations 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,nations which aspire to have Euro as their currency someday.
Bluntly put, Europe’s financial system is dysfunctional and unsustainable in the medium to long term without drastic reform measures. The first step out of this mess would be to regain investor confidence in EU’s bond markets, specifically the PIGS nations.
This would enable them to raise capital from the market and not wait for bailouts from ECB and other institutions. However regaining investor confidence would not be an easy task as seen in the bond auctions in Europe. Bond buyers demanded higher yields on Italian and Spanish debt barely a day after European leaders announced a series of measures to end the debt crisis.
Off late the focus has shifted from the PIGS nations to Italy which is indebted to the tune of €1.9 trillion, with more than €200 billion of debt coming due next year. Some analysts fear that unless Italy lowers its borrowing costs it could very well find itself in the middle of a flare-up in the crisis. In the recent bond auction, Italy paid 6.06% interest on its new 10-year debt, up from 5.86% only a month ago – interest rate levels that some analysts feel the nation can’t afford for long.
This article has bee authored by Pankaj Baid from Symbiosis Institute Of International Business.