European Debt Crisis- the Situation, Consequences & Way Ahead

Posted in Finance Articles, Total Reads: 9695 , Published on 29 October 2011
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European Sovereign Debt Crisis is the current economic situation in which the entire Euro zone will not be able to pay its debt obligation, if the economic situation does not improve in the future. The issue regarding the Europe crisis talks about the 17 European countries which have common currency ‘Euro’. The seeds of Europe debt crisis which the world is facing today were sown way back in 1999 when the proposal for common currency ‘Euro’ for the trade benefit and inclusive economic growth of the entire Europe was implemented. Greece entered the Euro zone in October 2000 based on its economic compatible condition although even then Greece had a high budget deficit and it is still blamed for under reporting its critical figures in order to get in the Euro zone.

 

In late 2000 due to financial crisis the Greece largest industries, tourism and shipping, were badly affected. The Greece had joined the group knowing that it would be easier for it to get the debt with a globally strong currency Euro. The Greeks continued lavish spending (events like Athens Olympic which are reported to cost Greece several times more than the estimated cost, public care) combined with long following trade deficits and large tax evading population lead the Greece budget deficit and public debt to rise to insurmountable amount. And now the deficit percentage and the debt to GDP ratio for the Greece are highest among all the European States. Adversaries like housing bubble in Spain and speculation by traders in Portugal leads to similar situations in these countries as well. These European peripheral countries (PIIGS) borrowed enormous amount of debt in Euros and hence have huge sovereign debt obligations (Fig1).

For example, Greece has a total debt of $540 billion dollars, 125% of its GDP (Fig3). In order to raise money to pay its debt obligations, the Greece increased the interest rate on its bonds to 15%(Fig2).But because of the already piled up huge debt obligation, there is huge risk involved in investing in Greece sovereign bonds as they might default, therefore nobody is buying Greek bonds. Greece’s ten year bonds have been reduced to junk status by Moody’s which downgraded them to CA rating, just one rating above default. Other PIIGS economies are facing the similar problem .The markets expressed concerns over PIIGS ability to repay its debt which it has taken from stronger economies like Germany, France, UK, US and others. This creates another problem ‘the contagion effect’.

CONSEQUENCES: WORST CASE SCENARIOS

What if the Greece defaults? This can lead to cascading economic aftermaths:

The world around: All the major countries have provided enormous debt to Greece .If Greece defaults on its debt; this will have cascading effects on other economies. Most probably then other PIIGS economies will also default. The banks of those countries which have provided the debt to PIIGS will face tremendous liquidity crunch and the people will face huge credit crunch where they would not be able to borrow money. This would lead to low production, less development, reduced trade and a situation leading to global economic depression.

INDIA: India’s developing economy is dependent on FDI and FII. If Greece defaults on its debt all the liquidity in the region would vanish. All the companies and banks that have invested in these bonds would be in severe need of liquidity. In order to raise money, they will liquidate their stocks and securities in which they have invested in India and other markets around the world. All the stock markets would suffer heavily and the markets of the developing countries like us may crash. Indian companies that were seeking to raise money in foreign markets due to rise in interest rates in India will not be able to find any lender in international markets.

THE WAY AHEAD

Bailout: Though for now the Greece has been temporarily saved from defaulting through a bailout package of 109billion Euros or $ 155 billion by EU and the IMF. They have provided them the soft loans at the relatively very low rate of 3.5% and with a term period of 15-30 years. But it is still not a permanent solution, Greece needs continuous flow of surplus funds to pay its debt obligations and EU members themselves are suffering from the contagion effect. Therefore, expectation of bailout funds from them does not seem to be a plausible solution.

China coming into picture: China with a tremendous foreign reserve of $3.2 trillion may come into picture as its trade exports cover very large part of EU. And if the euro depreciates then it would affect the profit margins of China. China with its enormous foreign reserve can help Greece to pay its debt obligation and can get long term returns at high interest.

Greece opting out of Euro zone: One of the most advised opinions for Germany is to opt out of EU and restart with its older domestic currency ‘Drachma’. With this it would be able to devalue its currency and start doing the business with the other countries providing the products and services at cheap value because of its undervalued or depreciated currency. The sustained trade surplus and increased domestic consumption are the only plausible ways through which it can pay its debt obligation.

Definitely, Greece carries only a part of the Europe debt and solving the Greece debt crisis will not be the answer for the entire Europe. But Greece has the highest debt to GDP ratio and is closest to default. Therefore solving the Greek Domino would definitely bring confidence in the European economies and the way ahead for the Euro zone to look out for.

Well, whatever the case may be and whatever the situation may arise in future, one thing is for sure that if EU occurs to exist, Stricter EU regulations and better transparency will be placed and the stability norms will never be flouted.

This article has been authored by Deepak Panwar from FMS Delhi



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