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Euro Crisis Simplified

Posted in Finance Articles, Total Reads: 1875 , Published on November 03, 2012

The idea of creation of common currency for countries belonging to the European Union was formed so that there is better integration among EU countries & also there is a possibility of creation of an alternate reserve currency vis-à-vis the dollar. The countries which wanted to use this common currency had to sign the Maastricht Treaty which had the following clauses:

  1. Inflation rate of the participating country should not be higher than 1.5% of the average inflation rate of the 3 best performing countries in Eurozone
  2. The ratio to government deficit to GDP for a year should not exceed 3%
  3. The ratio of government debt to GDP should not exceed 60%
  4. The long term interest rate for a country should not be higher than 2% than the 3 lowest inflation states

Any country that satisfied the above conditions would be allowed to use the common currency. By adopting Euro as their currency & being part of monetary union countries received a higher credit rating which helped them borrow at lower rates. As a result countries like Greece, Portugal & Italy borrowed more & more money at lower interest rates with longer maturities. Also, there was irresponsible spending by many of these countries in areas of public welfare, wage hikes & no formalized structure which would help them earn amount of revenue that they were spending each year.

It was also reported that some of the clauses of Maastricht Treaty were breached by these countries & they used creative accounting techniques to hide these discrepancies.The clauses mentioned in Maastricht treaty were broken by few member nations. Government debt instead of being limited got doubled in these years with only 5 countries having their debt below 60% of GDP. Also government deficit was not capped, with only 4 countries falling below 3%. Also a clause in the Treaty which restricted countries from being bailed out in case of economic problems got broken when a bailout package got designed for Greece, Portugal & Ireland.

All these were concealed in the years prior to 2008 where the governments were able to pay timely interest on their borrowings due to well-functioning global economy. Problems surfaced in 2008, when there was economic downturn & countries were not able to make timely interest payments. It was on Jan 14,2009 that for the first time, Standard & Poor downgraded Greek government bonds to A- , the lowest rating among Eurozone member states. It also strangely presented the start of a big crisis that was about to unravel.

Now that Greek bonds were downgraded, investors started demanding a higher premium for lending to Greece, which led to an increase in their borrowing costs. This leads to a vicious cycle where a country has to pay a higher cost for borrowing which further leads to more fiscal strain, which further increases borrowing cost. S&P also predicted in October 2009 that Greek Debt would increase to 125% of GDP by 2010.As a result, it became more costly to hedge a Greek bond against default. On April 27, 2010 Greek debt was downgraded to junk status. Thus, yields on 2 year Greek bonds rose 13% up from 6.3% a few days before. Also, the yield for 10 year bonds went above 10%. Speculators used this as an opportunity to bet on the downfall of the euro & the fact that richer northern European countries will try to rescue the smaller countries.

They speculated using Credit Default Swaps or CDS, which is an instrument that lets you buy insurance on a vehicle or house you don’t own. Whenever there is damage to that vehicle or house you get compensated for it even though you do not own it. Speculators used CDS to bet that Greek bonds would lose value. If that happened investors would get compensated for it. To avoid further damage European Central Bank (ECB) started buying more of Greek bonds. Thus ECB ended up owning a lot of junk bonds which increased its risk. In countries like Greece where economic assistance was provided, the assistance came with a lot of austerity requirements which led to unrest within the country.

The root cause of the crisis was the idea to have a monetary union within the member countries without the presence of a fiscal union. As a result monetary policy is designed by the central bank but fiscal policy is designed by the member countries independently. So if a country does not manage its finances with responsibility it does not have the option to devalue its currency & make its exports more competitive & find a way to earn money. Another outcome of the monetary union was that countries like Spain could not increase interest rates even though they saw a huge real estate bubble building up. One more outcome of the Euro has been that it has increased the friction between states as the southern states feel that northern states are imposing unreasonable austerity measures on them.

The way forward

Let Germany, Finland, France, Austria & Netherlands exit the euro & have their own common currency. This currency could have a higher value due to higher competitive nature of these countries. The remaining countries in EU could use same currency Euro but could have it devalued so as to increase their competitiveness. For this to get implemented the northern states like Germany will have to forgo significant portion of their debts that they have lent to southern states like Greece.  It will also require creation of another central bank which will take care of new currency of the above states.

Another solution could be to have a fiscal union among the member countries in addition to the existing monetary union. For this to be implemented a huge amount of bailout or debt haircut will have to be arranged by the richer northern states to take care of the huge debt piled up by some of these countries. This would also require countries to strictly follow the amendments of Lisbon or Maastricht Treaty which they haven’t followed till now.

Depending on the solution adopted by EU will decide the fate of Euro & its existence in the future.

This article has been authored by Akshay Iyer from SIBM Pune.

Image courtesy of FreeDigitalPhotos.net

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