Dear readers, I know that in my last post I promised to talk more about valuation. Believe me I haven’t forgot that. But I am bound to discuss the pressing issue of eurozone crisis as it is affecting the life of all of us. Every day we hear and read about euro debt crisis and saving euro. But all the issues are reported in isolation so we don’t get an overall picture. In this post I would try to provide a complete picture by answering some basic questions asked by all. So to begin with the first question should be:
What is Eurozone crisis?
We all know that the currency euro is used by eurozone in 17 countries. Each member country has its own central bank and the overall eurozone has a central bank called European Central Bank (ECB). The main aim of ECB is to maintain a price stability throughout eurozone by maintain an inflation rate of close to but not more than 2%. To achieve this aim the ECB sets the interest rate it would charge for giving out loan to the banks which ultimately determines the interest rates charged by commercial banks on loan. Here an interesting point to note is that usually a country like UK determines its own monetary and fiscal policy. With eurozone the member countries have their own fiscal policy (i.e. tax rates) but the monetary policy is determined by the ECB which is an independent body and any country has no direct control over it. So if one member country like Greece wants to change its monetary policy, it can’t.
Now we would come to the main part, the debt crisis. To begin with, the first thing to understand is the main source of income for a country is the tax revenue that it collects which is spent for the welfare of the citizen like social welfare, infrastructure, military etc. Now as a normal household, we generally spend depending on our income. What if in a month we need to spend more than we earn? We would borrow some money from the bank and in the next month spend less, save some money and payback the bank. When a country spends more than it earns it is called budget deficit which it finances form banks by issuing its bonds. Because the countries like Greece, Portugal, Ireland, Spain and Italy are members of eurozone and had top credit ratings, the banks had no problem giving those loans so these countries can borrow at low interest rate. But this borrowing went beyond their means to payback which came into light in 2010. As these countries and mainly Greece had no money to payback the maturing debt, it had to raise more debt and this is what they had been doing. But at this point, the creditors (banks) lost confidence in these countries and they knew that it is not safe to give these countries any loan as they would not be able to pay it back. To take the extra risk, the banks started demanding higher interest rates on their loan which reached over 60% for Greece 2 Year bonds. For the countries struggling to pay their original loans, paying such high interest is impossible. At this point, if these countries are left alone they would default which would have serious repercussions for the global economy. This could be understood by the fact that the bankruptcy of an American Investment bank Lehman Brothers had spread such a contagion which ultimately resulted in the financial crisis, what would happen if some countries in the eurozone default on their debt? To prevent this from happening ECB and IMF decided to help these countries by giving them bailout funds. Greece alone had been promised a package of €110 billion and a further €109 billion. The main aim of these bailouts is that the economy of the country would improve and it would again be possible for it to borrow money commercially. But this is not happening as the rating agencies have downgraded the Greek bond to the junk category. So the bad economic condition of many eurozone countries with some on the brink of default is what is termed as eurozone debt crisis.
Why don’t the ECB let Greece default?
Greece can be thought of as a patient on his death bed who is kept alive on life supporting machines. You remove these machines and the patient would die. But his death would be a huge blow for his family and friends. Greece is living on the bailouts which are not enough for it to get better owing to its vast amount of debt. And these bailouts are not free, they come with conditions attached. Greece has to reduce its budget deficit which can only be done by spending less and taxing more, the so called austerity measures. This on top of already high unemployment rate in Greece is highly protested against. Also Greece can only affect its fiscal policy as the monetary policy is controlled by the ECB. Usually under this condition a country can dilute its debt outstanding by increasing the inflation following a loose monetary policy. But Greece has not got this option. So what if Greece defaults? The biggest lenders for Greece is the European banks, so if Greece defaults on its debts these banks would have to write-off its loans which would lead to great loss for these banks and they would themselves need huge bailout packages from government. A lot of American banks have written Credit Default Swaps (CDS) against the European Sovereign debt. These countries defaulting means the American banks would be in trouble. The ECB itself has brought a lot of these debts, so a default means ECB taking a huge hit. If the banks collapse there would be no credit in the market, the money market would freeze, signs of which can already be seen. The contagion won’t stop there as the borrowing cost for other troubled countries like Spain, Ireland, Portugal and Italy would go through the roof and the size of these economies is a lot larger than Greece , ECB hasn’t got enough firepower to bail them out. The bottom line is the already suffering global economy would be in deep trouble and the whole economy would collapse.
So what is being done?
The eurozone leaders are holding summits and are pushing towards some agreements. There are many options to be explored:
● Letting Greece pay less than it owes. This simply means that the creditors won’t get back all that they owe. Initially it was said that the banks would take a ‘haircut’ of 20% but now the discussion is over 50%. The French banks have the highest exposure against these loans, so France is opposing such a move. The debt level can be seen from the following figure:
● Increasing the size of European Financial Stability Facility (EFSF) from €440 billion to about €2 trillion. EFSF is a company which was agreed by the countries that share the euro on May 9th 2010 and incorporated in Luxembourg under Luxembourgish law on June 7th 2010. The EFSF’s objective is to preserve financial stability of Europe’s monetary union by providing temporary financial assistance to euro area Member States in difficulty. But confusion is over how this assistance would be provided. Some are suggesting the guarantee of a portion of default on debt by any member states; others are in favour of using the money to bailout countries in trouble. No one is certain if the €2 trillion would be enough to bailout big economies like Spain and Italy. Also debate is over how the size of this facility can be increased. There are two options, either leveraging EFSF or increasing the amount it could raise through bond issue guaranteed by the member states.
● The third option is to safeguard the banks by providing them rescue packages and letting Greece default. This would restore confidence in European banking sector which has been worst hit by this crisis.
Whatever is to be done should be done now. The market needs some solid and firm steps to calm down. The anxiety and volatility of the market results in the market rally one day on some good news and sell off for the next four days on some bad news. The investors no longer can be certain as to which is a safe investment as no one is certain of who and to what extend is exposed to these debts and what would happen in case of a default. The eurozone leaders must take decisive actions to save the euro and the world economy. Feel free to leave your insightful comments and join the blog if you like it. I would end this post with a cool song on the eurocrisis, it can be found at http://www.guardian.co.uk/business/video/2011/jul/14/euro-crisis-song-video
Keep tuned as there is more to come....
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