European debt crisis

In early 2010, following downgrading by international ratings agencies, fears of a sovereign debt crisis developed concerning some countries in the Euro Area, specifically: Greece, Spain, Ireland, and Portugal. This led to a crisis of confidence as well as the widening of bond yield spreads and risk insurance on credit default swaps between these countries and other Eurozone members, most importantly Germany.

Concern about rising government deficits and debt levels across the globe together with a wave of downgrading of European Government debt has created alarm on financial markets. In Europe the debt crisis has been mostly centred on recent events in Greece where there is concern about the rising cost of financing Greek Government debt.

Global context

Niall Ferguson writes that "the sovereign debt crisis that is unfolding ... is a fiscal crisis of the western world". Financing needs for the Eurozone in 2010 come to a total of €1.6 trillion, while the US is expected to issue US$1.7 trillion more Treasury securities in this period, and Japan has ¥213 trillion of government bonds to roll over. The countries most at risk are those that rely on foreign investors to fund their government sector. According to Ferguson similarities between the U.S. and Greece should not be dismissed.

Rising bond yields in some government bond markets have intensified the fear that the emerging sovereign debt issues could become a global contagion. Given the deterioration in government accounts there is growing concern that this crisis will spread to the United States which has a limited domestic savings pool, a high public sector deficit, and a large accumulated government debt and relies on foreign capital inflows for funding, in contrast to the Euro Area which does not.

Recent U.S. government bond auctions have been very poorly received , both because of the perceived risk associated with a U.S. Dollar depreciation relative to the Chinese RMB and because of the enormous funding requirement of the U.S. government. Some commentators have termed recent U.S. public debt auctions "failures".

Greek government funding crisis

Causes

The Greek economy was one of the fastest growing in the eurozone during the aughts. From 2000 to 2007 it grew at an annual rate of 4.2%. Despite this rapid growth, the government of Greece continued to run large structural deficits, and in the last ten years government debt has never fallen below 100% of GDP. The keep within monetary union guidelines, the government of Greece has also been accused of misreporting the true financial state of the country during this period.

The global financial crisis that began in 2008 had a particularly large effect on Greece. Two of the countries largest industries are tourism and shipping, and both were badly effected by the downturn with revenues falling 15% in 2009. In 2009 the government of George Papandreou revised its figures, upping the reported deficit from 5% to 12.7%.

Greece government deficit is currently estimated to be 13.6%which one of the highest in the world relative to GDP. Greek government debt was estimated at €216 billion in January 2010. [5]Accumulated government debt is forecast, according to some estimates, to hit 120% of GDP this year. This is considerably more than the OECD average of circa 80% One of the key problems surrounding the Greek government bond market is its reliance on foreign investors with some estimates suggesting that up to 70% of Greek government bonds are held externally.

Austerity measures

In an attempt to lower its cost of financing and calm bond markets, the Greek government has introduced fiscal austerity and appealed to the EU for assistance in lowering the cost of refinancing its large public debt and in fending off speculative attacks on its bond market.

On March 5, 2010, the Greek parliament passed the Economy Protection Bill, expected to save €4.8 billion through a number of measures including public sector wage reductions. Passage of the bill occurred amid widespread protests against government austerity measures in the Greek capital, Athens. On 23 April 2010, the Greek government requested that the EU/IMF bailout package be activated. The IMF has said it was "prepared to move expeditiously on this request". The size of the bailout is expected to be €45 billion ($61 billion) and it is expected to take three weeks to negotiate, Greece will need some of the money before 19 May, when it faces a debt roll over of $11.3bn.

Downgrading of debt

On 27 April 2010, the Greek debt rating was decreased to 'junk' status by Standard & Poor's amidst fears of default by the Greek government. Yields on Greek government rose to 15.3% on two-year government bonds following the downgrading.. Some analysts question Greece's ability to refinance its debt. Standard & Poor's estimates that in the event of default investors would lose 30–50% of their money. Stock markets worldwide declined in response to this announcement.

Following downgradings by Fitch, Moody's and S&P , Greek bond yields rose in 2010, both in absolute terms and relative to German government bonds. Although all Greek government bond auctions this year have been over subscribed, yields have risen, particularly in the wake of successive ratings downgrading.

Immediately after the most recent downgrading, European Commission officials have warned rating agencies that Brussels is ready to intervene using new EU regulations to curb their influence.

Greek government bond Auctions have all been over-subscribed in 2010 [6]. According to the Financial Times on January 25, 2010 "Investors placed about €20bn ($28bn, £17bn) in orders for the five-year, fixed-rate bond, four times more than the (Greek) government had reckoned on." In March, again according to the Financial Times, "Athens sold €5bn (£4.5bn) in 10-year bonds and received orders for three times that amount." Similarly in April 2010 the sale of more than 1.5 billion euros ($2 billion) in Treasury bills met with "stronger-than-expected" demand.

Possibility of default

The premiums on Greek debt have risen to a level that reflect a high chance of a default or restructuring. One analyst gives an 80 to 90% chance of a default or restructuring. Martin Feldstein has called a Greek default "inevitable." A default would most likely take the form of a restructuring where Greece would pay creditors only a portion of what they were owed. Perhaps 50 or 25% This would effectively remove Greece from the Euro, as it would no longer have collateral with the European Central Bank. It would also destabilize the Euro Interbank Offered Rate, which is backed by government securities.

The overall effect of Greece being forced off the euro, would itself be small for the other European economies. Greece represents only 2% of the eurozone economy. The more severe danger is that a default by Greece will cause investors to lose faith in other European countries. This concern is focused on Portugal, Ireland, Spain, and Italy. All of whom have high debt and deficit issues. Spain and Italy are far larger and more central economies, and a default by either of them would have dramatic repercussions. Both countries have most of their debt controlled internally, and are in a better fiscal situation than Greece and Portugal making a default unlikely unless the situation gets far more severe.

Proposed solutions

Germany, which can borrow at the lowest interest rates in the E.U, has been looked to as the source of a potential bailout for the Greek government should it fail to raise the necessary money to fill its budget gap through the credit markets. A potential Greek bailout has proven unpopular in Germany, and with upcoming provincial elections German Chancellor Angela Merkel has been reluctant to promise Greece a cash bailout, though on March 5, 2010 did promise that Germany would "stand by Greece." Greek Prime Minister George Papandreou's suggestion that his country seek relief from the International Monetary Fund was met negatively by the President of the European Central Bank, Jean-Claude Trichet.

Role of credit rating agencies

The international credit rating agencies – Moody's, S&P and Fitch – have played a pivotal and controversial role in the current European bond market crisis. These agencies entered 2010 with their reputations already severely damaged by their consistent failure to identify real risks evident in their failure to downgrade U.S. sub-prime mortgage bonds in 2007 prior to the recent financial crisis. The failures of agencies to accurately identify risk where it exists dates back decades, ratings agencies did not identify Enron as a risk, they failed to predict the bankruptcy of all the largest Icelandic banks in 2008 and the consequent severe financial weakening of Iceland itself, they failed to identify risks in the Newly Industrialised Countries in Asia before the Asian crisis of the 1990s and they failed in Latin America.

The German finance minister has said traders should not take global rating agencies "too seriously" following downgrades of Greece, Spain and Portugal. Guido Westerwelle, German foreign minister, called for an "independent" European rating agency, which could avoid the conflicts of interest that he claimed US-based agencies faced. According to the Financial Tmes "The latest furore over the agencies’ role in the sovereign debt market" is likely to bring about more supervision of these agencies.

In an effort to limit the damage caused by rating downgrades the European Central Bank has announced that it will keep accepting BBB- rated debt as collateral past the end of the year, ensuring Greek bonds will still be eligible even as the country's credit rating deteriorates. Meanwhile, European leaders are reportedly studying the possibility of setting up a European ratings agency in order that the U.S.-based ratings agencies have less influence on developments in European financial markets in the future. Given what is seen by many as the reckless conduct of the ratings agencies European regulators will be given new powers to supervise ratings agencies. These supervisory powers will come into effect in December 2010.

Controversies

There has been considerable controversy about the role of the English-language press in the regard to the bond market crisis. The Spanish Prime Minister has ordered Spanish intelligence services to investigate the role of the Anglo-Saxon media in fomenting the crisis. No results have so far been reported as a result of this investigation.

According to the Spanish newspaper "El Pais" "the National Intelligence Center (CNI) was investigating "whether investors' attacks and the aggressiveness of some Anglo-Saxon media are driven by market forces and challenges facing the Spanish economy, or whether there is something more behind this campaign."". The Spanish Prime Minister has suggested that the recent financial market crisis in Europe is an attempt to draw international capital away from the Euro in order that countries, such as the U.K. and the U.S. can continue to fund their large external deficits which are matched by large government deficits. The U.S. and U.K. do not have large domestic savings pools to draw on and therefore are dependant on external savings. This is not the case in the Euro Area which is self funding.

The Greek Prime Minister Papandreou is quoted as saying that there was no question of Greece leaving the euro and suggested that the ­crisis was politically as well as financially motivated. "This is an attack on the eurozone by certain other interests, political or financial".

The role of Goldman Sachs in the Greek bond 'crisis' is also under scrutiny . It is not yet clear to what extent this bank has been involved in the unfolding of the crisis or if they have made a profit as a result of the sell-off on the Greek government debt market. Speculators and hedge funds engaged in selling Euros have also been accused by both the Spanish and Greek Prime Ministers of worsening the crisis. Angela Merkel has stated that "institutions bailed out with public funds are exploiting the budget crisis in Greece and elsewhere".

Spread beyond Greece

According to the Financial Times: "So far, investors have concentrated their ire on peripheral eurozone economies because of the zone's inability to resolve cleanly the Greek crisis. That is understandable, say many economists, but they add that the focus on continental Europe is unfair."

According to David Mackie of JPMorgan "the euro area has the fiscal capacity to backstop banks across the region and to support the sovereign states of Greece, Spain, Portugal and Ireland, along with some help from the IMF." Jürgen Stark, a European Central Bank executive board member, said restoring sustainability to the public finances was "even harder for the UK, the US and Japan. Given their high budget deficits and the high and rising debt levels". Mr Stark's analysis is not merely an attempt to divert attention from the eurozone. It is identical to that of the IMF.

The fund believes that most advanced economies need to tighten fiscal policy significantly in the next decade to stabilise debt at 60 per cent of national income by 2030. The tightening needed in the US, Japan and the UK is just as bad as that required in Greece, Spain, Ireland and Portugal.

The crisis has reduced confidence in other Eurozone economies. According to some analysts Ireland, with a government deficit of 14.3 percent of GDP, Spain with 11.2 percent, and Portugal at 9.4 percent are most at risk. In April 2010, following a market increase in Irish 2-year bond yields, Ireland's NTMA state debt agency said that it had "no major refinancing obligations" in 2010. Its requirement for €20 billion in 2010 was matched by a €23 billion cash balance, and it remarked: "We're very comfortably circumstanced".

Since the crisis began yields have risen as rating agencies downgraded debt. As a result of these downgrades, fears were raised over the possible contagion effect to other bond markets in vulnerable Eurozone countries. The focus on government debt has led to a weakening of the euro which was welcomed in Germany, one of the world's leading exporters.

Long term solutions

European Union leaders have made two major proposals for ensuring fiscal stability in the long term. The first proposal is the creation of a common fund responsible for bailing out, with strict conditions, a EU member country in the brink of default. This reactive tool is sometimes dubbed as the European Monetary Fund by the media. The second much older proposal is the construction of single authority responsible for tax policy oversight and government spending coordination of EU member countries. This preventive tool is dubbed as the European Treasury. The monetary fund is to be financially supported, at least initially by EU member governments, and on the other hand, the treasury is to be financially supported by the European Commission. All of the EU proposals involve giving greater power to EU institutions and reducing policy choices of EU member states.

Some European think-tanks such as the CEE Council have argued that the predicament some Mainland EU countries find themselves in today is the result of a decade of debt-fueled Keynesian policies pursued by local policy makers and complacent EU central bankers, and many economists have recommended the imposition of a battery of corrective policies to control public debt. Some senior German policy makers went as far as to say that emergency bailouts should bring harsh penalties to EU aid recipients such as Greece.

But other experts argue that an abrupt return to “non-Keynesian” financial policies isn’t a viable solution for Southern EU countries and predict the deflationary policies now being imposed on countries such as Greece and Spain might prolong and deepen their recessions.

Regardless of the corrective measures chosen to solve the current predicament as long as cross border capital flows remain unregulated in the Euro Area [7], asset bubbles [8] current account imbalances are likely to continue. The suggestion has been made that long term stability in the eurozone requires a common fiscal policy rather than controls on portfolio investment. In exchange for cheaper funding from the EU, Greece and other countries, in addition to having already lost control over monetary policy and foreign exchange policy since the Euro came into being, would therefore also lose control over domestic fiscal policy.

However, strong European Commission oversight in the fields of taxation and budgetary policy and the enforcement mechanisms that go with it have been described as infringements on the sovereignty of eurozone member states and are opposed by key EU nations such as France and Italy, which could jeopardize the establishment of a European Treasury.

Objections to proposed policies

The Greek government bond market sell off is seen as justification for imposing fiscal 'austerity' on Greece in exchange for European funding which would lower borrowing costs for the Greek government. The negative impact of tighter fiscal policy would though offset the positive impact of lower borrowing costs and social disruption could have a significantly negative impact on investment and growth in the longer term.

Fiscal austerity leading to a deeper recession would see Greek bond markets rally and Greek yields fall thus guaranteeing that European holders of Greek government debt would retain the value of their investments at the cost of a severe contraction of the Greek economy. Draconian fiscal policy measures aimed exclusively at lowering Greek bond yields would increase the mark-to-market value of Greek government bonds at the expense of the Greek people. The 'rescue package' proposed by the EU and IMF [9] would simply protect foreign holders of Greek government bonds, who invested in Greek bonds at inflated values, at the expense of the local economy. Such policies have been used frequently by the IMF in recent decades, and have attracted much criticism.

Wilhelm Hankel, emeritus professor of economics at the University of Frankfurt/MainSome, suggested in an article published in the Financial Times, that the preferred solution to the Greek bond 'crisis' is a Greek exit from the Euro followed by a devaluation of the currency. Fiscal austerity or a Euro exit is the alternative to accepting differentiated government bond yields within the Euro Area. If Greece remains in the Euro while accepting higher bond yields, reflecting it's high government deficit, then high interest rates would dampen demand, raise savings and slow the economy. An improved trade performance and less reliance on foreign capital would result.

Timeline of Greek crisis

Below is a brief summary of some of the main events in the Greek Sovereign debt crisis.

October 2009

• A new Greek government is formed after the election, led by PASOK, which received 43.92 % of the popular vote, and 160 of 300 parliament seats.

November 2009

• 5 Nov.: New budget draft reveals a deficit of 12.7% of GDP, more than twice the previously announced figure.
• 8 Nov.: Final budget draft aims to cut deficit to 8.7% of GDP in 2010. Draft also projects total debt rising to 121% of GDP in 2010 from 113.4% in 2009.

December 2009

• Dec. 8: Fitch Ratings cuts Greece's rating to BBB+ from A-, with a negative outlook.
• Dec. 14: Greek PM Papandreou outlines first round of policies to cut deficit and regain investor trust.
• Dec. 16: S&P cuts Greece's rating to BBB+ from A-.
• Dec. 22: Moody's cuts Greece's rating to A2 from A1.

January 2010

• Jan. 14: Greece unveils the Stability and Growth Program which aims to cut deficit from 12.7% in 2009 to 2.8% in 2012.
• Jan. xx: 5-year bond issue is five-times oversubscribed but yields and spreads rise.

February 2010

• Feb. 2: Government extends public sector wage freeze to those earning less than EUR 2,000 a month.
• Feb. 3: EU Commission backs Greece's Stability and Growth Program and urges it to cut its overall wage bill.
• Feb. 24: One-day general strike against the austerity measures halts public services and transport system.
• Feb. 25: EU mission in Athens with IMF experts delivers grim assessment of country's finances.

March 2010

• Mar. 5: New public sector wage cuts and tax increases is passed and estimated to generate savings of EUR 4.8 bn. Measures include increasing VAT by 2% to 21%, cutting public sector salary bonuses by 30%, increases on fuel, tobacco and alcohol consumption taxes and freezing state-funded pensions in 2010.
• Mar. 11: Public and private sector workers strike.
• Mar. 15: EMU finance ministers agree on mechanism to help Greece but reveal no details.
• Mar. 18: Papandreou warns Greece will not be able to cut deficit if borrowing costs remain as high as they are and may have to go to the IMF.
• Mar. 19: European Commission President José Manuel Barroso urges EU member states to agree a standby aid package for Greece. Barroso says the EMU countries should be on stand by to make bilateral loans.
• Mar. 25: ECB President Jean-Claude Trichet says his bank will extend softer rules on collateral (accepting BBB- instead of the standard A-) for longer (up to 2011) in order to avoid a situation where one ratings agency (Moody's) basically decides if an EMU country's bonds are eligible for use as ECB collateral.
• Mar.: €5bn in 10-year Greek bonds sold - orders for three times that amount are received.

April 2010

• Apr. 11: EMU leaders agree bailout plan for Greece. Terms are announced for EUR 30 bn of bilateral loans (roughly 5% for a 3-year loan). EMU countries will participate in the amount based on their ECB country keys. Rates for variable rate loans will be 3m-Euribor plus 300 bp + 100 bp for over 3-year loans plus a one-off 50 bp charge for operating expenses. For fixed rate loans rates will be swap rate for the loan's maturity, plus the 300 bp (as in variable) plus the 100 bp for loans over 3 years plus the 50 bp charge.
• Apr. 13: ECB voices its support for the rescue plan.
• Apr. 15: Olli Rehn says there is no possibility of a Greek default and no doubt that Germany will participate in the bail out plan. In the mean time there had been serious objections from parts of German society to the country's participation in the Greek bail-out.
• Apr. Sale of more than 1.5 billion euros Greek Treasury bills met with "stronger-than-expected" demand, albeit at a high interest rate.
• Apr. 23: Greece officially asks for the disbursement of money from the aid package effectively activating it.
• Apr. 27: Standard and Poor's downgrades Greece's debt ratings below investment grade to junk bond status.
• Apr. 27: S&P downgrades Portugese debt two notches and issues negative outlook, warning that further downgrades to junk status are likely. Stock indices around the world drop two to six percent on the news.
• Apr. 28 S&P downgrades Spanish bonds from AAA to AA-

See also

• Economy of Greece
• Junk Bond