A HOLISTIC APPROACH ON EURO CRISISEUROPEAN UNIONThe European Union [EU] is a unique economic and political partnership between 27 Europeancountries. It was created after the Second World War for establishing political and economiccooperation among the member countries, so that they will be interdependent on each other.They thought it will deter other countries to wage war against them and also to prevent conflictamong themselves.To keep up with the modern day challenges like climate change, terrorism, globalization,economic and political stability a treaty was signed in December 13, 2007 by all the 27 membercountries in Lisbon. The Treaty of Lisbon defines what the EU can and cannot do. It also definesthe structure of the EU’s institutions and how they work. The Treaty entered into force on 1December 2009.EUROOn 1 January 2002, euro banknotes and coins were introduced in 12 Member States of theEuropean Union. Five more Member States have adopted the euro in recent years, so a total of17 Member States with 332 million people and other 175 million use the currency daily. TheEuro Zone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece,Ireland, Italy, Luxembourg, Malta, Netherland, Portugal, Slovakia, Slovenia, and Spain. The euro is the second largest reserve currency as well as the second most traded currency inthe world after the United States dollar. The euro is managed and administered by theFrankfurt-based European Central Bank (ECB). As an independent central bank, the ECB has soleauthority to set monetary policy for those 17 countries [like the RBI we have in INDIA].EURO CRISISThe crisis started when countries started to set aside the realty and lived beyond their capacity.During the credit boom, cheap capital flowed into Greece, Ireland, Portugal and Spain tofinance their trade deficits and housing booms. Easy loans with low interest rates resulted ininflation in wages and goods which in turn made their exports more expensive and left importsrelatively cheaper.But the countries started to feel the heat only after the global financial crisis 2008-2009. Duringthe crisis unemployment increased and revenue from tax dwindled. Countries had to refinance
their banks, which are exposed to the US subprime mortgages. Even before the crisis Europeancountries were running unsustainable current-account deficits [Occurs when a countrys totalimports of goods, services and transfers is greater than the countrys total export of goods,services and transfers. This situation makes a country a net debtor to the rest of the world]. Asa result, the net liabilities of some countries exceeded 100% of GDP. Governments in Greece,Portugal, Ireland, Spain and Italy have debts of about €3 trillion ($4.2 trillion).To some extent the investors and creditor countries are also to blame because of their blindbelief that no euro-zone government would default on its debt. A year ago 17 nations of theEuro Zone, ECB [European Central Bank], IMF [International Monetary Fund] created a bailoutfund to handle the debt crisis, but it didn’t work out the way it was intended. At that time theydidn’t realize the magnitude of the crisis. Right now the debt crisis is deeper and morewidespread than almost anyone feared at the start of the year. The crisis has already broughtdown governments in Italy, Greece, Ireland, Portugal and Slovakia.According to the September forecast of the IMF, Euro Zone’s GDP will grow by 1.1 % in 2012.But the austerity [measures taken by governments to reduce expenditures in an attempt toshrink their growing budget deficits] measures taken by the countries are around 1.25 % ofEuro Zone’s GDP. It is just one of the clear indicators that they will be pushed to recession.
EURO CRISIS AND AMERICAN SUBPRIME CRISISEuro crisis is similar to US subprime crisis [Loans offered to individuals who do not qualify for loansand they have a reasonable chance of defaulting on the loan repayment] that happened in 2008. Theroot causes are the same — too much debt and too little growth to service it. Greece and otherover indebted nations are like huge subprime borrowers who spent more than they couldafford by building up debt that they now cant pay back. Like big U.S. banks during the housingboom, many European banks had shoddy underwriting standards [The process by which alender decides whether a person, firm or company is creditworthy to receive loan] and boughtdebt that was far riskier than they realized. A Greek default could be the European equivalentof the Lehman Brothers bankruptcy in 2008, which started a run on the whole U.S. financialsystem.But the stark difference is that the US officials created TARP, the Troubled Assets ReliefProgram, which allowed them to inject capital into banks. Since theres no centralized fiscalauthority [Fiscal policy is carried out by their respective governments of those 17 Euro countriesbut the monetary policy is by one central bank (ECB)] in Euro Zone comparable to the U.S.Congress or the Treasury Dept it is hard to come up with a bailout. Because to come up withbailout plans these 17 countries should come to a consensus, which they are not doing.
EUROPEAN BANKS IN PERILEuropean Banks shares trade below their asset value. The amount of loans given by Europeanbanks already exceeded their deposits. So they have to sell their assets, check the lending andrely on short-term bills, longer-term bonds or loans from other banks. Now investors who wantto be on the safer side don’t want to expose themselves to the banks which have euro zonebonds on their books. Before the crisis the investors relied on the backing of the governmentsbut it is no longer applicable.With the debt of the countries increasing, at some point of time the banks of the countries willfind hard to refinance their own debts at a reasonable interest rate. With the assets of the EuroZone banks declining it will be more cautious in providing loans and it will increase the interestrates for the loans to the companies and consumers. It will result in credit crunch. It will alsocreate trust deficit among banks and will not lend to each other.Top 20 banks with high exposures to the PIIGS (Portugal, Italy, Ireland, Greece, and Spain)Bank Name Country Exposure Market capitalization [in billions] [in billions]Allied Irish Banks Ireland $129.02 $2.00Banca MPS Italy $290.98 $7.96Banco Popular Español Spain $182.94 $6.91Intesa Sanpaolo Group Italy $607.03 $51.06EFG Eurobank Ergasias Greece $76.01 $2.07BBVA Spain $552.90 $52.80Bank of Ireland Ireland $102.43 $1.39Unicredit Italy $541.54 $34.41Banco Santander Spain $567.20 $92.08Dexia Belgium $132.95 $5.229Commerzbank Germany $67.38 $18.45BNP Paribas France $280.96 $79.91Deutsche Bank Germany $140.61 $49.73Credit Agricole France $192.06 $29.97KBC Bank Belgium $39.70 $9.05DZ Bank Germany $24.69 $10.34Landesbank Baden-Württemberg Germany $32.05 $11.27Barclays UK $123.51 $43.91Landesbank Berlin Germany $13.11 $5.60Royal Bank of Scotland Group UK $146.42 $60.96Source: EBA [European Banking Authority] – Exposure, Bloomberg – Market capitalization
Exposure – Banks which have lend loans or having the bonds or bills of those PIIGS countries.Market Capitalization – Total number of shares multiplied by the current price of the share.WHAT THE CRISIS MEANT FOR BUSINESSAs a result of the crisis the banks will squeeze lending. Business will struggle to find source forits working capital. The business will start to lose their confidence in the system and alreadythere are reports that firms are postponing their investments and purchases. So businesses willtry to save cash by reducing their expenditure through less spending on capital projects,advertising campaigns and in some cases even layoffsVICIOUS FEED BACK LOOP Declining business activity will result in increase in the unemployment. The unemployment inSpain and Greece is 22.6 % and 18.4 % respectively. So the tax receipts will go down, welfaresand subsidies of the government will increase. It will again create budget deficit and increasetheir countries sovereign debts. It will push the countries into dilemma whether to go aheadwith the reforms and austerity measures, which their people will oppose strongly. Recent revoltagainst the austerity measures is just the beginning and many more to follow. Fear of theconsequences will then drive investors even faster towards the exits.
EURO CRISIS AND AMERICAU.S. government and banks dont have much direct exposure to Euro zone. American banks arealso in much better shape than those in Europe, thanks to their aggressive action in 2008 and tothe 2009 "stress tests" that forced many of them to raise more capital and strengthen theirbalance sheets. Big U.S. companies are also healthy, with strong profits, and few if any aredependent upon European banks. But Fitch one of the rating agencies says 50% of the U.S.money market funds are trapped in the commercial papers of the European Banks.A recession and financial crisis in Europe would weaken demand for American goods andservices in one of the worlds biggest markets, at a time when the U.S. economy is still trying tosolve its own problems. Since the Euro has the ability to take the whole world along with theminto recession America at some point of time will force Europeans to take action.EURO CRISIS AND BRITAINSo far Britain is just a spectator of the euro zone crisis. It is still reluctant to get itself into thenegotiation table. It already used its veto power against the initiative to change the Treaty ofLisbon for more fiscal union. The main reason for its behavior is, they don’t want to give theirfiscal independence and it has its own currency.But the reality is different. The economy of Britain is strongly dependent on exports and twofifth of its exports are shipped to Euro Zone. British banks are exposed to the Euro Zone byproviding loans of $350 billion (£220 billion) to Ireland, Spain, Italy, Portugal and Greece, which
is equal to 15% of its GDP. And $210 billion loan was provided to French and German banks,who are in turn lenders to Italy and Spain. So if Euro collapses then some of the British bankswill also collapse. London’s ambition to be the financial centre of the world will also take a hit.Sooner or later Britain will be forced to wake up to the euro crisis.EURO CRISIS AND FRANCEFrance is the strongest, next to Germany in the Euro region. But France is no exception to thecontagious nature of the Euro crisis. French banks are heavily exposed to the banks of Greece,Portugal and Italy. French banks hold £261bn of Italy debt. The unemployment rate is 9.7%,which is an all time high in 12 years and its trade deficit is staggering $97 billion.France wants ECB to act as a lender of last resort, which Germany rejects. France also doesn’tlike any kind of institution or countries to have role on deciding their national budgets.EURO CRISIS AND GERMANYGermany is in a position to determine the fate of the Europe. But the government is facing stiffopposition for bailouts backed largely by German tax payer’s money and they don’t want toprovide liquidity to countries that are unwilling or unable to solve their own problems.Germany’s surplus and savings were invested in Euro countries, collapse of the Euro will be aterrible outcome for Germany’s economy. It can be realized by the recent German bondauction which resulted in only selling of bonds worth €3.6 billion ($4.8 billion), of a potential €6billion issue.
Now Germany faces a dual task of saving the countries from contagion and forcing them tostick to the reforms and austerity measures [Measures taken by governments to reduceexpenditures].IMPLICATIONS OF EURO CRISIS ON INDIAIndia started to feel the impact of the Euro crisis, thanks much to the globalization. • Evolving US dollar as a hedge against Euro resulted in demand for the dollar. This results in the depreciation of rupee value against dollar [1 US$ = above 53 Rs]. • Capital flows will dry up because euro-zone banks provide half of India’s foreign loans and remittances from Europe will come down. • European Union share in India’s exports is 18%. So exports will also take a hit. • Indian companies don’t have exposure to the government contracts; the bulk of the business is with private players. IT companies will be in trouble if the problem spread to UK, because UK alone is generating more than half of the revenue from Europe.Due to the crisis the Euro economy will slow down and it will result in less demand, and in turndecreasing prices. This is the only silver lining for India because the declining global oil andcommodity prices, which could bring down inflation from double digit. In turn it will result ineasing interest rates, and it could be a boost for the industries.
WHAT COULD BE DONE • The only institution which can provide immediate relief is European Central Bank (ECB) which can offer unlimited liquidity for longer duration against broader range of collateral so that it can pacify the market panic and provide European banks with fresh capital. This credit will help the banks in lending and gives some time for the countries to reform their debt structure. But already ECB and Germany rejected the idea of ECB acting as a lender of last resort to Euro Zone countries. Because printing money and bailing out countries is against ECB’s founding charter. • Before any large scale bailouts Germany wants to have more fiscal integration among the European Union members by altering the Treaty of Lisbon. So that the creditor countries will have a say in the fiscal policy of the debtor countries. • China has the ability to save Euro since it has the world’s largest foreign exchange reserves of $3.2 trillion. But the country refused to aid any bailout and only agreed to provide indirect support through investment. • To lift the confidence of investors Euro Zone countries can bear joint liability for the government debts, which is also rejected by Germany. Because it will violate Germany’s constitution and raise its borrowing costs also they believe that, it will prevent the debtor countries from going ahead with the reforms and austerity measures. • Leaving the countries to default and exclude them from Euro Zone would also not work because it will result in contagion. If that’s the case then Greece will be first followed by Ireland, Portugal, Italy and Spain.WHAT WILL HAPPEN IF A COUNTRY EXIT OUT OF THE EURO ZONE • The million dollar question is whether The European Union can withstand the exit of the countries from euro and the re-establishment of national currencies. If a country is allowed to leave the Euro Zone and establish its own currency, first the banks which gave credit to the country will go bankrupt; it is more applicable for banks from weaker economies. • Then depositors will rush to siphon out their savings to different country to avoid a forceful conversion into a weaker currency. The governments will be forced to put limits on the withdrawals and sometimes even closing the banks temporarily to prevent the banking system from collapsing. So it will almost stop the flow of money in the economy and results in making the recession worse. • The permanent solution for the countries out of the Euro is to stop the capital outflows by establishing their own currency and pass a law to make it mandatory for everyone to carry out financial dealings in the new currency by offering one-for-one exchange rate with the euro. This exercise will devalue their currency and reduce the asset prices so
their assets will be inexpensive compared to other countries. It could encourage people to start invest. But if the investors refused to take the bait then it will make the situation much worse. The countries central banks could just print their currency and pay off their debts but that will lead to hyper inflation. Inflation with no investment and production will be a nightmare for any country. • Exit of the default countries will result in competitive disadvantage for the creditor countries like Germany because they have to compete with weaker currencies. It will lead to capital controls, protectionism, raising tariffs against the currency of other countries, results in animosity between the countries. If that’s the case then the survival of the European single market and of the EU [European Union] itself would then be under threat. • Collapse of the Euro will benefit none. If creating a common currency itself is a mistake, quitting will be a bigger mistake.WHAT WILL HAPPEN IF EURO ZONE IS INTACTIf countries decided not to exit the Euro Zone, their economies should grow to pay off theirdebts. In order to do that, they need to improve their competitiveness by streamlining thepublic sector and overhaul the markets for labor and services. They need to take a balancingstand between spending for the immediate growth and austerity measures for handling thelong term debt.Monetary policy has to be supported by the fiscal policy and vice versa. It is lacking in the Euroregion. To achieve that recently almost everyone in the region agreed for a fiscal union, exceptBritain.According to a report by IMF the developed nation’s debt to reach 60% of GDP by 2030 only ifthey improve their budget balances by a huge 8% of GDP by 2020.CONCLUSIONThe Euro can be saved only if the European countries shed their differences and work togetherfor their common cause, if not the Europe itself will disintegrate. At the end of the day the eurocrisis is an economic problem but can be solved only by strong commitment from the politicalestablishment of the respective countries.