Strategies to handle the European Debt Crisis
by Mustafa Mustansir, FIFC
Since 2009, the Eurozone which is an economic and monetary union of 17 European Union states, has been suffering from an ongoing crisis, known as the Eurozone Crisis. The crisis is a combination of rising sovereign debt, capital and liquidity constraints in the respective banking systems, lower growth and loss of competitive advantage. The crisis has also had a political impact in some EU nations.
2.0 History of Debt Crisis
The crisis on hand has evolved for over two decades with the signing of the Maastricht Treaty in 1992 in the Netherlands. The treaty came into effect on November 1, 1993 laying foundations for what then became Europe’s biggest project for a decade: the European Monetary Union (EMU) and the single currency known as Euro.
The treaty also set out a number of convergence and stability criteria that had to be met before a country could become a member of the EMU. Government deficits were limited to 3 percent of GDP and inflation was to be no more than 1.5 percent above that of the 3 lowest inflation rates in EMU members. (Agency)
When governments enter into budgetary accords and treaties or institute debt limitations by way of constitutions or statutes, they create potential collective action problems in which the dilemma is maintaining compliance with the terms of the agreement. (Savage) By 2002, several member states had been finding it difficult to continue to finance their fiscal and current account deficits in order to grow their economies under the EU banner. The countries could neither borrow more directly, nor could they print money or devalue their currency.
Consequently, countries like Greece were pushed to finance their deficits by circumventing the benchmark fiscal and monetary practices of the EU, and selling rights to receive future cash flows to lenders in order to raise funds to fill fiscal gaps. By 2009, investor sentiment turned negative as government and private debt levels rose. Depositors began withdrawing funds from the risky banks, and lenders began demanding ever higher interest rates.
The real-estate meltdown at the same time exacerbated the circumstances, as the same banks were faced with liquidity shortages. Governments were forced to give guarantees and buy bank debt, increasing sovereign debt, and meant that some countries were on the brink of default and total collapse of their banking systems, requiring bailouts.
3.0 Countries of the European Debt Crisis
In 2010 excessive debt with demands for higher interest from borrowers and spill-over effects of recession made it almost difficult for countries like Greece to be able to meet their debt obligations. Subsequent austerity measures adopted by the governments to curb spending and bring down deficits were met with public resistance and also led to change of governments. Let us examine the case of Greece which received € 247 billion in bailouts, Ireland and other affected countries.
3.1.1 National Factors
Domestically, analysts point to high government spending, weak revenue collection, and structural rigidities in the Greek economy as contributing factors to the crisis. Over the past decade, Greece borrowed heavily in international capital markets to fund government budget and current account deficits. The reliance on financing from international capital markets left Greece highly vulnerable to shifts in investor confidence. (Congressional Research Service)
3.1.2 Factors linked to the EU
Moreover, Greece's economic problems stern from its joining the Eurozone, a single currency region where monetary policy is managed by a largely independent European Central Bank (ECB). The ECB is committed to maintaining stable prices without regard for levels of unemployment or economic growth. Greek industry has been unable to compete with its German competitors. If Greece had retained an independent currency, it could have maintained balanced trade and supported domestic industries and employment by devaluing its currency. (Friedman)
Greece's trade deficits were financed by borrowing, including deposits in Greek banks from Germany and other northern European countries. When the financial crisis began in 2008, however, these countries sought to withdraw their deposits from Greek banks and reduce their lending. (Friedman) What followed was a severe liquidity crisis in the Greek banking system, exacerbated by the absence of a Greek central bank to provide liquidity and guarantee its stability.
3.1.3 Assignable causes of Global Changes
Furthermore, it can be argued that strong economic growth of Greece depended on income from the shipping and tourism sectors. During the recession triggered in 2008, the later sectors suffered and so did the Greek economy which had excessively borrowed funds to finance the structural deficits behind its higher growth during the mid-2000s.
The sovereign debt crisis of Ireland had its roots more in the real-estate meltdown in 2008 unlike its other counterparts. On the brink of the crisis, major Irish banks went burst and government had to guarantee their debt to save the banking system. However, the government itself was met with gross incapacity to guarantee payments. Hence, it had to request a bailout. Ireland has received € 67.5 billion in bailouts.
3.3 Other Countries
Portugal received € 78 billion in bailouts following mismanagement of public funds, risky credits and borrowing, and poor recruiting practices in government services. Portugal had requested a bailout to merely improve its public finances.
Spain was also exposed owing to the housing bubble burst and a sharp rise in interest rates on its 10-year bonds. It received € 41 billion under ESM. Other countries included Cyprus; caught amidst Greek fallout owing to its banking sector’s exposure receiving € 10 billion in bailout loans.
4.0 Initial European Initiative to beat the crisis
4.1 European Financial Stability Facility (EFSF)
In 2010, finance ministers of 16 Eurozone countries struck a deal to establish a € 440 billion package to rescue the troubled economies of the Eurozone. Under the scheme debt backed by guarantees from governments would be sold and the money raised would be used to make loans to countries in need under strict budget austerity conditions. (The New York Times)
The facility would last for three years, and be the central element of the € 750 billion aid package agreed to a month earlier. Under the deal that created the package, a further € 60 billion would come from the European Commission, with € 250 billion from the International Monetary Fund. (The New York Times)
4.2 EFSF aim, structure and interest rates
The EFSF was incorporated as a separate legal entity under Luxembourg Law, with the 16 Eurozone countries as its shareholders. Its purpose was to financially support Member States in difficulties caused by exceptional circumstances, and financial stability of the euro area as a whole and of its Member States. The financial support shall be provided by EFSF in conjunction with the IMF and shall be on comparable terms to that of Greece or on such other terms as may be agreed. (European Financial Stability Facility)
Financial assistance was to be provided by way of loans, precautionary facilities, refinancing financial institutions, and purchase of bonds under a Financial Assistance Facility Agreement backed by guarantees. The pricing structure for EFSF loan agreements would be the sum of EFSF cost of funding plus a Margin as stipulated. (European Financial Stability Facility)
5.0 Aid actions under the Troika Auspices
The crisis shook the foundations of the EMU, and noticing the urgency the European Commission, the European Central Bank and the International Monetary Fund formed a committee dubbed as the Troika to initiate discussions with member states for possible corrective measures and draft a stability framework. The committee was also responsible for scrutiny, negotiations and administration of bailout packages for countries seeking funds in rescue.
5.1 European Commission
The European Commission is one of the main institutions of the European Union. It represents and upholds the interests of the EU as a whole. It drafts proposals for new European laws, and manages the day-to-day business of implementing EU policies and spending EU funds. (European Union)
5.2 European Central Bank (ECB)
At the brink of the crisis, the ECB played its role as the central bank for the Eurozone. It commenced open market operations to buy government debt from affected countries, took measures to ease dollar swaps and also changed its policy for buying bonds to buying even junk bonds to rescue countries like Greece. The ECB lowered interest rates and also brokered deals with central banks of major economies i.e. the USA, Japan etc. to keep the banking system liquid around the world.
5.3 International Monetary Fund (IMF)
Being one of the top financing institutions to bailout countries in difficulties under strict austerity conditions, as of 2013 the IMF has disbursed up to € 120 billion in different tranches to respective funds seeking nations of the Eurozone. At the heart of negotiations and drafting of a bailout framework, the IMF played an active role among the Troika not only to fix the European problem but also diffuse the worldwide recession.
5.4 Aid actions by ESM taken over from EFSF and potential future actions
On 24 June 2011, the European Council decided to establish a permanent crisis resolution mechanism –the European Stability Mechanism (ESM). The function of the ESM will be to perform the same activities as the amended EFSF with a lending capacity of € 550 billion, and be the main instrument to finance new assistance programmes.
Moreover, the EFSF would continue only to remain active in financing programmes commenced before ESM and after 2013, the EFSF will continue in an administrative capacity until all outstanding bonds and loans have been repaid. (European Financial Stability Facility )
5.5 Recurring constitutional doubts in Germany
The constitutional courts in Germany have been notorious as Germany’s actions to fulfil its promises made on the EU tables are challenged recurrently for their constitutional soundness. Firstly, it was the Maastricht Treaty, when sceptics questioned the exact charter of the union, its strict tests for economic convergence, and what democratic controls were there for the German Parliament. (Economist Newspaper Ltd.)
Recently, the courts were in the limelight again when Greece’s bailout was challenged as unconstitutional. However, the court gave the ruling for it to be legal, eliminating a major legal hurdle to the crisis response that had been closely eyed by financial markets. (Comtex)
Next, operation of the ESM was also challenged. It was demanded that the ECB reverse its decision to buy bonds before the ESM operated. However, the Court ruling does not change anything for Germany with respect to capital calls-a unanimously shared interpretation among member-states. (European Financial Stability Facility )
6.0 Initiatives of the ECB
The ECB decided on several measures to address the severe tensions in certain market segments which were hampering the monetary policy transmission mechanism. The ECB Governing Council decided on conducting interventions in the euro area public and private debt securities markets (Securities Markets Programme).
The ECB also adopted a fixed-rate tender procedure with full allotment in relation to Longer-term Refinancing Operations (LTROs) and Main Refinancing Operations (MROs). Further, in coordination with other central banks, ECB adopted the temporary liquidity swap lines with the Federal Reserve, and resumed US dollar liquidity-providing operations. (European Central Bank) Interest rates were also cut periodically to historic levels of 0.25% in November 2013. The initiative helped devalue the euro in relation to other currencies boosting exports for the Eurozone economies.
6.1 Structure, status and peculiarities of the ECB
The European Central Bank and the national central banks together constitute the Eurosystem-the central banking system of the euro area. The Governing Council is the main decision-making body of the ECB and consists of six members of the Executive Board and the governors of the national central banks of the 17 euro area countries.
The Council usually meets twice a month. At its first meeting each month, it assesses economic and monetary developments and takes its monthly monetary policy decision. At its second meeting, the Council discusses mainly issues related to other tasks and responsibilities of the ECB and the Eurosystem. (European Central Bank)
6.1.1 Creation and targets of ECB
On 1 June 1998, the European Monetary Institute (EMI) was replaced by the European Central Bank as the EMI had completed all its tasks in relation to the establishment of EMU. The main objective of the Eurosystem is to maintain price stability i.e. safeguarding the value of the euro. (European Central Bank)
6.1.2 Capitalisation of the ECB
The capital of the ECB comes from the national central banks (NCBs) of all EU Member States and amounts to €10,825,007,069.61 (as of 1 July 2013). The NCBs’ shares in this capital are calculated using a key which reflects the respective country’s share in the total population and gross domestic product of the EU. Shares are adjusted every five years and whenever a new country joins the EU. (European Central Bank)
6.1.3 Low ECB interest rates
The ECB has the responsibility to formulate monetary policy in the euro area. Recently, on 7 November 2013, the governing council lowered interest rates on the main refinancing operations to historic level of 0.25% and that on marginal lending facility to 0.75%. The aim of lowering interest rates in multiple steps is to lower the cost of borrowing leading to the devaluation of euro in relation to other currencies, making Eurozone exports more competitive in the international markets.
6.2 Secondary bond purchases (SMP, OMT)
From 10 May 2010 to February 2012 the ECB conducted interventions in debt markets under the Securities Markets Programme (SMP). Terminated in September 2012, as of 6 December 2013 € 184 million was outstanding under the SMP scheme.
Further, in August 2012 the ECB announced the possibility of conducting outright open market operations in secondary sovereign bond markets to safeguard an appropriate monetary policy transmission. In September 2012, the technical features for such operations had been decided; named Outright Monetary Transactions (OMT).
6.2.1 Features of SMP and OMT
On 14 May 2010 the ECB decided to establish the Securities Markets Programme (SMP). Under which Eurosystem central banks may purchase the following: (a) on the secondary market, eligible marketable debt instruments issued by the central governments or public entities of the Member States whose currency is the euro; and (b) on the primary and secondary markets, eligible marketable debt instruments issued by private entities incorporated in the euro area. (European Central Bank)
Subsequently the SMP was replaced by the OMT programme in September 2012. Under OMT transactions were focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years, without any limits. The liquidity created through OMT was fully sterilised. (European Central Bank)
6.2.2 Controversy: Common perception vs. facts
Two features of the OMT programme have generally been seen as particularly important: its potentially unlimited nature as well as the conditionality defined in a standard financial assistance program in the Eurozone. The more recent debate about the potentially unlimited nature of the OMT programme is at the core of the constitutional complaints in the German courts.
The plaintiffs argue the fact that the program is unlimited leads to incalculable costs to the German tax payer without a proper involvement of the Bundestag that is supposed to take this decision. This in turn would undermine the budgetary autonomy of the German parliament. (Wolf)
However, the ECB took action that was effective and appropriate in solving a fundamental problem it faced, namely a dysfunctional monetary policy transmission mechanism. Its action was clearly within its mandate of ensuring the proper conduct of monetary policy. The pure announcement of a potential OMT programme helped to reduce risks and to coordinate markets in a good equilibrium. (Wolf)
22.214.171.124 Direct financing of states
Direct financing has the natural advantage of promoting economic restructuring. Small and micro-sized enterprises most often need principals or long-term debt financing, which can almost only be done through direct financing. The United States was at the centre of the financial storm in 2008. Three years later, the U.S. economy was recovering at a faster pace than Europe thanks to a more balanced financial system relying more on direct financing-Europe relies more on indirect financing. (Shuqing)
Accordingly, the Eurogroup has worked intensively on the operational framework of the future ESM Direct Recapitalisation Instrument. The main features of the instrument are now agreed in view of having the instrument operational once an effective Single Supervisory Mechanism is established. The objective of an ESM direct recapitalisation shall be to preserve the financial stability of the euro area as a whole and of its Member States, and to help remove the risk of contagion from the financial sector to the sovereign by allowing the recapitalisation of institutions directly. (European Central Bank)
126.96.36.199 The hyperinflation spectre
Some experts argue that ECB’s initiative of OMT may in fact lead to hyperinflation across the Eurozone. It is argued that in the first stage governments whose debt the ECB buys, will sell bonds to the EU banks. These bonds will be assets for the banks and in return sovereign deposits will be created for governments.
In the next stage the EU banks sell these bonds to the ECB in return for euros. However, going forward, as the backstop of the ECB is in place and the expectation of default is removed from the front end (i.e. 1 to 3 years), exchanging carry (i.e. interest income) for cash will be a losing proposition. The EU banks will demand that the euros be sterilized to receive ECB debt in exchange at an acceptable interest rate. (Sibileau)
Hence, the ECB issues debt which the EU banks purchase from the Euros they had received in exchange for the sovereign bonds. Currently, the EU is issuing debt with 7-days maturity, and should the situation continue, in the later stages the EU would be left with sovereign bonds having maturity of up to 3 years financed by its 7-days maturity debt. The EU banks will need a positive net interest income to profit from the sovereign deposits created in the earlier stages to support the same ECB debt.
Now if the interest payable on the ECB debt is higher than interest receivable to the ECB on sovereign debt, the result would be a net-loss of interest income, leaving no other alternative for the ECB but to print more euros to cover the gap. This would be a spiralling circularity where the net interest loss forces the ECB to print euros that need to be sterilized, issuing more debt and exponentially increasing the net interest loss, ultimately leading to hyperinflation across the Eurozone. However, this is unlikely as major economies i.e. Germany would already have left the Eurozone by then preventing a large scale hyperinflation. (Sibileau)
188.8.131.52 Moving towards a transfer union?
Many economists argue that the euro zone needs to become a transfer union, where payments flow from richer to poorer states, if the single currency is going to survive. But a look at existing systems in different countries shows that the design of such a union is crucial -otherwise some countries will become permanently dependent on hand-outs. (Suaga)
The economic union has been more beneficial to the northern members than the less economically strong and competitive southern states. Economists also argue that the real winners of a transfer union will be states like Germany given their competitive edge. German exports jumped by 18 per cent owing to devaluation of euro by virtue of lower interest rates which restricted hot inflows of capital during the height of crisis.
6.0 Alternative strategies
The Eurobonds are suggested government bonds issued by 17 member-states of the Eurozone, jointly, in euro. These are like normal debt instruments which require the investor to loan a certain sum of money for a certain period at a certain interest rate to the Eurozone as a whole. Economists and the ECB have been suggesting use of Eurobonds to tackle the sovereign debt crisis.
However, states like Germany have expressed reservations in that it would raise the liabilities of the country substantially to the debt crisis. Critics have also argued about the problem of free riders, as some countries will look to benefit more than others despite the same contributory rights.
6.2 Euro exit strategies
Economists from notable institutions around the world also suggest that following the debt crisis, and the economic and political mess created by the rescue plans, where the burden of the crisis was unequally shared and austerity imposed on unwilling taxpayers, the euro has had its day.
The euro was a noble experiment, but it has failed. Instead of wasting more money on expanding the system's scope and developing ever larger rescue funds, it would be better for the EU and others to think about how best to revert to a system of individual currencies. (Barro)
7.0 Conclusions and recommendations
The collective initiatives and sacrifices of member nations have saved the euro for now. The situation is improving and austerity measures are bearing fruits despite earlier resistance in Greece, Ireland and Spain. Three years on EFSF, the euro is stable. However, in the long-term advocates of a common currency and monetary union must ensure a mechanism to streamline fiscal disparities among member countries on the road to convergence.
At the same time, initiatives must be taken to improve competitiveness of weaker members, and upgrade membership criteria so that non-compliant stressed members leave the union. A stronger and equally competent union will end the issue of free riders and transfer unions. Exit strategies by renewal of independent currencies is also an option but the struggle of member nations during this crisis manifests a solidarity beyond interests of just a common union. It indicates that the euro has come too far to return.
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