Strategies to handle
the European Debt Crisis
by Mustafa Mustansir, FIFC
1.0 Introduction
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 Greece
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.
3.2 Ireland
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)
6.2.2.2 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)
6.2.2.3 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)
6.2.2.4 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
6.1 Eurobonds
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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Overview:
