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A bailout for now, but troubles ahead

After several months of haggling, euro zone countries finally agreed last week on an aid package to help Greece meet its crippling debt and deficit burden. The bailout comprises of USD 145 billion provided by loans, over a three year period, from the International Monetary Fund and European Union member states. More recently, on the 10th May, the EU approved a second USD 980 billion aid package towards rescuing the euro, which had over the weeks come under a bear hammering. The package will also service other debt-ridden countries within the euro zone. The markets exhaled a sigh of relief.

Volatility in the markets has been a consequence of doubt concerning Greece and the possibility of a sovereign debt default. This note will seek to explain the circumstances leading to the current crisis and subsequently argue that the euro, as a currency unit, may find it progressively hard to survive, despite the commendable rescue initiatives undertaken by member states of the European Union.

In January this year, it became apparent that several EU nations, including Greece, Ireland, Spain, Portugal and the United Kingdom, faced acute debt problems, leading to fears of possible defaults. This created a crisis of confidence and subsequently a widening of spreads on bond yields and risk insurance on credit default swaps. The debt crisis focused mainly on Greece, which is perhaps the worst placed with respect to the rising cost of financing its government borrowings. The IMF/EU rescue package would be conditional on the ability of the Greek government to implement certain austerity measures.

The Greek economy was a star performer within the euro zone, growing by as much as 4.5% per annum over a seven year period. This invited a rush of foreign capital perhaps more than what could be conveniently absorbed, resulting in rises in asset prices and overall cost structures. A high growth economy and falling bond rates allowed the Greek government to run large deficits, and its debt to GDP ratio remained above 100%. The global financial crisis following the collapse of Lehman Brothers had a particularly profound impact on the Greek economy. Tourism and shipping, important props of industry, were badly affected. Apparently the Greek government consistently misreported official economic data and paid investment bankers large sums in fees for arranging transactions that disguised the true levels of borrowings. This enabled the government to spend well and truly beyond its means, whilst hiding the actual imbalances from EU overseers. Currently, analysts estimate that the Greek deficit is approximately 14% of GDP, which must be one of the highest in the world.

Greek treasury paper was downgraded to junk status amidst fears of a default by the government. Yields on two-year bonds rose to 15.5% following the downgrade and 10-year paper traded at an effective yield of 11.3%. However, subsequent to the EU/IMF bailout, which offers Greek banks access to cheap funds, yields on 10-year bonds fell to 8.5%. It is now abundantly clear that without the bailout agreement, Greece would have been left with little choice but to have run a default on some of its debt. The problem is that as a member state of the euro zone, Greece cannot print its own currency. This denies its government the flexibility of inflating away a portion of its debt obligations, or providing a monetary
stimulant to pump-prime its economy. A default would have almost certainly forced Greece out of the euro zone. Whilst this on its own may not have been a calamity, many analysts fear that it may have created a contagion effect, where investors would lose faith in other euro zone countries, primarily Portugal, Ireland and Spain. All of them run serious financial imbalances and carry large volumes of national debt. Italy’s financial position also remains precarious and since it is considered, together with Spain, a core European economy, a default by either of them would create severe repercussions.

History has demonstrated that financial crises quickly acquire a momentum of their own and display an uncanny ability to hop quickly from one market to another. One of the primary concerns prior to the bailout was that the crisis would spread beyond Greece. It had, in fact, reduced confidence in other European economies and in the euro itself as a single currency unit. Analysts estimate that the UK’s budget deficit will surpass Greece’s as the worst performer in the EU, during the course of 2010.

Despite the cheer brought about by the substantial rescue package, the problems of Europe’s non-performing economies will not go away in a hurry. Ireland, Greece, Spain and Portugal are all burdened with high levels of unemployment. As monetary tightening takes place, government spending would be slashed and stringent curbs enforced on both public and private sectors. Thus unemployment levels will only rise. This would consequently result in lower rates of growth and hence a longer path to recovery. Many observers remain unconvinced by the bailout strategy in the first place. Continued political opposition and strikes may create a situation where the Greeks may not live up to their promises of austerity and spending curbs. These are practically brutal in any case – tax cuts are worth 11% of GDP. Moreover, despite how hard they might try, Greece will be bankrupt again in three years, as their debts are simply too big and will need to be rescheduled.

Going forward, it will be difficult for these countries to become competitive again without tolerating high rates of unemployment. This is a political nightmare and difficult to achieve. Unemployment would lead to social unrest and strikes, falling rates of growth and, consequently instability and effectively capital flight. It is really a matter of time before things are back to square one. The question that some analysts continue to ponder is how would Greece, Spain and Ireland pay for all this extra debt? How would they create economies that make them competitive again, if they have to remain within the constraints of a single currency and have no control over monetary policy? Effectively they are denied the leverage of currency devaluation, which is an important strategic imperative used by governments in times of a crisis. This raises the concern that the euro, as a single currency unit, cannot be sustained in the longer term without complete political integration which is unlikely to happen. Member states would resist the very thought of ‘one government’, that denies them national integrity. A single currency cannot function amongst a disparate set of economies. Within the euro zone, certain peripheral countries have substantial unemployment, high rates of inflation and excessive cost structures. Other core nations, such as Germany are completely in the opposite, with high productivity and well managed public finances. Even if by some stroke of luck this crisis was to pass, economic cycles have demonstrated that others perhaps of a less severe nature will happen, creating instabilities all over again.

But for now, the markets may allow themselves a few moments of calm after weeks of turmoil. In the long term the solution lies in political adeptness amongst EU ember states. Many would agree that this would be a lot harder to achieve than the rescue package which required several awkward months to put together.


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