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 Sovereign Debt crisis – The Survival of a single currency

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Join date : 2011-06-18
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PostSubject: Sovereign Debt crisis – The Survival of a single currency   Wed Feb 29, 2012 7:18 am

"The euro crisis can be regarded as a form of systematic crisis that not only threatens the euro but the world economy in entirety."

n early 2010, fears of sovereign debt crisis developed in some countries concerning: Portugal, Italy, Ireland, Greece and Spain (sardonically known as PIGS). The sovereign debt crisis started in the eurozone in late 2009 when the socialist government revealed that the predecessor government had understated the level of fiscal deficit for Greece. But the criticisms have not supported this argument; they have stated that the fiscal adjustment imposed on Greece merely has postponed an unavoidable restructuring of its sovereign debt due to which the levels of public debt has reached skyrocketing levels. But critics have also stated that Japan despite its slow rate of economic growth has been able to sustain the already 'skyrocket' levels of sovereign debt. Greece represents a very small part of the Eurozone's GDP but if Greece leaves the Eurozone then there will be significant increase in losses, the new currency will be devalued , will create massive run on the Greek banking system and eventually whole of the Eurozone will sweep in trouble. The euro crisis can be regarded as a form of systematic crisis that not only threatens the euro but the world economy in entirety.

The economy of Greece was the fastest growing economy during the period 2000 to 2007 which grew at a rate of 4.2% per annum and the PIIGS countries have portrayed the high levels of budget deficit as a percentage of GDP: The budget deficit of Greece was 15.4%, Ireland had 14.3%, Spain had 11.2%, Portugal had 9.3% and Italy had 5.3% of GDP in the year 2009. There were many factors that allowed the government of Greece to run large structural deficits like falling bond yields and there were attempts by the Government to manipulate the numbers of fiscal deficit to hide the reality. The Government of Greece has run large deficits to finance public sector jobs, pensions and other social benefits. Since Greece is on the euro it could not print more currency to overcome the deficits. The global financial crisis of the year 2008 also had a large impact on Greece as the country's largest industries: tourism sector and shipping sector were badly affected.

Greek crisis can be argued to be a case of 'Government failure' rather than a 'market failure'. Even till 2011 it has not been able to repay the bailout and has a huge sovereign debt of 340 billion euros. The data by Eurostat and CIA Factbook revealed that Greece had Debt to GDP ratio of 142.7% which was the highest in 2010 among all the other partner countries of European Union. A round of austerity measures were adopted by these countries to overcome the crisis which includes cut in the public expenditure, changes in the rate of taxes, freezing the increases in public sector wages which were executed in 2010. Eurozone ministers have also agreed to ramp up the firepower of their rescue fund "European Financial Stability Facility", to provide financial assistance to eurozone states in economic difficulty in 2010. A second round of austerity measures were implemented recently which includes cutting or freezing of pensions and state salaries, firing 20,000 state workers, closing down of loss making state organizations, cutting health spending and speeding up the process of privatization in lieu of which there has been approximately 20 percent cut in the pensions. On 26th October 2011 the leaders of 17 eurozone countries met in Brussels and proposed 50% write off of Greek sovereign debt held by the banks and €1 trillion bailout funds under EFSF. The ministers agreed to insure the first 20-30% of the issue of new bonds to create funds for financing the needs of the countries in difficulty and also agreed to create co investment funds to attract foreign buyers of the eurozone government bonds. The ministers also agreed to make both the schemes operational in January.

The ministers have recently agreed on a detailed plan to enlist the factors responsible for the sovereign debt crisis in these countries consisting of the level of country's sovereign debt, the rigidity of the nominal exchange rate given its membership of the eurozone and macroeconomic developments in the functioning of financial markets. Greece has suffered from a basic failure of the external and public debt management as it has suffered from the misfortune of rolling over large amounts of the sovereign debt when the market for private players was closed. In the past thirty years, the economy of Greece has experienced massive increase in the deficits due to strong electoral elections, entry into the European Economic and Monetary Union, inaction of Greek political ethics and has also accumulated enormous state debt. Some of the factors that caused financial crisis in the United States had a huge impact on Europe through transmission channels like first, upward pressure on European Exchange rate vis-a-vis dollar. Second, a spillover of global liquidity in the European financial markets was witnessed as investors borrowed in currencies with low interest rates and invested in high yielding currencies. Third, the large capital flows were diverted towards other real estate markets in several other countries.

There are few measures by which the European countries can cope up with the crisis, which include :i) to adopt austerity by cutting wages, working on the reduction of public spending and raising taxes, ii) to reform the eurozone , as the universal monetary policy and fragmented fiscal policy has been a dysfunctional mix, iii) to exit from the eurozone. Euro area countries especially in the periphery have committed to slash the budgets to reduce their fiscal deficits to the EMU's 3% maximum. Spain has carried out structural reforms of its banking system and labor market. The Government of Ireland has backed the financial system by guaranteeing bank liabilities, nationalizing troubled banks and is also readjusting its fiscal accounts, reducing the minimum wages for public sector workers, reduced social welfare budget and eliminating public jobs. Other Eurozone countries have also implemented austerity measures like reducing their budget deficit and reforming the social security system.

There are many lessons that the world can learn from the crisis. Some of which include avoidance of austerity measures, public and external debt management, avoidance of defaults, fiscal prudence, unfettered public spending should be avoided as it can send debt-GDP ratio skyrocketing, self insurance should be prudent, intra regional trade and control over the exchange rates. Along with this avoidance of some factors like deflation, protectionism, nationalism, financial meltdown and capital account restrictions should be encouraged as the slowdown in the Eurozone will impact the financial health of developed economies and impede the economic recovery of developing nations. It is also expected to have a tremendous impact on its major trading partners such as US, China, India and many more.

The efforts made by the Government of these countries are not bearing fruitful results as there's a need for debt restructuring and this should be combined with the structural reforms by making the private sector more efficient as well as reducing corruption problems. In the New Year Message delivered by the French President, he has mentioned the need to increase the taxes on imported goods and halt the spending cuts by the government. The most striking feature of this crisis is the substantial widening in the sovereign risk spreads and the downgrading of the credit ratings of these countries to the level of junk status. Will the debt difficulties of European countries be solved on time or will it disseminate to the rest of the world causing Global recession? There are many doubts on the survival of a single currency. It can be quoted for Greece that if it is too small to fail then why it should burst and flood the whole valley? Will Europe be able to avoid another recession?

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