WHEN DID THIS BECOME AN ISSUE?
In December 2009, the financial press started to focus on the VERY HIGH fiscal deficits of some Eurozone countries, and nicknamed them PIIGS (Portugal, Ireland, Italy, Greece and Spain). It wasn’t until six months later (May 2010) that the world investment markets reacted. This was the largest challenge since the EURO creation and the original agreement outlining the member countries’ obligations. It was not the first time the terms of the agreement were tested – the fiscal guidelines have been relaxed several times – but this was the first time when a member country was in danger of defaulting on their bonds.
GREECE THE FIRST CASUALTY
Greece appeared in the headlines first. They had to restate their 2009 reported deficit several times. They originally reported a 2009 deficit estimate of 3.7% in Apr 2009, increased to 12.9% in Dec 2009, and 13.6% in Apr 2010. The adjustment was very large and raised credibility questions (this was not the first time). In April 2010, ECB and IMF had emergency meetings and agreed on a €110bn bailout package. The commitment would be transferred in several trenches, contingent on the effectiveness of Greece’s austerity plan. Seeing that this might not be an isolated occurrence, the European Financial Stability Facility (EFSF) was formed.
When analyzing Greece’s debt requirement, it is interesting to note that even if Greece did not pay any interest payments on its debt in 2010, it was still be in a net deficit position and borrowed 4% of GDP more through bond issuing. Also current yields have skyrocketed with bond yield exceeding 20% (on 2-year as of Apr 18). The austerity plan has met resistances from the public and the economic environment has deteriorated.
The next trench of bailout will be conditioned on the progress report due in June, and sources expect restructure of the sovereign debt before the end of summer.
IRELAND HAD TO SAVE THE BANKS
Ireland was the next who required official help. Within half a year after passing the ECB bank stress test, Allied Irish Bank and Bank of Ireland suddenly needed a bailout, thus made Ireland the first to use the EFSF. At the time Ireland was suffering from a major recession. Unemployment rose sharply and hit the highest since after the recession in the early 90s, and tax revenue were falling. The fiscal situation was already strained. The government of Ireland decided to nationalize the banks and take on additional debt of the banks. The bailout cost of 43% of GDP was too much for the government to handle. After receiving assistance their situation has stabilized.
PORTUGAL VOTES NO TO AUSTERITY
Portugal’s Prime Minister Jose Socrates had insisted that Portugal would not require help to solve its fiscal problems. In February 2011, the ECB acted swiftly to stabilize the Portuguese government bond yield by buying the bonds in the open market. In late March, people expected Portugal to survive through a viable austerity plan. However, the plan presented by Mr. Socrates to the parliament for a vote was rejected by all opposition parties. The PM resigned 2 hours after.
In early April 2011, Portuguese officials started to negotiate with the EU for assistance on the short term cash flow problems. Officials were loathed to call it a bailout until Mr. Socrates confirmed the decision. The IMF has estimated the bailout package to be €73.9bn.
THE EUROZONE STRONGER TOGETHER THAN APART – CREATION OF THE STABILITY MECHANISM
All the countries in the Eurozone benefit from currency stability. Since its introduction, the euro has been well received around the world and it is a legitimate contender as a major reserve currency. Currently, all of the governments that use the euro within their borders are committed to it. And even more countries in the European Union want to adopt it.
WHY DOES THIS PROBLEM EXIST- IS THERE A SOLUTION?
Because the countries are using a shared currency and monetary policy, which they do not control, they are required to run a more rigid fiscal policy. When fiscal policy is abused, it is very difficult to rectify without major consequences to the economy. At this time, there could be a major desire to abandon the euro and switch to in house monetary policies, which will rectify the fiscal situation without the same pain. If the Eurozone wants to stay together, there has to be a system of wealth transfer from the stronger countries to the weaker. And first, the strong countries will not be willing to support the weak countries without assurances of payback. But eventually, there will have to be concessions. Looking at history, we can use similar circumstances in the United States and Canada when they were amalgamating states and provinces. They had to develop a system where the federal government supports the members of the country. This is going to be a major challenge to the euro because the member countries have such diverse histories and cherish their individuality.
SHORT TERM OUTLOOK FOR THE NEXT QUARTER (2011Q2)
Currently, all of the countries in the Eurozone want the euro to succeed. This will result in compromises by the member countries to resolve any questions or any doubts which might arise for some time. The ultimate goal is to show unified support. Since the problems started to arise in 2009, the Eurozone has established this confidence with the investment community. But the future is not assured. Finland just had an election which gave more support to an anti-euro party. There could also be a major change after ECB President Jean-Claude Trichet’s term expires in late 2011.
To date, these problems have not been hurting the investment market, and seem not to be a major factor in the near future. Greece, Portugal and Ireland are all small countries whom together account for less than 8% of Eurozone GDP. Currently there is a lot of talks of Greek bond default, and different plans for restructuring their debt. As long as the restructuring does not cause a write down on the books of insurance companies and banks, the effect will probably be mute. Greek debt is a small portion of the outstanding debts on the balance sheets of banks and insurance companies outside of Greece, but it sends a signal of how other countries’ debt default will be handled. Werner Hoyer, German Foreign Minister for European affairs said “A haircut or a restructuring of the debt would not be a disaster,” “if Greece’s creditors agreed that talks with the Greek government would be helpful toward a restructuring of the debt, then of course this would be supported by us.”
It will be the larger countries that will create more concerns, such as Spain, Italy, or even France. Spanish banks are under pressure from mortgage backed assets. Can the stability mechanism support larger bailouts?