The Euro-Zone Crisis 101

WARNING! The following post contains discussions of economics and finance which may cause drowsiness and fatigue. Read at your own risk!

In recent months, numerous friends, colleagues and family have asked me to explain the Euro-zone crisis and the impact it is having on Denmark. It is a complicated topic so I thought I would write a primer providing a brief overview of what is happening and potential outcomes.  Throughout the post, I have included financial jargon in brackets (“”). These are big, sophisticated words that economists and bankers use to make it sound like they know what they are talking about but replace simpler words which mean the same thing.

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The European Union is a collective of 27 European countries (EU-27). Of these, 17 are members of a monetary union known as the “Euro zone”. These countries use a single currency (money) known as the Euro.

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Introduction to Economics & Finance: To understand the Euro-zone crisis, it is necessary to first discuss basic finance and how countries borrow money. In many ways, it is similar to personal finance. Countries generate income through taxes and fees (income taxes, sales taxes, etc) and spend money providing goods and services to their citizens (health care, education, etc). If a country spends more than they make (“deficit spending”), they must either a) increase income by raising taxes/fees, b) reduce spending by reducing services or c) borrow money to make up the difference. While an individual goes to a bank for a loan, countries turn to debt markets (“bond markets”) to borrow money.

When a country borrows (“raises”) money on the bond market, they must pay interest (“yield”) on the money they borrow. The amount of interest they pay depends on several factors including a) how much money they borrow, b) how long they will borrow it for and c) how much they have already borrowed.  These variables are largely reflected in the debt-to-GDP ratio. GDP, or Gross Domestic Product, is simply the amount of money a country’s citizens generate every year. Two other factors which influence a country’s borrowing costs are a) how much they spend relative to GDP and b) how quickly a country’s GDP is growing.

A simple example from personal finance is the best way to illustrate this. If a person has a salary of $100,000/year and $50,000 in debt, they have a “debt-to-GDP” ratio of 50%. If their salary increases by $5,000 per year and they borrow $5,000, that’s not necessarily a problem. However, if their salary decreases by $5,000 per year and they borrow $5,000, it’s a bigger issue.

Credit Ratings: As with individuals, countries are given a credit score (“credit rating”). A credit rating assesses the risk a country will be unable to repay money they borrow and will go bankrupt (“default”). Unlike personal credit scores, credit ratings use letters. The highest credit rating is AAA or triple A. Ratings drop to AAA-, AA+, AA, etc, then BBB, etc. “A” and upper “B” credit ratings are considered “investment grade” as these countries are considered at a low risk of default. “BB+” grade investments and lower are considered “junk” bonds as these countries are at a higher risk of default. The lower the credit rating, the higher the risk of default and the higher the “yield” a country must pay to borrow.

Credit rating Agencies: Credit ratings are assigned by credit-ratings agencies. The three credit-rating agencies are Standard and Poors (S&P), Fitch and Moody’s. Each agency analyzes a country’s finances (ie, debt-to-GDP, economic growth) to determine its risk of default before assigning a rating. This is a continuous process which may result in an “upgrade” or “downgrade” of a country’s rating. Furthermore, agencies assign an outlook (“ratings watch”); “stable”, “positive” or “negative” depending on the direction a rating is headed.

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The Euro Zone Crisis: All of which brings us to the Euro-zone crisis. In 2010, Greece, a member of the Euro zone, began to run into financial difficulties. Greece has long had low growth and and large deficits, resulting in a high debt level. However, a change in government revealed that previous governments had provided false information to the markets and that its financial situation was worse than anyone realized with a debt-to-GDP ratio of 160% and a debt of €350 billion.

Credit-rating agencies immediately determined the country at a high risk of default and “downgraded” its credit rating (CC, negative outlook). Overnight, the interest rates on Greek debt increased so much that the country could no longer afford to borrow.

To many people unsympathetic with Greece’s plight, a common solution is “spend less money than you make”.  Given Greece’s penchant for corruption, mismanagement and overall laziness, there’s some validity to this “tough love” approach. Unfortunately, it’s also rather short-sighted. First, it’s not easy to implement changes quickly. No one, Greek or otherwise, likes paying higher taxes for less services. This leads to social unrest (ie, strikes, riots) and emigration, which further exacerbates the problem.

Raising Debt: Secondly, raising debt on the open markets is a continuous (“dynamic”) process. Countries borrow money for various lengths of time (“maturities”) ranging from months (ie, T-bills) to years (1-30 years) depending on their spending needs. Unlike mortgages and other personal loans, government bonds are not repaid by instalment but rather by lump sum at their maturity date. Thus, a 30 year bond issued in 1982 must be repaid in full this year. If a country does not have sufficient money to repay a loan (often billions of dollars), it must issue another bond to repay the first. While this is akin to using one credit card to pay off another, it is a regular practise among western countries. For Greece, which can no longer borrow from the bond market, the only option is to defaultor turn to “lenders of last resort”.

Lenders of Last Resort: The two primary lenders of last resort are the International Monetary Fund (IMF) and the World Bank. Started to help rebuild countries following the end of World War II, nations have long turned to the IMF and World Bank for “bailouts” when facing financial difficulties. Doing so is not a quick fix, however. Despite the term “bailout”, the IMF and World Bank require stringent economic and social reforms (ie, taxes increases, reduced social services) in exchange for lending money. No reforms, no money.

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The Bond Market: To date, I have spoken of the debt or “bond market” in the abstract. But what IS it? The bond market is primarily “institutional investors” who lend large sums of money to countries and large companies. Institutional investors include banks, hedge funds, pension funds, sovereign wealth funds and foreign governments (ie, China).

The largest Greek institutional investors are Credit Agricole, BNP Paribas and Societie Generale, three French banks that are among the largest in the world. Credit Agricole has lent over €25 billion (“exposure”) to Greece and Greek institutions. A Greek default would result in the bank losing (“writing off”) all of this money, something that would seriously weaken or possibly even lead to the failure of the bank. Although French banks have the most exposure, numerous other European banks (particularly German) have also lent large sums of money to Greek debt.

“So what”, you say. If a bank takes a big risk (ie, lending money to Greece) and fails, that’s simply capitalism at work. The problem is, Greece’s situation is not isolated within the Euro zone. Weak economies, high debts and rating downgrades have also forced Portugal (BB, negative outlook) and Ireland (BBB+, negative outlook) to go to the IMF and World Bank for bailouts.

But by far the biggest fear is Italy (and to a lesser extent, Spain). Similar to Greece, Italy has an alarmingly high debt-to-GDP ratio (120%,), low growth and suffers the same corruption, mismanagement and lack of productivity which plague Greece. Increasing concern over the state of Italian finances has resulted in a ratings downgrade (BBB+, negative outlook) and pushed yields on Italian bonds as high as 7%, a rate unsustainable over the long term.

Furthermore, at €1.7 trillion, Italy’s total debt is the third highest in the world after the US and Japan and dwarfs that of Greece, Portugal, Ireland and Spain (collectively known as “PIIGS”). It is feared a Greek default would trigger contagion which would spread to the rest of the PIIGS. The Euro zone, IMF and World Bank have already lent so much money on Greece, Ireland and Portugal that they simply do not have the money to bail out Italy. And an Italian default would be catastrophic to the European economy and banking system with severe repercussions world-wide.

This fear, coupled with general paralysis by European governments has forced out leaders in Greece and Italy in recent months. New un-elected (“caretaker”) governments have begun implementing harsh “austerity measures” which elected governments have been unwilling to make but these cuts are pushing the economies of these countries into recession (particularly Greece), creating a downward spiral from which it is very difficult to escape.

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After two years, Euro-zone, IMF and World Bank officials have come to the conclusion that even WITH economic and social reforms, Greece will NEVER be able to repay all of its debt. For all intents and purposes, the country is bankrupt (“insolvent”). However, they are unwilling to say so officially because of the economic ramifications. Not only are they worried that bankruptcy could trigger bank failures and other defaults (ie, Portugal), it would also trigger a form of unregulated financial derivatives known as Credit Default Swaps (CDS) which are essentially insurance policies paid out in the event of a default. Instead, the Euro Zone, IMF and World Bank have decided to “prop up” Greece long enough to organize a “structured default”.

Structured Defaults: A structured default convinces lenders to forgive a percentage of a country’s debt so that it is not required to formally default. The benefits of a structured default are that lenders get SOME of their money back (compared to nothing in a formal default) while at the same time relieving Greece of some of its debt and giving it a greater chance to get out of its downward spiral.

More importantly, a structured default is designed to control the amount of money banks will lose and buy them more time to strengthen their finances in the event of a formal Greek default. Furthermore, because a structured default is VOLUNTARY (negotiated with lenders), it legally shouldn’t triggering payout of CDS (although this topic is still under much discussion). Current negations are for institutional investors to forgive 50% (“take a 50% haircut”) of Greek debt.

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So, will it work? After a rather chaotic autumn, things seem to have calmed down in recent weeks. Negotiations in Athens on a structured default seem to be nearing a successful conclusion. Yields on key Italian and Spanish bonds have begun to drop from unsustainable levels. There has also been a significant drop (“correction” or “devaluation”) in the Euro in recent weeks, making European exports more affordable and European countries more competitive globally.

However, the situation is still very uncertain. Euro-zone economies are falling back into recession, a trend exacerbated by forced austerity measures/deficit reductions. Despite recent drops, bond yields remain unsustainably high for Italy and MUST fall further. Furthermore, core Euro-zone members (such as France) which are “backstopping” weaker Euro zone members have recently received downgrades (AA+, negative outlook), making it more expensive for THEM to borrow and therefore more difficult for them to help ailing Euro-zone partners.

No one can predict the outcome of this crisis. All officials are trying to do is prevent a disorderly collapse in countries such as Greece and Portugal while suring up the finances of banks and countries such as Italy and Spain and implementing long-neglected austerity measures. It’s like cough medicine. No one likes it, no one wants it, but it’s in everyone’s best interest to shut up and accept it. The longer you wait, the more undesirable the outcome and the longer it will take to recover.

Will the Euro zone survive? Probably, although possibly with fewer members with countries such as Greece and Portugal either thrown out (unlikely) or leaving voluntarily (more likely). While there are many benefits to a common currency, there are also many shortcomings. In many ways, countries such as Greece and Portugual would be better served outside of the euro zone but leaving the Euro-zone would be a very painful process in itself.

What is certain is that it will take years, even decades, for European countries to pay down their debts (a process known as “de-leveraging”). In the meantime, the region will suffer weak economic growth, wage freezes and a general drop in living standards as a result of a weaker Euro and more expensive imports.

Key National Statistics:

Canada

  • GDP per capita (2010): $46,148
  • Debt-to-GDP: 84%
  • Economic growth (2010): 3.07%
  • Credit Rating: AAA, stable

Denmark

  • GDP per capita (2010): $55,988
  • Debt-to-GDP: 43.7%
  • Economic growth (2010): 2.08%
  • Credit Rating: AAA, stable

Greece

  • GDP per capita (2010): $26,934
  • Debt-to-GDP: 160%
  • Economic growth (2010): -5.05%
  • Credit Rating: CC, negative outlook

Italy

  • GDP per capita (2010): $33,917
  • Debt-to-GDP: 119%
  • Economic growth (2010): 1.30%
  • Credit Rating: BBB+, negative outlook

USA

  • GDP per capita (2010): $47,184
  • Debt-to-GDP: 102%
  • Economic growth (2010): 2.83%
  • Credit Rating: AA+, negative outlook
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About Canadianindenmark

A Canadian expat working in the biotechnology industry in Copenhagen, Denmark
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