European Sovereign Debt Crisis during 2010-2011 - Term Paper Example

Contents I. Introduction II. Background of the crisis III. Reasons behind the Financial Crisis IV. Body -Portfolio Theory and CAPM -Woes to the Economy V. Central Bank Measures VI. Conclusion I. Introduction There was a European sovereign debt crisis that raged this region in 2010 and 2011. Defaulting loan creditors increased in number across the continent of Europe and this led most banks’ grappling with what their next move would be. The financial institutions of many European countries collapsed; there was increased government debt. This began in the early 2008 with the banking system of Iceland collapsing. This was recorded to spread to Greece, Portugal and Ireland at the wake of 2009. This led to the business and the economies’ collapsing and the investors lacking confidence in these economies and this led to the further increase of the public sector debt. The public fiscal balances have faced substantial collateral damages since the 2007 global debt crisis. (Mitsopoulos, M. and Pelagidis, T. (2010) II. Background of the Crisis The crisis majorly erupted in the 2009 autumn season when there was bad governance in the euro zone as well as Greece. The roots of this had come in the previous decade where there was major borrowing in the international capital markets to fund the government budget and the current account deficit. The structural rigidities, weak revenue collection policies, strategies and the profligacy of the Greece government led to this heightened debt crisis. The newly elected government revised the budget to almost double in October. The investors were not pleased by this but the government tried to sell its bonds to the international market which fared well until the euro stat and the European union statistical agency had to go back at it and downgraded its bonds again. The nation then had a great debt in relation to its GDP. There was a weak coordination and management as regards the dealing with deficit. This was seen as the major reason why the debt was not controlled. III. Reasons behind the financial crisis The policies that were put in place were not the right ones to deal with the issue. To make the matters worse, the government wrong timing in the disclosure of the 2009 fiscal deficit to be below 10% and the proclamation that it would rise was sickening as this led to the investors lacking confidence and even lenders to be reluctant in offering loans to Greece. There was ever abundance on ambiguity in the budget lines. The budget lines were used to show the grouped spending items within the division of public administration the management was seen to lack competency and inefficiency due to the ambiguity that mislead the lenders and the investors driving in more fears among them. The officials lacked the knowledge required in the evaluation of the policies against the government preferences. (Mitropoulos & Pelagidis, 2010) These programs have been progressing at a very slow tempo and have, therefore, derailed the reform programs in the health, labor culture and pension schemes and for such reasons, the country has been facing major structural unemployment in the last decade especially among the young people. This has been compensated by the GDP in regard to the feeble laws that have been imposed. (Schneider et al., 2010) On April 23rd 2010, the Greek government made an official request to be assisted by the IMF in conjunction with the euro zone countries because its statistics had shown a major crisis in its part to raise the funds to repay what they owe other countries. IV. Body Portfolio Theory and CAPM Due to situations like the ones facing the European market, investors have come up with various ways to determine pricing of their stocks and manage their risky portfolios alike. Some of the theories used under such are Portfolio theory and CAPM. These are expounded as per the following paragraphs. Portfolio theory is a theory that is centered on the process through which any given investor can make up portfolios that maximize the amount of expected returns putting into account the market risk constraint. These investors are always assumed to be risk averse. The theory explains that it is a possibility to establish an ‘efficient frontier’ for the most optimal portfolios considering the maximum return at a given amount of risk. (investopedia.com, 2011) CAPM- Capital Asset Pricing Model, on the other hand, is a model used by investors to explain the existing relationship between expected returns and the risk. It is applied in the pricing of stocks that are considered risky. The main idea behind this model is the urge by investors to get their compensation in two major ways: risk and money time value. The formula used under CAPM is; r = rf + βa (rm + rf); where rf = risk free return rate βa = the stock’s beta rm = Market’s expected return (investopedia.com, 2011) Woes to the Economy The German-Greek spread was very high now at 650 basis points now and moody’s, a rating agency down rated the bonds before standard and poor’s further did this to a level that was very low in the late 2010. A three year stabilization plan for the Greek economy was agreed on among the Euro zone countries, IMF and the Greek government. This was to involve an increased amount to $145. This was not just to happen that way, but the Greek government had to agree to cut its budget deficit in three years from a GDP of 13.6% to 3% by the year 2014. The euro zone countries had to take measures in regard to this and eventually decided in collaboration with the IMF, they would provide an increased $636 to the countries which were vulnerable due tom the effects of the Greece debt crisis. Fig 1: A graph showing debt ranges and sources of Greece as compared to other EU countries Greece has been depicted to be the largest borrower and with the highest debt as compared to other Euro zone countries. Fig 2: The Greek Debt in Comparison to Euro zone Average The current debt crisis in Greece has been caused by a mix of international and domestic factors. In the domestic factors, there has been increased government spending, tax evasion, structural rigidities and corruption Transparency International (2010). In the international level, this has been due to adoption of the Euro and the EU rules so as to reduce the debt accumulation have advertently led to the increased debt that Greece is currently experiencing. The increased government spending and the contraction of the revenue sources had increased the debt. The GDP of Greece grew more than that of the euro zone countries by 1%. The GDP was out increased private consumption and the increased investments due to the provision of capital at a low interest rate and the increased public spending facilitated by the European Union and the government, the EU threshold was 3% but the spending had increased by a huge margin up to 81% as compared to the rise in the revenue by only 31%. (Featherstone, 2008) This further increased the deficit. There have been high expenses as far as health sector is concerned as well as the pension scheme sector. The government officials have mismanaged funds and the tax collection procedures are not up to date and have led to most of the funds that would have ended up with the government in form of taxes to be evaded. More so, the Greeks have failed to observe the fiscal discipline where they are supposed to balance the expenditure with the revenues. The government has imposed a complex tax code, bureaucratic tax collection procedures and high levels of taxation. All these have weakened he revenue collection and heightened the need to evade the tax as this has been seen by the investors as inconsiderate. The best tax system should have been one that does not make the people feels intimidated or as if they are entirely working to give out as taxes. (De Grauwe, P, 2010) The production has received a minor increase that would not justify the 5% per annum increase in the wages. Policy makers and economists have suggested that the country needs to reduce its wages to the public and increase productivity through substitution of the finances. The country has been known to have a comparative advantage in the shipping industry as well as in the tourism sector and would, therefore, direct investment strategies in that direction. There was a common monetary policy which was viewed to be conservative and was managed by the ECB or the central bank having major countries like Germany and France involvement. The euro member countries were, therefore, viewed with high regard and could therefore be held reliable even to be offered loans at lower interest rate. This was seen as a favorable term and Greece took the advantage to finance its debt as well as to borrow more. That artificial access to credit allowed the country to accumulate large debts. There were issues with the European rules enforcement. This specifically refers to the lack of the enforcement of the stability and growth pact that was set up in the 1997. This stated that the public finance rules had to be implemented. It advocated that the public debt was not to exceed 60% of the GDP and the budget deficit not to exceed 3 % of the GDP. Failure to adopt his was leading to a fine of not less than 0.5 % of the GDP in that country. However, the EU has never carried out financial sanctions against these countries that have defied the rules set. This reluctance in its part has led to countries like Greece to have major debts piled up in their stores. It is viewed that if these laws would have been strictly followed, then probably the country would not have been in such dilemma to fulfill the skyrocketed obligation in terms of a debt. (World Economic Forum, 2009) V. Central Bank Measures The contrast has been experienced in Greece which has expansionary fiscal policies, increasing the government expenditure and reducing the taxes and also increased wages to the workers. That has reduced the competitiveness of exports and has led to the fewer saving in its part. This has led to continuous borrowing from the euro zone countries and this has caused the imbalance in their economic affairs. The Greeks have to depend on either tourism or the shipping which are affected by the economic conditions. This problem has loathed problems towards the development of Germany as the country is the leading financial or loan contributor in the EU and has had to break from its internal policies and plans so as to assist in financing the economy of the Greece. The debt crisis has led to the spiking of the bonds. This has also had a contra effect towards reducing the value of the euro. The exports of Germany have ended up being performing badly. The central bank was acting like a regulator to the debt crisis and controlling the danger of having the euro losing its purchasing power. The minimum credit rating that was required by the Greek bonds to be used in the ECB liquidity operations was suspended. This was used to ensure that the European banking sector had liquidity. The ECB helped in reducing the economic pressure by having the Federal Reserve’s kept in it. Banks operate like a fiat money system that operates on confidence. The shareholders had their confidence was shaken as shown in the graph. Fig 3: Withdrawal of Confidence: European Banks’ MSCI Price Index It started buying the European bonds in secondary markets. (Rossi, V., & Aguilera, R. D. (2010) In this it also helped to reduce inflation as this would mean that the exports of the countries would be bought at a lower price and eventually some of the major players in reducing the debt crisis like Germany would no longer have the surpluses in their current accounts that would be used to fund the EU. (Euroactiv, 2010) The spread of the debt crisis in Greece is not only a structural problem but also a liquidity problem. The politicians have said that this crisis has greatly increased due to Greece being governed by the laws that exist in the Euro zone and should consider leaving it and should take on hard structural reforms as indicated in the International Review of Applied Economics. It has been a cycle in the performance of Greece as much of their earnings have been used to fuel the long term debt which has been skyrocketing. VI. Conclusion The government still has corrupt officials who lack knowledge of the way to handle debt matters. Some of these have remained to be corrupt and have not made some policies out of the nations benefit but out of greed and self sufficiency. The exports have remained uncompetitive, the shipping and tourism industry has not improved, and leading to tourists shifting their destination and the shipping industry has been thoroughly affected by the economic conditions. Index Government debt/ Public debt- Amount of money that the central government owes. Euro zone- A monetary union and economic union involving states which have taken up the euro as their sole legal tender. GDP- Refers to the value (market value) of commodities in entirety within a given nation in a specified period. IMF- International Monetary Fund CAPM- Capital Asset Pricing Model Tax evasion- An effort by persons to evade taxes illegally. EU- European Union (a political and economic union formed up of 27 members states from Europe). Comparative advantage- A case where may be a country is be in a position to produce similar goods to another, but at a lower cost. Monetary policy- A process through which money supply is controlled; mostly by the central banks of the equivalent countries by use of interest rates for stability and economic growth. Fiscal policy- The application of taxation and government expenditure to impact on the economy. Reference list: De Grauwe, P. (2010). The Greek Crisis and the Future of the Euro-Zone. Eurointelligence. Dyson, K. and Featherstone, K. (1999). The Road to Maastricht: Negotiating Economic and Monetary Union. Oxford University Press. Fotopoulos, Takis. (1992). “Economic Restructuring and the Debt Problem: The Greek Case”, International Review of Applied Economics, Vol. 6, No. 1. Euroactiv,com. (2010). ECB Backs Treaty Change for EU’s “Economic Government” Retrieved 1 November 2011 http://www.euractiv.com/euro/ecb-backs-treaty-change-eus-economic- government-news-496016 investopedia.com. (2011). Capital Asset Pricing Model – CAPM. Retrieved 17 November 2011 http://www.investopedia.com/terms/c/capm.asp#axzz1dyQJEGKL investopedia.com. (2011). Modern Portfolio Theory – MPT. Retrieved 17 November http://www.investopedia.com/terms/m/modernportfoliotheory.asp#axzz1dyQJEGKL Mitsopoulos, M. and Pelagidis, T. (2010). Explaining the Greek Crisis: From Boom to Bust. Basingstoke: Palgrave Macmillan. Mitsopoulos, M. and Pelagidis, T. (2006). Analysis of the Greek Economy: Rent-Seeking and the Reforms. Athens: Papazisis. reuters.com. (2010). “Fiscal Woes to Dog Greek Bonds Even if Aid Offered,” 1 November 2011 http://www.reuters.com/article/2010/03/22/us-markets-bonds-peripheral-analysis- idUSTRE62L3XB20100322 Rossi, V., & Aguilera, R. D. (2010). No Painless Solution to Greeces Debt Crisis. International Economics , Programme Paper IE PP 2010/03. Schneider, F., Buehn, A. and Montenegro, C.E. (2010). Shadow Economies All over theWorld: New Estimates for 162 Countries from 1999 to 2007. Policy Research Working Paper 5356. Washington, DC: World Bank transparency International.org(2010). Corruption Perceptions Index 2009. 1 November 2011 http://www.transparency.org/policy_research/surveys_indices/cpi/2010 World Economic Forum (2009). The Global Competitiveness Report, 2009–2010. Geneva: World Economic Forum. Read More