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Saturday, March 31, 2012

ICSA CSE Prelims 2012 Indian Economics Lecture 11

Thursday, March 15, 2012

Greece’s Debt Crisis

(Posted as per request of Ms. Diana Bala, one of my 9 students who have qualified for interview in Civil Services Examination 2011)
Buildup of Greece’s Public Debt:  
Over the past decade, Greece borrowed heavily in international capital markets to fund government budget and current account deficits. The profligacy of the government, weak revenue collection, and structural rigidities in Greece’s economy are typically cited as major factors behind Greece’s accumulation of debt. Access to capital at low interest rates after adopting the euro and weak enforcement of EU rules concerning
debt and deficit ceilings may also have played a role. During the decade preceding the global financial crisis that started in fall 2008, Greece’s government borrowed heavily from abroad to fund substantial government budget and current account deficits. Between 2001, when Greece adopted the euro as its currency, and 2008, Greece’s reported budget deficits averaged 5% per year, compared to a Eurozone average of 2%, and current account deficits averaged 9% per year, compared to a Eurozone average of 1%.10 In 2009, Greece’s budget deficit is estimated to have been more than 13% of GDP. Many attribute the budget and current account deficits to the high spending of successive Greek governments. Greece funded these twin deficits by borrowing in international capital markets, leaving it with a chronically high external debt (116% of GDP in 2009). Both Greece’s budget deficit and external debt level are well above those permitted by the rules governing the EU’s Economic and Monetary Union (EMU). Specifically, the Treaty on European Union, commonly referred to as the Maastricht Treaty, calls for budget deficit ceilings of 3% of GDP and external debt ceilings of  60% of GDP. Greece is not alone, however, in exceeding these limits. Of the 27 EU member states, 25 exceed these limits. Greece’s reliance on external financing for funding budget and current account deficits left its economy highly vulnerable to shifts in investor confidence. Although the outbreak of the global financial crisis in fall 2008 led to a liquidity crisis for many countries, including several Central and Eastern European countries, the Greek government initially weathered the crisis relatively well and had been able to continue accessing new funds from international markets. However, the global recession resulting from the financial crisis put strain on many governments’ budgets, including Greece’s, as spending increased and tax revenues weakened.
Outbreak of Greece’s Debt Crisis: Since late 2009, investor confidence in the Greek government has been rattled. In October 2009, the new socialist government, led by Prime Minister George Papandreou, revised the estimate of the government budget deficit for 2009, nearly doubling the existing estimate of 6.7% of GDP to 12.7% of GDP.15 This was shortly followed by rating downgrades of Greek bonds by the three major credit rating agencies. In late November 2009, questions about whether Dubai World, a state-controlled enterprise in Dubai, would default on its debt raised additional concerns about the possibility of a cascade of sovereign defaults for governments under the strain of the financial crisis. Countries with large external debts, like Greece, were of particular concern for investors. Allegations that Greek governments had falsified statistics and attempted to obscure debt levels through complex financial instruments also contributed to a drop in investor confidence. Before the crisis, Greek 10-year bond yields were 10 to 40 basis points above German 10-year bonds. With the crisis, this spread increased to 400 basis points in January 2010, which was at the time a record high. High bond spreads indicate declining investor confidence in the Greek economy. Despite increasing nervousness surrounding Greece’s economy, the Greek government was able to successfully sell €8 billion ($10.2 billion) in bonds at the end of January 2010, €5 billion ($6.4 billion) at the end of March 2010, and €1.56 billion ($1.99 billion) in mid-April 2010, albeit at high interest rates. However, Greece must borrow an additional €54 billion ($68.8 billion) to cover maturing debt and interest payments in 2010, and concerns began to develop about the government’s ability to do so. At the end of March 2010, Eurozone member states pledged to provide financial assistance to Greece in concert with the IMF, if necessary, and if requested by Greece’s government. Negotiations and discussions about the package continued and investor jitteriness spiked again in April 2010, when Eurostat, the EU’s statistical agency, released its estimate of Greece’s budget deficit. At 13.6% of GDP, Eurostat’s estimate was almost a full percentage point higher than the previous estimate released by the Greek government in October 2009. This led to renewed questions about Greece’s ability to repay its debts, with €8.5 billion ($10.8 billion) falling due on May 19, 2010. On April 23, 2010, the Greek government formally requested financial assistance from the IMF and other Eurozone countries. The European Commission, backed by Germany, requested that more details on Greece’s proposed budget cuts for 2010, 2011, and 2012 be released before providing the financial assistance. In late April 2010, the spread between Greek and German 10-year bonds reached a record high of 650 basis points,19 and one of the major credit rating agencies, Moody’s, downgraded Greece’s bond rating by one notch. On April 27, 2010, another ratings agency, Standard and Poor’s, downgraded Greek bonds to “junk” status. In meetings with members of the German Parliament (Bundestag), IMF Managing Director Dominique Strauss-Kahn reportedly raised the prospect of a three-year assistance package to Greece totaling €120 billion ($152 billion), substantially larger than initially reported in news reports. As negotiations among the IMF, Eurozone member states, and Greece continued, Greece agreed to additional austerity measures. On May 2, 2010, the Eurozone and IMF announced a three-year, €110 billion (about $145 billion) stabilization plan for Greece. Eurozone countries are to contribute €80 billion (about $105 billion) in bilateral loans, pending parliamentary approval in some countries. The IMF is to contribute a €30 billion (about $40 billion) loan at market-based interest rates. The agreement is considered historic, because it is the first IMF loan to a Eurozone country and the overall package is substantial relative to Greece’s GDP (forecasted to be €229 billion [$291 billion] in 2010).20 In exchange for financial assistance, Greece submitted a threeyear plan aimed at cutting its budget deficit from 13.6% of GDP in 2009 to below 3% of GDP in 2014. The Eurozone/IMF package was announced amidst Greek protests that at times started turning violent.
Despite the substantial size of the financial assistance package, the threat of Greece’s crisis spreading to other Eurozone countries remained. Bond spreads for several other European countries spiked and the euro started to depreciate rapidly. In a bid to “save the euro,” on May 9, 2010, European Union governments announced that they would make an additional €500 billion (about $636 billion) available to vulnerable European countries. The IMF may contribute up to an additional €220 billion (about $280 billion) to €250 billion (about $318 billion). Following the announcement, the market reacted positively, as bond spreads for several vulnerable European countries dropped and the euro began to strengthen.Reliance on financing from international capital markets left Greece highly vulnerable to shifts in investor confidence. Investors became jittery in October 2009, when the newly-elected Greek government revised the estimate of the government budget deficit to nearly double the original number. Over the next months, the government announced several austerity packages and had successful rounds of bond sales on international capital markets to raise needed funds. In late April, when Eurostat, the European Union (EU)’s statistical agency, further revised the estimate of Greece’s 2009 deficit upwards, Greek bond spreads spiked and two major credit rating agencies downgraded Greek bonds. 
Eurozone/IMF Financial Assistance: The Greek government formally requested financial assistance from the 16 member states of the Eurozone and the International Monetary Fund (IMF), and a €110 billion (about $145 billion) package was announced on May 2, 2010. The package aims to prevent Greece from defaulting on its debt obligations and to stem contagion of Greece’s crisis to other European countries, including Portugal, Spain, Ireland, and Italy. Despite the substantial size of the package, some economists are concerned that the Eurozone/IMF package might not be enough to prevent Greece from defaulting on, or restructuring, its debt, or even from leaving the Eurozone. Greece’s debt crisis threatened to widen across Europe, as bond spreads for several European countries spiked and depreciation of the euro began to accelerate. On Sunday, May 9, 2010, EU leaders announced that they would make an additional €500 billion ($636 billion) in financial assistance available to vulnerable European countries, with the IMF contributing up to an additional €220 billion (about $280 billion) to €250 billion (about $318 billion). The same day, the European Central Bank (ECB) announced it could start buying European bonds, and the U.S. Federal Reserved also announced it would reopen currency swap lines with other major central banks, including the ECB, to help ease economic pressure. When markets opened on Monday, May 10, 2010, bond spreads in Europe dropped and the euro began to strengthen, suggesting that the package was successful in stemming the spread of Greece’s crisis.