European crises

In 1958, an organisation called European Coal and Steel Community was formed. This evolved into the European Union (EU) which was established by the Maastricht Treaty in 1993. The European Union introduced the euro on January 1, 1999. On this day, 11 member countries of the EU started using euro as their currency. It benefited countries such as Portugal, Italy, Ireland, Greece and Spain (together now known as the PIIGS). "Before these countries started to use the euro as a currency, they had to borrow money at interest rates much higher than the rates at which a country like Germany borrowed. When these countries started to use the euro they could borrow money at interest rates close to that of Germany, which was economically the best managed country in the EU, and this was a benefit to them. The rest of Europe, in effect, used Germany's credit rating to indulge its material desires. They borrowed as cheaply as Germans could to buy stuff they couldn't afford, They kept buying stuff they cannot really afford. Also other than the low interest rates, the inflation in the PIIGS countries was higher than the rate of interest. And the European peripheral countries (PIIGS) racked up enormous amount of debt in euros. While the sovereign debt increases have been most pronounced in only a few eurozone countries they have become a perceived problem for the area as a whole. In May 2011, the crisis resurfaced, concerning mostly the refinancing of Greek public debts. In late June 2011, the crisis situation was again brought under control with the Greek government managing to pass a package of new austerity measures and EU leaders pledging funds to support the country. Concern about rising government deficits and debt levels across the globe together with a wave of downgrading of European government debt created alarm in financial markets. On 9 May 2010, Europe's Finance Ministers approved a comprehensive rescue package worth 750 Billion (then almost a trillion dollars) aimed at ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF). In 2010 the debt crisis was mostly centered on events in Greece, where the cost of financing government debt was rising. On 2 May 2010, the eurozone countries and the International Monetary Fund agreed to a 110 billion loan for Greece, conditional on the implementation of harsh austerity measures. The Greek bail-out was followed by a 85 billion rescue package for Ireland in November, a 78 billion bail-out for Portugal in May 2011, then continuing efforts to meet the continuing crisis in Greece and other countries.

Eurozone sovereign debt concerns Greek debt in comparison to Eurozone average The Greek economy was one of the fastest growing in the eurozone from 2000 to 2007; during that period, it grew at an annual rate of 4.2% as foreign capital flooded the country.[24] A strong economy and falling bond yields allowed the government of Greece to run large structural deficits. After the removal of the right-wing military junta, the government wanted to bring disenfranchised left-leaning portions of the population into the economic mainstream.[25] In order to do so, successive Greek governments have, among other things, customarily run large deficits to finance public sector jobs, pensions, and other social benefits.[26] Since 1993 debt to GDP has remained above 100%.[27] Initially currency devaluation helped finance the borrowing. After the introduction of the euro in Jan 2001, Greece was initially able to borrow due to the lower interest rates government bonds could command. The late-2000s financial crisis that began in 2007 had a particularly large effect on Greece. Two of the country's largest industries are tourism and shipping, and both were badly affected by the downturn with revenues falling 15% in 2009.[27] To keep within the monetary union guidelines, the government of Greece had misreported the country's official economic statistics.[28][29] In the beginning of 2010, it was discovered that Greece had paid Goldman Sachs and other banks hundreds of millions of dollars in fees since 2001 for arranging transactions that hid the actual level of borrowing. [30] The purpose of these deals made by several subsequent Greek governments was to enable them to continue spending while hiding the actual deficit from the EU. In May 2010, the Greek government deficit was estimated to be 13.6% which is one of the highest in the world relative to GDP. Greek government debt was estimated at 216 billion in January 2010. Accumulated government debt was forecast, according to some estimates, to hit 120% of GDP in 2010. The Greek government bond market relies on foreign investors, with some estimates suggesting that up to 70% of Greek government bonds are held externally.

On 27 April 2010, the Greek debt rating was decreased to the upper levels of 'junk' status by Standard & Poor's amidst hints of default by the Greek government.[41] Yields on Greek government two-year bonds rose to 15.3% following the downgrading. Standard & Poor's estimates that in the event of default investors would fail to get 3050% of their money back. Danger of default Without a bailout agreement, there was a possibility that Greece would prefer to default on some of its debt. The premiums on Greek debt had risen to a level that reflected a high chance of a default or restructuring. Analysts gave a wide range of default probabilities, estimating a 25% to 90% chance of a default or restructuring.[65][66] A default would most likely have taken the form of a restructuring where Greece would pay creditors, which include the up to 110 billion 2010 Greece bailout participants i.e. Eurozone governments and IMF, only a portion of what they were owed, perhaps 50 or 25 percent. [67] It has been claimed that this could destabilise the Euro Interbank Offered Rate, which is backed by government securities. Greece represents only 2.5% of the eurozone economy.[72] Despite its size, the danger is that a default by Greece will cause investors to lose faith in other eurozone countries. This concern is focused on Portugal and Ireland, both of whom have high debt and deficit issues.[73] Italy also has a high debt, but its budget position is better than the European average, and it is not considered among the countries most at risk. EU emergency measures On 9 May 2010, the 27 member states of the European Union agreed to create the EFSF, a legal instrument[122] aiming at preserving financial stability in Europe by providing financial assistance to eurozone states in difficulty. The facility is jointly and severally guaranteed by the Eurozone countries' governments.[123] In order to reach these goals the Facility is devised in the form of a special purpose vehicle (SPV) that will sell bonds and use the money it raises to make loans up to a maximum of 440 billion to eurozone nations in need. The new entity will sell debt only after an aid request is made by a country.[124]

The EFSF loans would complement loans backed by the lender of last resort International Monetary Fund, and in selected cases loans by the European Financial Stabilisation Mechanism. The ECB has announced a series measures aimed at reducing volatility in the financial markets and at improving liquidity:[130]

First, it began open market operations buying government and private debt securities.

Second, it announced two 3-month and one 6-month full allotment of Long Term Refinancing Operations (LTRO's). Thirdly, it reactivated the dollar swap lines[131] with Federal Reserve support.[132]

Subsequently, the member banks of the European System of Central Banks started buying government debt. Reform and recovery In November, as concerns started to resurface about the fiscal health of Ireland, Greece and Portugal, EU President Herman Van Rompuy said "If we dont survive with the eurozone we will not survive with the European Union."[167] In March 2011 a new reform of the Stability and Growth Pact was initiated, aiming at straightening the rules by adopting an automatic procedure for imposing of penalties in case of breaches of either the deficit or the debt rules.[168][169] Subsequently, the proposed European treasury was implemented as the temporary European Financial Stability Facility, which will function until the permanent European Stability Mechanism is established following ratification of its treaty. In July 2011, it was agreed during the EU summit that the EFSF will be given more powers to intervene in the secondary markets, thus dramatically socializing risk in the eurozone, which ends the crisis.[170]

How European crisis could impact India? A crisis in an economy impacts other economies via three channels: Trade Channel: When an economy falls into a recession, it impacts the affected countrys trading partners too. Falling household and business demand in the slump-hit economy hits the exports/imports of its trading partners. The share of exports to EU (excluding UK) and imports from EU has fallen over the years. In 1987-88, exports to EU constituted about 18.6% of total exports. This has declined to 17.5% by 2008-09. The decline of imports is higher from 25% in 1987-88 to 12% in 2008-09. Hence, total trade between India and EMU is about 29.5% and could be impacted due to the crisis. (Source: RBI) However, trade channel can impact Indian external sector indirectly as well. When the recent crisis gripped the world 2008, most policymakers, economists and experts put forth the view that India would be only marginally affected. Two reasons were cited for th

First, India was a virtual non-entity in global trade as its share was less than 0.5%0.7% of the total global trade volumes. Hence, it was assumed that its economy was largely insulated from the turmoil. Second, share of developed economies in trade had declined. In 1987-88 developed economies contributed 59% of exports and in 2008-09 their share has declined to 37%. The share of developing economies has increased from 14% in 1987-88 to 37% in 2008-09. In case of imports developed economies share has again fallen from 60% in 1987-88 to 32% in 2008-09 while developing economies has risen from17% to 32%. (Source: RBI)

Because of this shift it was felt that impact of global crisis on Indian economy would be limited. As crisis originated in US and developed economies with developing economies still growing, it was felt Indian trade will continue to grow. However once the crisis struck in September 2008, Indian trade sector declined sharply and growth was negative for 13 straight months from Oct-08 to Oct-09. Financial Channel: The current crisis has shown the power of finance channel (though trade channel was also very strong as above analysis points). The impact of turmoil in one economys financial markets is not merely transmitted to other markets, the quantum and direction of the movement is also more or less similar (decline in equity markets, rise in corporate bond spreads and depreciation in currency). This is because cross border financial linkages have increased substantially over the years. Besides, the correlation between assets too has been rising across the world. If you plot the BSE Sensex with other advanced economy stock indices, you more or less see the same trend. So much so, one can determine the trend in the Indian equity market by just looking at movements in other global indices.

Foreign Institutional Investment: Unlike FDI, it is difficult to pinpoint the origin of FII investment. However, the linkage here is pretty direct. With a turmoil in global financial markets, FII inflows will decline. We have a large number of global financial firms which operate across the world and in case of a decline in one major market, there is a pull out from other markets as well. commmercial Borrowings: External commercial borrowings could also decline if the European crisis spreads to other economies. ECBs declined in the first stage of the crisis as well.

Confidencechannel This channel shows confidence declines in business and households seeing the global uncertainty. So even if an economys macroeconomic conditions and outlook look favorable, the decline in confidence can disrupt the economic conditions. Decline in confidence is also one of the reasons for decline in business investments which led to decline in overall Indian GDP growth. Credit growth also declined because of decline in business investments.