About the Euro crisis

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About the Euro crisis

 

1.        Comment on the rationale for the formation of the European Union

 

1.1    Definition and formation of European Union


Figure 1 The 27 member states under European Union

Source: Solberg, S. J. 2010. The European Union (EU), Retrieved 9 Jan 2012 [online] http://commons.wikimedia.org/wiki/File:Global_European_Union.svg

 

The term “European Union” is used to refer to the Union as established by the Treaty on European Union (TEU). In 1993, the Council of the European Communities adopted the name of the Council of the European Union and the Commission of the European Communities was renamed the European Commission (Guild 1996, p. 3). The European Union (EU) right now is an economic and political union of 27 member states which are located primarily in Europe as shown in the figure above. And in the following we will look into the rationality for the formation of the European Union.

 

 

1.2    Rationality for the formation of the European Union

 

1.2.1            Regional approaches to Free Trade Area (FTA)

 

As economic regionalism has become the dominant trend in the international trading system which has paralleled the movement towards globalization since the early 1990s, it is believed that it comes with the removal of restriction in trade and investment and one of the important trend of the economic regionalism is the formation of free trade area (FTA) under regional economic blocs with the General Agree on Trade and Tariffs (GATT) (Alam 2008, p. 120). Members of FTAs eliminate tariffs on trade with each other but they could still retain autonomy in determining their tariffs with nonmembers. And it is believed that free trade area (FTA) will benefit the member states by liberal internal trade among the member countries according to comparative advantage, and also provides benefits through a greater variety of products available to consumers in the expanded market (Levy 1997). Therefore, there is no assurance that each member state would gain equal benefits in term of economy progress from the EU free trade area (FTA), but at least the customers who will enjoy lower priced products and more choices will definitely benefited.

 

1.2.2            One single trade bloc

 

By joining a large trade bloc like the European Union, companies within the member states would enjoy an expanded domestic market resulting in a lower cost of production and a higher production volume. As proposed by R. Scott Hacker and Qaizar Hussain (1998, p. 5) from the IMF Institute, before expanding a trading bloc the member state that consist of small country A and big country B, their position of production cost and production units is A and B as indicated in the figure below. And they further move to A’ and B’ after expansion of a trading bloc, then because the firms from the two countries expand output by the same amount due to the expansion of the trade bloc, then the small-country firms would produce at A’s and B’s for large country firms, though the drop in average cost in this case is greater for the smaller country firms, in general all firms enjoy advantage in term of cost reduction and production volume by having a larger trading bloc.

Figure 2
 The average cost and changes in production levels by joining a trade bloc

Source: Hacker, R. S. & Hussain, Q. 1998. Trading Blocs and Welfare-How Trading Bloc Members are Affected by New Entrants. Washington, D. C.: IMF Institute

 

1.2.3            Common monetary policy: European monetary union

 

The Economic and Monetary Union (EMU) is an umbrella term for the group of policies aimed at changing the economies of members of the European Union in three stages so as to allow them to adopt a single currency, the euro. As such, it is largely synonymous with the euro zone. All member states of the European Union are expected to participate in the EMU (Dumas 2010). According to Ali El-Agraa and Brian Ardy (2011, p. 149) in practice, the monetary integration would include three components in order to become a real monetary integration:

 

l  A common monetary policy

l  A common pool of foreign exchange reserves and a common exchange rate policy

l  A single central bank or monetary authority (MA) to operate these policies

 

And because of these three elements, we could summarize several key reasons why these member countries would like to join the European Union in term of the monetary integration: Firstly, with a common pool of foreign exchange reserves, there will be a much less chance for a single member state to have a deficit because other countries’ surplus; Secondly, because of the use of Euro inside the European Union, the business activities happening within the European Union would no longer need the money exchange which reduces the money exchange transaction cost; Thirdly, because of the large number of member states which majorly are developed countries with powerful economies though they are in small scale compared to that of the United States and Japan, but with the adoption of common currency, Euro, the European Union managed to make the Euro become a widely accepted currency like United States Dollar and Japanese Yen and as a matter of fact many other countries are storing up Euro as foreign reserve to strengthen their ability to tackle the economy risks and uncertainties.

 

But there are not only advantages of having a common currency but also there are disadvantages which to some extent have contributed to the current Euro crisis which will be probed into in the next part of this study.

 

2.        What is the Euro crisis and discuss the factors that has brought about the Euro crisis?

 

2.1    What is the Euro crisis?

 

In the spring 2010, the euro crisis began in earnest as the financial community began the question Greece’s ability to repay its debt. The snowballing crisis grew and grew, the euro sank to a four-year low, and the downward spiral caused the International financial community to mount an emergency rescue package. In May 2010, the European Central Bank and the International monetary Fund (IMF) put together a Herculean Greek rescue package of 750 billion euro which temporarily calmed the markets (Tanous, Cox & Santelli 2011, p. 14). But the crisis had just begun rather than being contained ever since the outbreak of the Greek crisis. In the following we will analyze some of the key reasons behind this Euro crisis.

 

2.2    Key reasons behind the Euro crisis

 

2.2.1            Budget deficit

 

One of the key reasons behind the euro crisis is that some of the countries had overly used the budget deficit which was widely adopted after the outbreak of the US led economy crisis in the late 2008. This begins as private debt is shifted into the balance sheet of the governments via the bailouts and purchases of toxic debt. The government-debt problem is then made worse as the economic downturn leads to an increase in expenditures in the form of unemployment benefits and stimulus spending, coupled with a decrease in tax revenues (munknee.com 2010). For example, Greece’s budget deficit continued to widen in November and the construction business kept shrinking as an austerity-fueled recession hit both government revenues and economic activity, data showed. The budget gap of the central government widened 5.1 percent year-on-year to 20.52 billion euros ($27.1 billion) in the first 11 months of the year 2011 while the debt-choked country had to pay a higher price to sell T-bills (cnbc.com 2011). In another case, Iceland’s general government deficit peaked at 13.5% of GDP in 2008 which decreased to 9.1% but it was still a deficit (politics.ie 2011). In addition, Portugal just yesterday announced a budget deficit that was 9.3% of GDP in 2010 compared to the media estimates of 8% (seekingalpha.com 2010). Similar cases could also be found in other member states in the European Union, mainly the PIIIGS – Portugal, Ireland, Iceland, Italy, Greece and Spain.

 

2.2.2            Unable to employ independent monetary policy

 

Take the Greece’s debt crisis as an example, before the year 2008 the interest rate is low and the Greece government had borrowed money extensively to fund the public service and other projects, and it spent more than it taxed which was common among the European countries. But when the economy was hit in 2008, the government had a reduced income in term of tax; therefore the government could not make the repay and had no choice but to raise the interest rate in response to the lenders’ demand for a better compensation due to the increased risks. And as a matter of fact, theoretically speaking, for a normal country in this position, it could adopt an expansive monetary policy and increase the issued volume of currency in the circle in the cost of devaluation of the currency which also encourages export. But Greece as a member state of the European Union, Greece had no independent control over the monetary policy. Such inability to control the currency freely and inflexibility was devastating (D’Anieri 2010, p. 270).

 

2.2.3            Huge public sector – case study of Greece

 

As the first country that was considered as triggering the Euro crisis, Greece is to some extent responsible for the current challenges and difficulties that the European Union member countries are facing. One of the root reasons behind the fiscal deficit is the large expenditure in the public sector. Greece is characterized by a big public sector, which has many chronic problems resulting in low efficiency and effectiveness and also high relative government budget spent in the field of public service (International Organisations Services 2002). And because of the fact that the government expenditure in the public sector is normally considered as economically nonperforming, the huge public sector will only occupy a considerate proporation of the government expenditure while bringing relatively less income especially in the short term basis.

 

2.2.4            High debt to GDP ratio

 

Debt to GDP ratio is a measure of a country’s federal debt in relation to its gross domestic product (GDP). This measure gives an idea of the ability of a country to make future payments on its debt. If a country were unable to pay its debt, it would default, which could cause a panic in the domestic and international markets. The higher the debt-to-GDP ratio, the less likely the country will pay its debt back, and the higher its risk of default (Investopedia.com 2011). Manasse and Roubini (2005) identify “safe zones” in which safe debt levels depend on a host of indicators, particularly a country’s ratio of short term debt to reserves and indicators of macroeconomic solvency and political stability. They identify a maximum debt ratio of about 50 per cent of GDP as “safe” for countries that have stable macroeconomic indicator and do reasonably well in term of liquidity and debt structure. But as the chart below show, some of the major European Union members had a high debt to GDP ratio in 2009, and Greece even had a 112.6% and Italy had a similar 114.6% indicating that the deficit level had greatly exceeded the normal and safe level which contributed to the debt crisis in these countries and even spread to the other European Union members through the common currency and other bridges. But we also should take note that the extremely high debt to GDP ratio is not only cause of the crisis since the governments had spent much more than should were capable to repay but also it is one of the results of the crisis because the economy problems such as the large expenditure spent in the public service in Greece had already exist before the governments’ adoption of the ambitious fiscal policies.


Chart 1 Projected budget deficit for 2009

Source: European Commission/Economic forecast autumn 2009

 

3.        Comment on the latest measures that have been introduced to solve or contain the Euro crisis

 

3.1    Financial rescue package

 

Euro zone nations in the middle of 2010 started setting up a massive bailout fund that could rescue any member of Europe’s currency union from default; it was aiming to soothe market jitters that have sent the euro to a new four-month low against the dollar. The so called “shock and awe” financial rescue package from the European Union and the International Monetary Fund will total euro750 billion ($1 trillion) – money that can be lent to any indebted euro zone nation risking default, and intended to counter investor fears that Spain, Portugal or others could follow Greece in requiring a bailout to meet debt repayments (arawakcity.org 2010). But it is believed that such rescue package only can buy some time for the already collapsing investor confidence and the currency’s long-term stability. Because fundamentally speaking, the governments’ debts come from government deficits which had been adopted in the ambitious fiscal policy to stimulate the economy growth, therefore, if the government could not cut the deficit significantly among the member states, the financial rescue package would only differ the debt crisis rather than solving the problem once for all.

 

3.2    The European Financial Stability Facility (EFSF)

 

The European Financial Stability Facility (EFSF) is a special-purpose vehicle in the form of a Luxembourg-based company owned by the governments of the 16 countries of the euro zone. Each of them contributes to its capital to the proportion of that country’s share in the European Central Bank’s capital (ranging from € 123 billion Germany to € 400 for Malta). And the EFSF can issues bonds guaranteed by euro zone member states and will convert this money into one-off loan to countries experiencing difficulties in refinancing debt such as Greece (Molle 2011, p. 215). One key defect of the European Financial Stability Facility (EFSF) is that its planned budget at the beginning is much smaller than the outstanding amount of the euro area government debt as in the mid of 2010 the debt had reached about 5.4 trillion (World Bank 2011, p. 139). Probably the rationality of the original European Financial Stability Facility (EFSF) was to help resolve the several countries’ debt crisis, but the worrying of investors about the spreading of the crisis to other countries such as Italy had actually required more than this amount of money.

 

3.3    The Brussels summit: trying to reach a consensus

 

As above mentioned, the high debt to GDP ratio among the major European Union member states had been directly cased by the governments’ high expenditure in term of deficit compared to their ability to repay the debts, therefore one of the key effective methods would be to control the total expenditure of the governments. On December 8th 2011, European leaders have started a two-day summit in Brussels in the latest effort to resolve the continent’s debt crisis and save the euro. Some officials have described the European summit as a moment of reckoning for the common currency, under siege by Europe’s burgeoning debt crisis.  But before the meeting opened on Thursday night, there remained a divergence of opinion on exactly how to resolve the two-year debt contagion that threatens the stability of the world economy (voanews.com 2011). But the views expressed in the Brussels summit seemed to be quite different in reaching a consensus on how the debt crisis should be settle. The most obvious uncertainty and challenge came from United Kingdom which had refused to sign up the plan to implement a tighter fiscal controls with automatic penalties for euro zone nations that overspend without major concessions in return. Though all EU states, bar Britain, are agreed in principle to taking part in a new euro zone “fiscal compact” tightening budgetary discipline according to an EU statement, Hungary had originally voiced its reluctance, while Sweden and the Czech Republic were undecided. But a statement said all nine non-euro nations had “indicated the possibility to take part in this process after consulting their parliaments where appropriate” (aljazeera.com 2011).

 

4.        Discuss the impacts of the Euro crisis on investments, capital raising and exchange rates of the major currencies

 

4.1    Impacts of the Euro crisis on investments

 

As the most recent summit held in the Brussels did not yield satisfactory fruits as the major European Union members could not reach a consensus regarding how the debt crisis spreading in the Euro zone should be addressed despite the U.S. Treasury Secretary Timothy F. Geithner traveled to Europe to press political leaders and central bankers to stem the region’s worsening debt crisis (bloomberg.com 2011), therefore as a matter of fact the Euro crisis has already been taken into 2012, and one of its major impacts is on the confidence of investors. Because there are obvious risks in the euro currency and also the some governments’ short term and long term solvency is under doubts, it not only means that the member states will have to pay a bigger premium and will also have to work harder to sell their bonds (Oakley 2010) but it also means that the Euro zone as a market for investment could not well compete with the other markets such as the raising Asian countries to reward the investors with sound profits. According to the most recent news, Banks parked record sums at the European Central Bank while Germany held an uninspiring bond sale, suggesting investors are remaining cautious as new data suggested Wednesday the euro zone crisis would likely linger well into 2012 (indiatimes.com 2012).

 

4.2    Impacts of the Euro crisis on capital rising

 

According to the data released several days ago, Commercial banks’ overnight deposits at the European Central Bank hit a new record high of 453 billion Euros ($591 billion), data showed on Wednesday, underscoring the ongoing fear banks have about lending to each other in the current debt crisis. The continuing sovereign debt crisis means many institutions still lack the trust to lend to each other and prefer to stash their money at the ECB (European Central Bank) (cnbc.com 2012). While the European banks still have to struggle to raise their capital adequacy ratio, it will lead banks to reduce the private sector share and thus increase the difficulties in capital rising in the private sector which further contribute to the overall recession in the euro area. In addition, with the continual growth of the emerging markets such as China and India, many international investment funds have choose the leave the Euro zone and to seek opportunities and risk evasion in these emerging markets or in the more stable and rapidly recovering developed markets such as the United States.

 

4.3    Impacts of the Euro crisis on exchange rates of the major currencies

Chart 2
 Currency performance of Euro against Pound, US Dollar and Yen in the past one year

Source: ft.com 2012

 

From the charts above, we can see that during the past 12 months the Euro exchange rate against other major currencies has declined gradually since the mid of 2011 and the devaluation is most obvious when it is against the Japanese Yen with a drop of  8.41% in the end of 2011. And according to most recent new updated several days ago, The euro came under renewed pressure, falling to an 11-year low (97.88) against the yen as a fresh round of downbeat data intensified fears the troubled region is heading for recession (telegraph.co.uk 2012). In the case of China, China remains deeply dependent on the US Dollar, and is still very vulnerable to a sudden depreciation it its value (forexblog.org 2011). The depreciation of the Euro will tend to make the CNY appreciate accordingly and Euro zone is one of the key export destinations of China in nowadays. In response, to boost economic growth, China has adopted several necessary and targeted measures. These included reining-in the appreciation of the renminbi and slightly relaxing its tight monetary policy. However, these clashed with the US and Europe’s expectations of continuing appreciation of the renminbi, and of China expanding domestic demand (wantchinatimes.com 2011). Therefore we can see that the impact of the Euro crisis on the Chinese currency is not certain, and it depend on how the government of China and its central bank understand and apprehend the Euro crisis in the future because the country’s ability to influence the exchange rate rather than depending on the market demand which could be good and bad.

 

 

 

 

Reference

 

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