European Debt Crisis

The European debt crisis is the shorthand term for Europes struggle to pay
the debts it has built up in recent decades. Five of the regions countries
Greece, Portugal, Ireland, Italy, and Spain have, to varying degrees, failed to
generate enough economic growth to make their ability to pay back
bondholders the guarantee it was intended to be.
Although these five were seen as being the countries in immediate danger of a
possible default at the peak of the crisis in 2010-2011, the crisis has far-
reaching consequences that extend beyond their borders to the world as a
whole. In fact, the head of the Bank of England referred to it as the most
serious financial crisis at least since the 1930s, if not ever, in October 2011.

Q: How did the crisis begin?
The global economy has experienced slow growth since the U.S. financial crisis
of 2008-2009, which has exposed the unsustainable fiscal policies of countries
in Europe and around the globe. Greece, which spent heartily for years and
failed to undertake fiscal reforms, was one of the first to feel the pinch of
weaker growth. When growth slows, so do tax revenues making high budget
deficits unsustainable. The result was that the new Prime Minister George
Papandreou, in late 2009, was forced to announce that previous governments
had failed to reveal the size of the nations deficits. In truth, Greeces debts
were so large that they actually exceed the size of the nations entire economy,
and the country could no longer hide the problem.
Investors responded by demanding higher yields on Greeces bonds, which
raised the cost of the countrys debt burden and necessitated a series of
bailouts by the European Union and European Central Bank (ECB). The
markets also began driving up bond yields in the other heavily indebted
countries in the region, anticipating problems similar to what occurred in
Greece.( A bailout is a colloquial term for giving financial support to a
company or country which faces serious financial difficulty or bankruptcy. It
may also be used to allow a failing entity to fail gracefully without
spreading contagion. The term is maritime in origin being the act of removing
water from a sinking vessel using a smaller bucket)

Q: Why do bonds yields go up in response to this type of crisis, and
what are the implications?
The reason for rising bond yields is simple: if investors see higher risk
associated with investing in a countrys bonds, they will require a higher
return to compensate them for that risk. This begins a vicious cycle: the
demand for higher yields equates to higher borrowing costs for the country in
crisis, which leads to further fiscal strain, prompting investors to demand even
higher yields, and so on. A general loss of investor confidence typically causes
the selling to affect not just the country in question, but also other countries
with similarly weak finances an effect typically referred to as contagion.
Q: What did European governments do about the crisis?
The European Union has taken action, but it has moved slowly since it
requires the consent of all nations in the union. The primary course of action
thus far has been a series of bailouts for Europes troubled economies. In
spring, 2010, when the European Union and International Monetary Fund
disbursed 110 billion euros (the equivalent of $163 billion) to Greece. Greece
required a second bailout in mid-2011, this time worth about $157 billion. On
March 9, 2012, Greece and its creditors agreed to a debt restructuring that set
the stage for another round of bailout funds. Ireland and Portugal also
received bailouts, in November 2010 and May 2011, respectively. The
Eurozone member states created the European Financial Stability Facility
(EFSF) to provide emergency lending to countries in financial difficulty.
The European Central Bank also became involved. The ECB announced a plan,
in August 2011, to purchase government bonds if necessary in order to keep
yields from spiralling to a level that countries such as Italy and Spain could no
longer afford. In December 2011, the ECB made 489 ($639 billion) in credit
available to the regions troubled banks at ultra-low rates, and then followed
with a second round in February 2012. The name for this program was the
Long Term Refinancing Operation, or LTRO. Numerous financial institutions
had debt coming due in 2012, causing them to hold on to their reserves rather
than extend loans. Slower loan growth, in turn, could have weighed on
economic growth and made the crisis worse. As a result, the ECB sought to
boost the banks' balance sheets to help forestall this potential issue.
Although the actions by European policy makers usually helped stabilize the
financial markets in the short term, they were widely criticized as merely
kicking the can down the road, or postponing a true solution to a later date.
In addition, a larger issue loomed: while smaller countries such as Greece are
small enough to be rescued by the European Central Bank, Italy and Spain are
too big to be saved. The perilous state of the countries fiscal health was
therefore a key issue for the markets at various points in 2010, 2011, and 2012.
In 2012, the crisis reached a turning point when European Central Bank
President Mario Draghi announced that the ECB would do "whatever it takes"
to keep the Eurozone together. Markets around the world immediately rallied
on the news, and yields in the troubled European countries fell sharply during
the second half of the year. (Keep in mind, prices and yields move in opposite
directions.) While Draghi's statement didn't solve the problem, it made
investors more comfortable buying bonds of the region's smaller nations.
Lower yields, in turn, have bought time for the high-debt countries to address
their broader issues.
Q: What is the current status of the crisis?
Today, yields on European debt have plunged to very low levels. The high
yields of 2010-2012 attracted buyers to markets such as Spain and Italy,
driving prices up and bringing yields down. While this indicates greater
investor comfort with taking the risk of investing in the region's bond markets,
the crisis lives on in the form of very slow economic growth and a growing risk
that Europe will sink into deflation (i.e., negative inflation). The European
Central Bank has responded by slashing interest rates, and it appears on track
to initiate a quantitative easing program similar to that used by the U.S.
Federal Reserve in the United States.
(Quantitative easing is an occasionally used monetary policy, which is adopted
by the government to increase money supply in the economy in order to
further increase lending by commercial banks and spending by consumers.
The central bank (Read: The Reserve Bank of India) infuses a pre-determined
quantity of money into the economy by buying financial assets from
commercial banks and private entities. This leads to an increase in banks'
reserves.)

Definition of quantitative easing
Central banks normally set the price of money using official interest rates to regulate the
economy. These interest rates radiate out to the rest of the economy. They affect the cost of
loans paid by companies, the cost of mortgages for households and the return on saving money.
Higher interest rates make borrowing less attractive because taking out a loan becomes more
expensive. They also make saving more attractive, demand and spending reduces. Lower
interest rates have the reverse effect.
But interest rates cannot be cut below zero and when official rates get close to zero the effect
they have on regulating the economy becomes muted. Banks still need to make a profit and in
troubled times the gap between the official interest rate and the rates faced by companies and
households can rise, because lenders want a greater return for the additional risk of granting a
loan when times are tough.
When interest rates are close to zero there is another way of affecting the price of money:
Quantitative Easing (QE). The aim is still to bring down interest rates faced by companies and
households and the most important step in QE is that the central bank creates new money for
use in an economy.
Only a central bank can do this because its money is accepted as payment by
everybody. Sometimes dubbed incorrectly "printing money" a central bank simply creates new
money at the stroke of a computer key, in effect increasing the credit in its own bank account.
It can then use this new money to buy whatever assets it likes: government bonds, equities,
houses, corporate bonds or other assets from banks. With the central bank weighing in, the price
of the assets it buys should rise and the yield, or interest rate, on that asset will fall. Companies
for example with a willing central bank seeking to buy its bond, will be able to pay a lower interest
rate when new bonds are issued or existing bonds come to the end of their life and need to be
replaced.
With cheaper borrowing the hope is that the central bank will again encourage greater spending,
putting additional demand into the economy and pulling it out of recession. As the money ends
up in bank deposits, banks should also find their funding position improved and make them more
willing to lend.
A side effect will be that this new money is expected to raise consumer prices giving people
another incentive to buy now rather than later.
Of course there are risks. First, a central bank can lose money on its purchases, money that will
ultimately have to be underwritten by taxpayers either with higher future taxation or by the central
bank creating more money and risking higher future inflation. Second, go too far with creating
and spending money and you will destroy the value of the currency. Inflation or even
hyperinflation is the result. Third, if a descent into QE destroys confidence in an economy rather
than gives reassurance that the authorities are on the case it can be counter-productive.
That is why central banks cannot use QE willy-nilly, but if you are not aggressive enough QE
simply will not work to change other interest rates in the economy and stimulate demand. The
trouble is, because the policy is unorthodox and the situation is dramatic no one knows how
much QE is too much and how much is not enough. Who would be a central banker at the
moment?


Definition of Equity

1. A stock or any other security representing an ownership interest.

2. On a company's balance sheet, the amount of the funds contributed
by the owners (the stockholders) plus the retained earnings (or
losses). Also referred to as "shareholders' equity".
2. The term's meaning depends very much on the context. In finance, in
general, you can think of equity as ownership in any asset after all
debts associated with that asset are paid off. For example, a car or
house with no outstanding debt is considered the owner's equity
because he or she can readily sell the item for cash. Stocks are equity
because they represent ownership in a company.

Definition of 'Debt'

Amount of money borrowed by one party from another. Many
corporations/individuals use debt as a method for making large purchases
that they could not afford under normal circumstances. A debt arrangement
gives the borrowing party permission to borrow money under the condition
that it is to be paid back at a later date, usually with interest.

Bonds, loans and commercial paper are all examples of debt. For example, a
company may look to borrow $1 million so they can buy a certain piece of
equipment. In this case, the debt of $1 million will need to be paid back (with
interest owing) to the creditor at a later date.

Q: Why is default such a major problem? Couldnt a country just
walk away from its debts and start fresh?
Unfortunately, the solution isnt that simple for one critical reason: European
banks remain one of the largest holders of regions government debt, although
they reduced their positions throughout the second half of 2011. Banks are
required to keep a certain amount of assets on their balance sheets relative to
the amount of debt they hold. If a country defaults on its debt, the value of its
bonds will plunge. For banks, this could mean a sharp reduction in the amount
of assets on their balance sheet and possible insolvency. Due to the growing
interconnectedness of the global financial system, a bank failure doesnt
happen in a vacuum. Instead, there is the possibility that a series of bank
failures will spiral into a more destructive contagion or domino effect.
The best example of this is the U.S. financial crisis, when a series of collapses
by smaller financial institutions ultimately led to the failure of Lehman
Brothers and the government bailouts or forced takeovers of many others.
Q: How has the European debt crisis affected the financial
markets?
The possibility of a contagion has made the European debt crisis a key focal
point for the world financial markets in the 2010-2012 periods. With the
market turmoil of 2008 and 2009 in fairly recent memory, investors reaction
to any bad news out of Europe was swift: sell anything risky, and buy the
government bonds of the largest, most financially sound countries. Typically,
European bank stocks and the European markets as a whole performed
much worse than their global counterparts during the times when the crisis
was on centre stage. The bond markets of the affected nations also performed
poorly, as rising yields means that prices are falling. At the same time, yields
on U.S. Treasuries fell to historically low levels in a reflection of investors
"flight to safety."
Once Draghi announced the ECB's commitment to preserving the Eurozone,
markets rallied worldwide. Bond and equity markets in the region have since
regained their footing, but the region will need to show sustained growth in
order for the rally to continue.
Q: What were the political issues involved?
The political implications of the crisis were enormous. In the affected nations,
the push toward austerity or cutting expenses to reduce the gap between
revenues and outlays led to public protests in Greece and Spain and in the
removal of the party in power in both Italy and Portugal. On the national level,
the crisis led to tensions between the fiscally sound countries, such as
Germany, and the higher-debt countries such as Greece. Germany pushed for
Greece and other affected countries to reform the budgets as a condition of
providing aid, leading to elevated tensions within the European Union. After a
great deal of debate, Greece ultimately agreed to cut spending and raise taxes.
However, an important obstacle to addressing the crisis was Germanys
unwillingness to agree to a region-wide solution since it would have to foot a
disproportionate percentage of the bill.
The tension created the possibility that one or more European countries would
eventually abandon the euro (the regions common currency). On one hand,
leaving the euro would allow a country to pursue its own independent policy
rather than being subject to the common policy for the 17 nations using the
currency. But on the other, it would be an event of unprecedented magnitude
for the global economy and financial markets. This concern contributed to
periodic weakness in the euro relative to other major global currencies during
the crisis period.
Q: Is fiscal austerity the answer?
Not necessarily. Germanys push for austerity (higher taxes and lower
spending) measures in the regions smaller nations was problematic in that
reduced government spending can lead to slower growth, which means lower
tax revenues for countries to pay their bills. In turn, this made it more difficult
for the high-debt nations to dig themselves out. The prospect of lower
government spending led to massive public protests and made it more difficult
for policymakers to take all of the steps necessary to resolve the crisis. In
addition, the entire region slipped into a recession during 2012 due in part to
these measures and the overall loss of confidence among businesses and
investors.
Q: From a broader perspective, does this matter to the United
States?
Yes The world financial system is fully connected now meaning a problem
for Greece, or another smaller European country, is a problem for all of us.
The European debt crisis not only affects our financial markets, but also the
U.S. government budget. Forty percent of the International Monetary Funds
(IMF) capital comes from the United States, so if the IMF has to commit too
much cash to bailout initiatives, U.S. taxpayers will eventually have to foot the
bill. In addition, the U.S. debt is growing steadily larger meaning that the
events in Greece and the rest of Europe are a potential warning sign for U.S.
policymakers.
Q: What is the outlook for the crisis?
While the possibility of a default or an exit of one of the Eurozone countries is
much lower now than it was early in 2011, the fundamental problem in the
region (high government debt) remains in place. As a result, the chance of a
further economic shock to the region - and the world economy as a whole - is
still a possibility and will likely remain so for several years.



Definition of 'Default'

1. The failure to promptly pay interest or principal when due. Default occurs
when a debtor is unable to meet the legal obligation of debt repayment.
Borrowers may default when they are unable to make the required payment
or are unwilling to honour the debt.

2. The failure to perform on a futures contract as required by an exchange.
Investopedia explains 'Default'

1. Defaulting on a debt obligation can place a company or individual in
financial trouble. The lender will see a default as a sign that the borrower is
not likely to make future payments. For example, if Company XYZ is unable
to make a coupon payment on its bonds, the bondholders would place XYZ in
bankruptcy. This would give the company an opportunity to claim XYZ's
assets as a form of repayment for the debt.

2. Defaulting on a futures contract occurs when one party does not fulfill the
obligations set forth by the agreement. The default usually involves not
settling the contract by the required date. A person in the short position will
default if he or she fails to deliver the goods at the end of the contract. The
long position defaults when payment is not provided by the settlement date.