Eurozone Debt Crisis The Role of Germany

As concern continues to grow about the deepening financial crisis in Europe, Germany's crucial role in the economy of the region is becoming more and more apparent. While the economies of most European Union countries have been languishing since 2008, Germany's economy has been booming since the country managed to quickly emerge from the global financial crisis that hobbled many others. Germany, owner of the eurozones strongest economy, is seen as the key to containing the crisis. The country has already pumped more than $100 billion into a eurozone rescue fund. But analysts say hundreds of billions more will be needed to prevent a meltdown, as a broad recession continues to threaten the financial stability of Greece, Portugal, Ireland, and even larger countries such as Italy and Spain. The leaders of Germany and other wealthy European countries are already facing political backlashes over what many of their constituents see as a doomed effort to prop up their poorer neighbours failing economies.

However, despite its stellar status, Germany is far from all-conquering. The Dax share index has lost 29% since the beginning of July significantly worse than London's FTSE 100 while business confidence is tumbling at the fastest rate since the collapse of Lehman Brothers. New data showed a sharper than expected fall in industrial orders in July, especially from beyond the eurozone. German taxpayers are becoming increasingly sceptical about efforts to help eurozone strugglers such as Greece. That in turn has put domestic pressure on the chancellor, Angela Merkel, whose coalition government has suffered a string of setbacks this year.

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Germany: Europes Pride or Problem Greece, Ireland, Italy, Portugal, and Spain (GIIPS) have become increasingly uncompetitive since adopting the euro. But competitiveness is relative, raising an important question: how did Germany, Europes largest and most competitive economy, fare under t he euro? Peripheral countries, assert the critics of Germany, not only entered the Eurozone at an uncompetitive exchange rate, but Germanys wage moderation also was equal to a real devaluation against other members in the Eurozone, since its unit wage costs rose at a slower rate of any European Union (EU) countries. Thus, the beggar-thy-neighbour policy pursued by Germany had an asymmetric impact on the members of the Economic and Monetary Union (EMU). According to this argument, Germany is most responsible for the emergence of a two speed Europe with Germany (as well as Austria and the Netherlands) as the healthy core and much of southern Europe as the troubled periphery

Since adopting the euro, Germany has seen its exports regain world share, rising 0.5 percentage points from 2000 to 2009a remarkable performance compared with the 11.6 percent contraction in the share of advanced countries over that period. Over the same period, exports have gained an additional 14 percent of GDP share in Germany, bringing the total gain from 1993 to 2008 to a remarkable 25 percentage points. In a nutshell, while the GIIPS became more inward-focused and driven by domestic activities, Germany became the worlds largest exporter. The percent of total German exports going to the Euro area as a whole has actually declined since the euro was introduced because the Euro area has grown more slowly than other regions. Germanys bilateral trade balance in goods with each of the GIIPS, however, has improved. For example, Greeces bilateral trade deficit with Germany widened from -1.5 percent of Greeces GDP in 1999 to -2.5 percent in 2008. Other core European countries, like the Netherlands, saw similar developments with the GIIPS, suggesting that all of the surplus countries benefited from increased demand in the weaker Euro area members.

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Nevertheless, the economic argument only tells part of the story. Whether Germany benefits from the EURO is also a deeply political question illuminating the future role and commitment of Germany in the Eurozone. The slow German rescue response to the peripheral countries, in particular Greece, raises at least some questions regarding whether Germany is pursuing more national prerogatives and a reduced European strategy. After all, a strong European Union and Eurozone depend especially on the commitment of Germany and the Berlin-Paris axis. The argument that Germany is not benefiting from the EURO and Angela Merkels mixed signals during the negotiations of a rescue package for the peripheral countries suggests that the Eurozone could be confronted with a less committed Germany and thus even a possible collapse of the Eurozone. Conversely, the crisis could provide an opportunity to create a more coordinated and politically integrated Union. Both directions will depend to a large extent on Germany. What Next: The Cure Starts With Germany Over the last 10 years, while Spain, Ireland, Portugal and others partied on low interest rates, the German people cut their wages, endured punishing structural reforms and accepted the pain of 5 million unemployed in a drive to modernize their own industries. Their sacrifices have brought them a large trade surplus and an 80 percent rise in German exports to China. When the last financial crisis first hit, the German government, like the rest of Europe, blamed America and Britain. A year later, as the financial crisis widened into a general economic crisis, the Germans retreated into even safer, more familiar territory, redefining the world crisis not as financial but as fiscal one of deficits and debt. As a result, Germany has denied any culpability for what has gone wrong. Indeed as long as it can argue that it is not a source of the problem, it can justify resisting costly measures to resolve it. Yet according to the Bank for International Settlements, Germany lent almost $1.5 trillion to Greece, Spain, Portugal, Ireland and Italy. At the start of the crisis German banks had 30 percent of all loans made to these countries private and public sectors. Even today this one category of loans is equivalent to 15 percent of the size of the German economy.

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Add to that heavy German involvement in the credit binge in American real estate (half Americas subprime assets were sold on to Europe), and in property speculation across Europe, and it is clear that wherever parties were taking place, German banks were supplying the drinks. As a result, Germanys banks are today the most highly leveraged of any of the major advanced economies, a massive two and a half times more leveraged than their U.S. banking peers, according to the I.M.F. But why should this concern Germany, which is competitive, fiscally sound and economically robust? Because all across Europe the poor condition of the banking sector is becoming a risk to recovery and stability. German banks like other European banks rely on raising short term funds, and in the next three years these already weakly capitalized and poorly profitable banks have to raise 400 billion from the markets, an amou nt that is nearly one-third of the entire euro zones 1.4 trillion in wholesale debt. A few days ago it was the turn of France like Germany rated AAA by credit rating agencies to face market pressure because of its high levels of exposure to the euro periphery. Each countrys problems are unique, but, as the epicenter of the crisis moves closer to Europes core, Germany too may find its once unchallengeable image as a financial bastion called into question. Thus, it is also time for Germany to acknowledge that it must be integral to solving the problem. Of course, no one should expect Germany to transfer a large percentage of its wealth to the E.U.s poorer countries but it must take a proactive role in ensuring a crisis solution through a common Euro-bond facility (which it has vehemently denied), legislation for greater fiscal and monetary coordination, and a role for the European Central Bank that takes it one step beyond being the guardian of low inflation by adding a second role as lender of last resort. With the eurozone's woes on the front pages most days, people in Germany, who are paying the lion's share into the rescue packages, appear to be turning against the single currency but remain faithful to the EU. There is a growing feeling amongst Germans that Germany made some painful reforms which the others did not. In the end, Germany will have to agree to a common mechanism for Europe to pay its way out of crises. Germanys recent failure to act from a position of strength endangers not only the country itself, but the entire euro project that Germany has spent decades developing.

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Implications of German Decisions 1. Crisis Contained This is touted to be the most likely scenario but the volatility is expected to continue for a longer time. Ambitious mechanisms have already been put in place to dampen the crisis and with the amount of political prestige that is already invested, political leaders will be willing to go even further to ensure a solution can be found. The current European Financial Stability Mechanism (EFSM), the European Financial Stability Facility (EFSF) and IMF measures are sufficient to cover almost all of the government financing needs of Ireland, Portugal and Spain. If the EFSF is to cover Italy it would have to be increased substantially. An increase in the EFSF seems to be the most likely development and is already partly anticipated in the market. 2. Euro Bonds Political leaders have called for a common European bond, or what is often referred to as an E-bond. In December 2010 the president of the Eurogroup, Jean-Claude Juncker, proposed the issuance of E-bonds of up to 40% of euro area GDP. The idea is that each member state would be allowed to borrow up to 40% of its GDP at low interest rates through an AAA rated E-bond market. To achieve an AAA rating the best performing countries will have to guarantee for part of the less well performing countries debt. This structure should give the member states an incentive to consolidate and ensure sound public finances. Furthermore, the E-bond market depth and wide basis would be similar to that of US public debt, ensuring better access to capital for the minor countries despite their economic difficulties. The proposal has so far been rejected by Germany, indicating that an enlargement of the EFSF is probably more likely. German Chancellor Angela Merkel is concerned about moral hazards and has said that: We must not make the mistake of thinking that collectivising risk is the answer. Japan has said that it would like to purchase 20% of the issued E-bonds but it did not say anything about potential purchases of any of the PIIGS sovereign debt. 3. Germany Walks out of the Euro This scenario is very unlikely but it cannot be completely ruled out if public opinion against financial support for the periphery countries increases significantly. There were concerns that it could also be triggered by the German constitutional court saying that politicians have gone too far and breached the no bail-out clause. However, Germanys constitutional court on 7th September 2011 rejected the challengers petition to Eurozone bailouts. If Germany were to leave the euro zone, the D-mark is likely to be in high demand from day one and would be expected to appreciate. However, bank runs could occur in the peripherals countries as the euro is likely to depreciate relative to the D-mark. Germany
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would lose competitiveness but the euro zone would benefit from a much needed increase in competiveness as the euro depreciates. On the other hand German banks and other investors could face substantial losses on their holdings in the rest of the euro area. Another uncertainty in this scenario is whether other countries would follow Germany. However, as stated earlier, there is a very minute possibility of this scenario actually occurring. 4. One or some of the countries default There is a possibility that one, or maybe a few of the periphery countries default on their debt resulting in a debt restructuring. The candidates most in danger of this are Greece, Ireland and Portugal. This does not automatically mean that they would have to leave the European Monetary Union. However, the country that defaults would have to be prepared for a period with limited access to financial markets Alternatively a periphery country may decide to leave the EMU if it deems it too tough to get the economy out of the doldrums without being able to devalue and regain some competitiveness this way or if internal public opposition becomes too strong. The implications for financial markets and the global economy of periphery countries leaving the euro area would depend on the fragility of the financial system at the time. Concerns about which other euro area countries may leave could result in a prolonged period of high volatility and a continuation of the debt crisis. This scenario has a very small likelihood of materialising as the economic cost seems to outweigh the economic benefits. However, in the end the decision really depends on public opinion and political leadership. Thus, this scenario cannot be fully ruled out. 5. Break-up of EMU The worst-case scenario is a total breakup of the EMU. This could happen by mutual agreement or as a resulting domino effect if Germany decides to leave. It is likely that some of the core countries would peg their currency to the D-mark. A break-up of the euro would affect the global economy, which is one of the reasons we see both China and Japan as willing to invest in funding for the most indebted countries. The turmoil and uncertainty could lead to severe losses in the financial sector that would impact the real economy, as we experienced it during the financial crisis. In contrast a scenario with a debt restructuring in Greece and maybe even Ireland would only have minor impact on the global economy as long as other member states can maintain their credibility. A break-up is a very unlikely option but the environment is so fluid and unpredictable that it cant be entirely discounted. For now it appears as though we are heading towards a larger bailout mechanism and as the crisis continues to flare up the need for fiscal unity will become increasingly necessary. At this point, the Europeans are too invested in the euro to risk its collapse and that means they must move in the direction of unity.
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Eurozone Debt Crisis The Role of Greece

The economy of Greece is the 27th largest in the world by nominal gross domestic product (GDP) and the 34th largest at purchasing power parity (PPP), according to data by the World Bank for the year 2009. However the country suffers from high levels political and economic corruption and low global competitiveness compared to its EU partners. After 15 consecutive years of economic growth, Greece went into recession in 2009. An indication of the trend of over-lending in recent years is the fact that the ratio of loans to savings exceeded 100% during the first half of the year. By the end of 2009, the Greek economy (based on data revised on 15 November 2010 in part due to reclassification of expenses) faced the highest budget deficit and government debt to GDP ratios in the EU. The 2009 budget deficit stood at 15.4% of GDP. This and rising debt levels (127% of GDP in 2009) led to rising borrowing costs, resulting in a severe economic crisis. Build up to the crisis As Greece prepared during the 1990s to adopt the euro as its national currency, its borrowing costs dropped dramatically. Interest rates on 10-year Greek bonds were dropped by 18% (from 24.5% to 6.5%) between 1993 and 1999. Investors believed that there would be widespread convergence among countries in the Euro zone. This belief was reinforced by the policy targets, called convergence criteria that countries had to meet in order to be eligible to join the Euro zone. Additionally, the common monetary policy was to be anchored by economic heavyweights, including Germany and France, and managed conservatively by the ECB. EU member countries were also to be bound by rules in the Stability and Growth Pact that limited government deficits (3% of GDP) and public debt levels (60% of GDP). These limits were to be enforceable through fines of up to 0.5% of GDP. All of these factors created new investor confidence in Greece and other Euro zone member states with traditionally weaker economic fundamentals compared to, for example, Germany. The influx of capital and pursuit of meeting convergence criteria did not result in a fundamental change in how the Greek economy was managed or in investments that increased the competitiveness of the economy. The Greek government took advantage of greater access to cheap credit to pay for government spending and offset low tax revenue. The government also borrowed to pay for imports from abroad that were not offset by exports overseas. Government budget and trade deficits ballooned during the 2000s and borrowed funds were not channelled into productive investments that would generate future growth, increase the competitiveness of the economy, and create new resources with which to repay the debt. Instead, the inflows of capital were used to fund current consumption that did not yield streams of revenue with which to repay the debt.

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Austerity Measures 2010 2011 Greece adopted a number of austerity packages since 2010. The first round of austerity came with the signing of the memorandums with the IMF and the ECB concerning a loan of 80 billion euro. Demonstrations and strikes followed the implementation of measures. Following fears of bankruptcy, further measures were implemented on 3 March 2010. The second austerity package failed to improve Greece's economic position, and on 23 April 2010 Prime Minister George Papandreou appealed to the European support mechanism for help, which asked for the implementation of more austerity measures. 2011 saw the introduction of further austerity. In the midst of public discontent, massive protests and a 24-hour-strike throughout Greece, the parliament debated on whether or not to pass a new austerity bill, known in Greece as the "mesoprothesmo" (the mid-term [plan] ). The government's intent to pass further austerity measures was met with discontent from within the government and parliament as well, but was eventually passed with 155 votes in favor. On 19 August 2011 the Greek Minister of Finance, Evangelos Venizelos, said that new austerity measures "should not be necessary". On 20 August 2011 it was revealed that the government's economic measures were still out of track; government revenue went down by 1.9 billion euro while spending went up by 2.7 billion. Impact on Major Economies Impact on US Economy The bilateral economic relationship between the EU and the United States is one of the largest and strongest in the world, 36 and economic turmoil in Greece and the broader Euro zone could have negative implications for the U.S. economy. At the start of the crisis, it was expected that austerity measures would slow growth in Europe and lead to a loss of confidence in the euro causing a depreciation of the euro relative to the U.S. dollar. Both of these factors would depress demand for U.S. exports to the Euro zone and increase U.S. imports from the Euro zone, causing the U.S. trade deficit to widen. Impact on Euro zone The current economic crisis in Greece puts the future of Euro into question. Nouriel Roubini, economics professor at the Stern School of Business at New York University, believes that some countries might exit the monetary union. Countries such as Spain and Greece are emblematic of the problem. They lack both the physical and human infrastructure needed to make themselves more competitive, yet it is in those areas spending on roads, universities and skills that the axe will fall. This presents a problem not just now but for the future, as the ageing baby boomer generation presents Europe with a steady decline in its working-age population.

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Impact on Indian Economy India is likely to witness a short term impact of Greeces public finance crisis if it spreads to larger Euro Zone economies, said Planning Commission deputy chairman Montek Singh Ahluwalia. Expressing his faith in the strength of Indias economy the deputy chairman added that Asias third largest economy is in much better position than the Euro zone countries which are on the verge of sovereign default and hoped that the crisis will remain limited to small countries and will not spread worldwide. Addressing a CUTS International function in the capital on Tuesday Montek Singh said, If it (Greece bailout package) succeeds in stabilising the global financial situation, that is beneficial for us. The crisis really is the crisis of sovereign debt in the industrialised countries....We are not in that situation... Implications First, the policy responses to Greeces debt crisis have set precedents for how the debt crises in other Eurozone countries have been handled. The original crisis response for Greece focused on the provision of IMF and European financial assistance, in combination with austerity and structural reforms. This policy response was contentious and took weeks to negotiate. When Ireland and Portugal needed assistance, however, their programs were easier to negotiate, because Greece served as a template for designing the crisis response. Now that bondholders are being asked to share in the response to Greeces crisis response by taking losses on their investments, markets are concerned that there will be losses on Irish and Portuguese bonds in the future. European officials deny this to be the case. Second, Greeces crisis has exacerbated concerns about the health of the fragile European financial sector. Several large European banks, such as BNP Paribas, Socit Gnrale, Deutsche Bank, UniCredit, and Intesa, are believed to be major private holders of Greek bonds. There have been continuing concerns about how these banks would be able to absorb losses on Greek bonds should Greece default or restructure its debt, particularly given widespread concerns that European banks may be undercapitalized. Specifically, there are concerns that the crisis could be transmitted through the European financial sector, triggering broader instability and requiring governments to recapitalize banks. European officials conducted two rounds of stress tests on European banks in June 2010 and July 2011. These tests examined how well European banks could absorb losses on distressed Eurozone bonds. Most banks performed well under the various scenarios laid out in the tests, but some questioned whether the tests were stringent enough. Third, Greeces debt crisis has created new financial liabilities for other European Countries. Euro zone countries have extended bilateral loans to Greece, and made financial commitments to the broader European Financial Stability Facility (EFSF). If these financial commitments are called on, they could substantially raise the debt levels in Euro zone countries, many of which are grappling with their own debt problems. For example, Frances total financial commitment to the rescue packages is 8% of GDP.

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Increasing the size of the EFSF, as some argue is necessary to give it the firepower it needs to respond to a potential crisis in Italy, for example, could increase Frances commitments to 13% of GDP. If these commitments were called upon, Frances debt level could rise to above 100% of GDP. Some argue that these commitments explain, at least in part, why French bond spreads have started to widen. Fourth, the Greek crisis has sparked a broader re-examination of EU economic governance, in order to improve the long-term functioning and stability of the currency union. The EU has been working on new legislation that would introduce significant reforms to economic governance. A proposed package of reform measures would strengthen enforcement of the Stability and Growth Pact, introduce greater surveillance of national budgets by the European Commission, and establish an early warning mechanism that would prevent or correct macroeconomic imbalances within and between member states.

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