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Terence Tse
EUROZONE CRISIS
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Copyright© 2014 Terence Tse
@terencecmtse
Throughout the financial crisis, we worry about the risk of the banks and the
financial sectors. Now, we worry about the sovereign risk or the risk of
government
• The
financial
crisis in
Greece is
excellent
case study
of this
problem
• To
understand
the crisis, it
is helpful to
review the
criteria of
joining the
euro
Copyright© 2014 Terence Tse
1
•
The country had to achieve a rate of
inflation within 1.5% of the rates in the
three participating countries with the
lowest rates
2
•
The country had to keep it currency
exchange rates within the limits defined
by the ERM for at least 2 years
3•
The country had to keep its interest rate
within 2% of the rates in the three
participating countries with the lowest
rates
4•
The country had a total amount of
money owed (public debt) of less than
60% of the GDP
5•
The country had to reduce its
government deficits to below 3% of its
GDP
• In 2010, there
are 16 member
countries in the
eurozone
• However, how
good are these
countries in
following these
criteria?
1
While some Eurozone countries managed to adhere to two of the most important
criteria, many have not been able to do so
Eurozone countries gross debt as % of GDP (2000-2011)
• Even the
largest
members
including
France and
Germany
have not
always been
able to
abide by the
rules
• There ought
to be
penalties for
violation of
the rules but
nothing
materialised
Percentage
180
Greece, 165.3
160
140
120
Italy, 120.1
Portugal, 107.8
100
Belgium, 98
France, 85.8
Germany, 81.2
Austria, 72.2
Malta, 72
Cyprus, 71.6
Spain, 68.5
Netherlands, 65.2
60%
80
60
Finland, 48.6
Slovenia, 47.6
Slovakia, 43.3
40
20
Luxembourg, 18.2
Estonia, 6
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Source: Eurostat, 2012
Copyright© 2014 Terence Tse
2
While some Eurozone countries managed to adhere to two of the most important
criteria, many have not been able to do so (cont’d)
Eurozone countries budget deficit as % of GDP (2001-2011)
18
15
Ireland, 13.1
12
Greece, 9.1
Spain, 8.5
9
6
France, 5.2
Portugal, 4.2
Italy, 3.9
3
3%
Germany, 1
0
2001
2002
2003
-3
-6
Copyright© 2014 Terence Tse
2004
2005
2006
2007
2008
2009
2010
2011
• Greece has
always had
a budget
deficit of
greater
than 3%
• The
Maastricht
Treaty also
includes a
“no-bail out”
clause
• However,
no one
seems to
have come
up with a
plan for
such
emergency
3
Greece has been facing a mountain of debt and it continues to grow
• Even though it
already had a lot
of debt when
joining the euro
in 2001, Greece
had continued to
borrow because
Copyright© 2014 Terence Tse
1•
With no fear of currency devaluation, it can have no
fear to borrow
2•
Lower interest rates enabled the country to borrow on
favourable terms
3•
Underpricing of default risk made it easy to have
access to further borrowing
4•
The country engaged in a spending spree (e.g. Olympic
game in 2004)
5•
Manipulation of accounting figures allowed it to hide the
extent of indebtness
6•
Tax evasion is prevalent – nearly 30% of the GDP is in
the black economy
4
The story for Ireland is slightly different but a familiar one
• In the
decade
before
2007,
Ireland’s
economy
grew
more
rapidly
than any
other in
Western
Europe
• Government
stepped in
to bail out
the banks,
which in
turn, has
accepted
bail-outs by
ECB and
the UK
• Property market
over-heated
during the boom
• The large banks
lent out too much
and made bad
commercial
property bets
Source: The Economist, 2010
Copyright© 2014 Terence Tse
5
Portugal may be on the verge of seeking financial rescue
• Portugal
managed to
raise more
debt in
January
2011, hence
showing
that
investors
are still
willing to
lend to the
country
Copyright© 2014 Terence Tse
10-year governmentbond yields (%)
• However,
the cost of
borrowing is
high for a
country with
high and
rising public
debt
Source: The Economist, 2011
• Unless the
borrowing cost
drops, it will
eventually
have to be
rescued by
other eurozone partners
• The problem
with Portugal is
that it has a
very, very frail
economy
6
The pressure on Greece increases the pressure on the euro
• The
market
is
getting
more
and
more
worried
about
the risk
of
Greece
Greece 5-year sovereign CDS
Basis point
Source: Financial Times, 2010
Copyright© 2014 Terence Tse
7
Seeing that the pressure on euro, the value of euro has declined
Against the dollar
$ per €
• The uncertainty in
Greece and that
of the reactions of
the members
have led to a
gradual drop in
the value of euro
• The fall in euro has
been further fuelled
by hedge funds
shorting the currency
Source: Financial Times, 2010
Copyright© 2014 Terence Tse
8
Even though Greece has not defaulted, there are implications to other European
countries …
Government bond spreads
10 year spreads over Germany
• It is
therefore
important to
deal with
the
situation in
Greece
carefully
• But the
question is
how?
• The
potential
default of
greece
has
spread
concerns
on other
European
countries
Source: Financial Times, 2010
Copyright© 2014 Terence Tse
9
As many European countries are carrying enormous amount of debt
• So, how much
debt are we
talking about?
• Here is a €100
Source: http://demonocracy.info/infographics/eu/debt_greek/debt_greek.html
Copyright© 2014 Terence Tse
10
As many European countries are carrying enormous amount of debt
• Here is a
€10,000
Source: http://demonocracy.info/infographics/eu/debt_greek/debt_greek.html
Copyright© 2014 Terence Tse
11
As many European countries are carrying enormous amount of debt
• Here is a €1
million
Source: http://demonocracy.info/infographics/eu/debt_greek/debt_greek.html
Copyright© 2014 Terence Tse
12
As many European countries are carrying enormous amount of debt
• Here is a €100
million
Source: http://demonocracy.info/infographics/eu/debt_greek/debt_greek.html
Copyright© 2014 Terence Tse
13
As many European countries are carrying enormous amount of debt
• Here is a €100
million
Source: http://demonocracy.info/infographics/eu/debt_greek/debt_greek.html
Copyright© 2014 Terence Tse
14
As many European countries are carrying enormous amount of debt
• How
about €2
billion
Source: http://demonocracy.info/infographics/eu/debt_greek/debt_greek.html
Copyright© 2014 Terence Tse
15
As many European countries are carrying enormous amount of debt
• At the
end of
2011,
Greece’
debt was
€ 360
billion
Source: http://demonocracy.info/infographics/eu/debt_greek/debt_greek.html
Copyright© 2014 Terence Tse
16
The Eurozone can choose to adhere to the clause and not bail Greece out. But
there are good reasons for doing and not doing it
Advantages
• Nevertheless,
this decision
carries both
advantages
and
disadvantages
Copyright© 2014 Terence Tse
• No moral hazard problem
• Ireland, Spain and Portugal would be more
cautious with their decisions to deal with their
financial problems
• Other members do not have to shoulder the burden
• Germany is not in the position to do so as it has
experienced no growth in the last quarter
• Greece will pay for its debt binge itself
• However, it is questionable as to whether the
Greeks can deal with the spending costs, wage
freeze and increase in tax
17
The Eurozone can choose to adhere to the clause and not bail Greece out. But
there are good reasons for doing and not doing it (cont’d)
Disadvantages
• Nevertheless,
this decision
carries both
advantages
and
disadvantages
Copyright© 2014 Terence Tse
• Greece may need to turn to the IMF for help
• While IMF is good in restructuring national
finance, it follows a tough regime – can Greece
take it given the social concerns?
• Eurozone members “lose face” as they need an
outsider to help
• Cannot even sort out your own background?
• Cost of borrowing for Greece could go up, making it
even more expensive and difficult to repay its debt
• Cost of borrowing for the other eurozone
members could also go up
• As it turns out, many banks in Europe hold Greek
assets
18
But if the Eurozone was to bail Greece out, will Germany be content with it?
• Would
Germany
be willing
to help?
Copyright© 2014 Terence Tse
• Probably not.
But does it have
a choice?
19
Even it is unwilling, Germany has helped
• Germany will
have no
choice but to
help out
because this
is the only
way to prevent
the Euro Area
to fall into a
complete
turmoil
Copyright© 2014 Terence Tse
• But Germany
and other
Euro area
members as
well as the
IMF will only
be able to
help if
Greece cuts
its public
spending
• However,
would
Greece be
willing to do
that?
20
People in Greece are not willing to accept the draconian measures imposed by the
IMF and Eurozone members
• People are
not willing to
accept the
austerity
measures
• They show
their views
by going on
strike and
clashing
with riot
police
• They are
unwilling
because they
are asking
“why do we
have to pay
for it as we
did not create
the problems
in the first
place?”
We are angry because we have no
responsibility for this crisis
Mary Kontogeorgou – trade union member
Copyright© 2014 Terence Tse
21
So, why not let Greece default then? After all, the Greek government owns “only”
€300 billion whereas Lehman Brother’s balance sheet before its implosion was
$613 billion
Gross exposures to Greek debt
Selected banks at the end of 2010, in € billions
• The general
argument
against is that
banks holding
Greek debt will
go busted in
this case
• But is it really
the case?
Source: The Economist, 2011
Copyright© 2014 Terence Tse
• As it turns out, few
foreign banks’
holdings of Greek
government bonds
are worth even
10% of their capital
• That means they
should comfortably
withstand the
substantial losses
that might arise
• So, Greek default
would do little
lasting harm to the
rest of Europe’s
financial system.
Why the big deal
then?
22
What is more worrying for Europe’s policymakers is the thought that Greece’s
affliction would spread not just to foreign banks but to foreign governments
• If Greece
defaults, it
signals to
investors that it
is possible that
a Western
government
cannot honour
its debt
• If this is the
case, other
PIGS such as
Ireland (with
€150 billion)
and Portugal
(with €160
billion) may file
for bankruptcy
Copyright© 2014 Terence Tse
Gross exposures to sovereign bonds
As % of core tier-1 capital at end of 2010,
selected banks
• Yet, it is believed
that banks would
be able to cope
partially because
they have reduced
their holdings of
Irish and
Portuguese bonds
• So, why the big
deal then?
Source: The Economist, 2011
23
What is more worrying for Europe’s policymakers is the thought that Greece’s
affliction would spread not just to foreign banks but to foreign governments
(cont’d)
• The problem is
that if the
contagion
spreads to
Spain and Italy
and if banks
have to accept
their losses on
their
government’s
bonds, that is
where the
major problem
starts
Copyright© 2014 Terence Tse
• The sum of losses will be
astronomical – Italy owes
€1.8 trillion, or 120% of a far
bigger GDP than Greece’s,
Ireland’s or Portugal’s, while
Spain’s debts amount to
€640 billion
• The impact will now extend
to banks outside the
Eurozone (such as Credit
Suisse and UBS of
Switzerland as well as HSBC
and RBS of the UK)
• Italy owes €1.8
trillion, or 120% of a
far bigger GDP than
Greece’s, Ireland’s
or Portugal’s.
Spain’s debts
amount to €640
billion
24
At first, the crisis was still treated as a liquidity issue instead of a solvency
issue…
• …There can be a
vicious circle in the
• Governments
making – the higher
are hoping to
cost of debt will make
solve a
10-year government-bond yields (%)
countries more
“deficit” issue
difficult to hit their
instead of a
budget targets,
potential
which, in turn, leads
default
to higher cost of debt
• The most
• Spain already shows
worrying
sign that it is not
problem is
being to endure the
that Spain
kind of sacrifices
and Italy are
demanded by
large
creditors
countries
• Germany and
compared to
Finland, on the other
the three
hand, will probably be
already in
willing to let default
trouble
happen as opposed
• If they go…
Source: The Economist, 2011
to supporting them
Copyright© 2014 Terence Tse
25
… but once it was realised that it was a major sovereign crisis, it was perhaps a
bit too late to react
• Greece is on
the verge of
an economic
collapse,
especially
after a great
deal of
austerity
programmes
have been
imposed on
them
• The new
government to
be elected in
mid-June will
determine
whether it will
stay or exit
Addition change in annual GDP
caused by (%)
• It is estimated that a
break-up of the
Eurozone would
have far more
negative effect on a
mere “Grexit”
• It is also thought
that other nonEuropean countries
– including the US –
would suffer from
economic impact
Source: The Economist, 2012
Copyright© 2014 Terence Tse
26
Whether it is a “stage-managed” exit of Greece or a complete break-up of the
eurozone, there bound to be lots of damages
• In either
scenario, the
following
aspects of the
economy will
be hurt
Copyright© 2014 Terence Tse
1
•
The real economy
2
•
Inflation
3
•
The financial sector
4
•
Public finances
5
•
Interest rates and government bonds
6
•
Exchange rates
7
•
Corporate bond spreads and ABS
8
•
Real estate and stock market
27
1
There can be five blows to the real economic activity
• Several
factors
would
depress
economic
activity:
•i
Even with advanced planning, the logistical
and legal problems of re-introducing
national currencies would be severe and
protracted
ii
•
Capital flight and distress in the
financial system would disrupt trade
and investment
A plunge in business and consumer
confidence would likely take place at
the same time when asset prices inside
and outside the Eurozone start
dropping again
The challenge of maintaining fiscal
credibility and securing government
funding would intensify
Non-Eurozone countries will be hit also
by currency appreciation and therefore
furthering damage to export already
affected by recession
•
iii
•
iv
•
v
Copyright© 2014 Terence Tse
• The shock could
create political
tensions
• With the EU’s own
market severely
depressed and the
rest of the world
affected by the
sharp depreciation
of the euro, there is
a very real risk of a
global trade war
28
Inflation will take place in the troubled Eurozone countries whereas deflation
will hit the other members
• The US
could also
be hit with
• While
deflation
those
• The sharp
leaving the Inflation in total euro break-up scenario (CPI, %YoY)
drop in
Eurozone
global
would be
activity,
hit by
coupled with
inflation
a stronger
with their
US dollar
new
would also
currencies,
prompt a
Germany,
sharp drop
for
in
instance,
commodity
would
prices
Source: ING, 2011
suffer from
2
deflation
Copyright© 2014 Terence Tse
29
3
The financial services sector would receive further impact and came under
further distress
• In addition to share prices, house prices
could also drop sharply in markets where
mortgage debt was already high and
rates go up relatively sharply
• Asset prices
initially dive
• The plunge in economic activity and
corporate profitability also lead to a sharp
rise in defaults on corporate bonds and
loans, compounding the problems of the
banks and other financial institutions
• Banks, insurers, mutual funds and
pensions funds in surplus countries
and/or countries with mature funded
pension schemes such as the
Netherlands and the UK face a triple
whammy of collapsing share prices,
immediate currency losses, and
increased default on their assets in deficit
countries
Copyright© 2014 Terence Tse
• Governments
would find
themselves
having to bail out
banks and
insurers again
• Pension fund
losses and
sharply lower
long-term interest
rates could lead to
premium hikes
and cut in
benefits, further
depressing
consumption
30
4
Regardless of which scenarios, public finances will be affected
• Countries
with the
new
currency
will suffer
from
inflation
• Yet, such
inflation
would
reduce the
debt-toGDP ratio
Copyright© 2014 Terence Tse
Italy vs. Germany – Gross debt-to-GDP ratio,
2000-2016
Source: ING, 2011
• However, the
flipside of
inflation is that
countries like
Germany would
experience
deflation
• As a result, its
debt-to-GDP
ratio would go
up
• So, while the
fiscal solvency
of the periphery
countries would
improve, that of
the core would
worsen sharply
31
5
The interest rates in the troubled Eurozone countries would continue to rise
whereas those in the safer ones would fall further
• Greece, and
any troubled
Eurozone
members in
the break-up
scenario,
would have to
deal with the
inflationary
consequences
of sharp
currency
depreciation
Forecasted yield spread the Grexit
scenario
Source: ING, 2011
Copyright© 2014 Terence Tse
• In the Grexit
scenario, Greek
yields would
decline from their
current
stratospheric levels
• However, contagion
would drive up
yields in the other
troubled countries
but drive down
yields in the safer
ones
• German 10-year
yield is expected to
drop to 1%
32
5
The interest rates in the troubled Eurozone countries would continue to rise
whereas those in the safer ones would fall further (cont’d)
Forecasted yield spread the break-up
scenario
• Even in the
break-up
scenario,
yields in the
troubled
countries
will take
time to
subside
Source: ING, 2011
Copyright© 2014 Terence Tse
• Bond yields in
Germany and the
Netherlands are
expected to drop
temporarily below
1%
• This reflects not
just the massive
deflationary shock,
but also a
significant capital
flight form the
troubled Eurozone
members
(assuming no
capital controls)
33
6
Confidence in the euro would be substantially weakened with Grexit
• Together
with the
economic
and
financial
problems
of the EU,
the
weakened
confidence
of the euro
would lead
it to plunge
Exchange rate of New Drachma and
Euro against US dollar
• It is forecasted
that exchange
rate between euro
and USD will fall
to parity
Source: ING, 2011
Copyright© 2014 Terence Tse
34
6
In the case of a break-up, all the new national currencies will suffer initially
• If the
Eurozone
broke-up, all
countries reintroduce
national
currencies
• Even though
the new DM
would the
strongest of
the bunch, it
will still suffer
as a result of
the impact of
the break-up
Copyright© 2014 Terence Tse
Exchange rate of new currencies
against US dollar
• Following the
initial dramatic
divergence,
there should be
a partial
recovery as
governments will
re-establish
policy credibility
and the shock to
the investors
wears off
Source: ING, 2011
35
6
In the case of a break-up, all the new national currencies will suffer initially
Devaluation of various currencies against
the new DM
• Given that
different
countries have
different fiscal
and
competitiveness
issues, the
respective
currencies will
devalue against
the new DM
Source: ING, 2011
Copyright© 2014 Terence Tse
36
7
There could also be substantial volatility in credit spreads on corporate
bonds and asset-backed securities
i
• Grexit
• Credit spreads would be wider in the troubled
Eurozone countries than the stronger ones
• Depressed
economic
activity, coupled
with a financial
system under
pressure could
force distress
selling
• It is predicted that even Germany could see a widening
of the spread 70bp, with the A rated corporate debt
issued by those in the troubled countries widens by
110bp
ii
• Break-up
• A-rated corporate debt might see a 320bp widening for
the stronger Eurozone countries and 450bp to 800bp
for the troubled ones
• Spreads would fall back but very gradual, given the
pessimistic recovery prospects
Copyright© 2014 Terence Tse
37
8
The real estate markets, especially those in the troubled Eurozone countries,
would fall further
House prices in the troubled Eurozone countries
• Given the surge
in inflation
resulting from
currency
depreciation,
real prices of
properties will
fall further in
real terms
Copyright© 2014 Terence Tse
38
If it is breakup – no matter what forms – is so costly and painful, why is Germany
so reluctant to provide capital to Greece?
“Memorandum macht frei”
• Merkel was
portrayed
in
“different”
ways by
media
Source: Dimokratia, 2012
Source: NewStateman, 2012
Copyright© 2014 Terence Tse
39
The newly established European Stability Mechanism is expected to authorise
€700 billion or $1 trillion of capital to rescue the Eurozone
• How much
money is $1
trillion?
Copyright© 2014 Terence Tse
• This is what
a $100 looks
like
• But what
does
$10,000 look
like?
40
The newly established European Stability Mechanism is expected to authorise
€700 billion or $1 trillion of capital to rescue the Eurozone (cont’d)
• What does
$1 million
look like?
Copyright© 2014 Terence Tse
41
The newly established European Stability Mechanism is expected to authorise
€700 billion or $1 trillion of capital to rescue the Eurozone (cont’d)
• What does
$100 million
look like?
Copyright© 2014 Terence Tse
42
The newly established European Stability Mechanism is expected to authorise
€700 billion or $1 trillion of capital to rescue the Eurozone (cont’d)
• What does
$1 billion
look like?
Copyright© 2014 Terence Tse
43
The newly established European Stability Mechanism is expected to authorise
€700 billion or $1 trillion of capital to rescue the Eurozone (cont’d)
• What does
$1 trillion
look like?
Copyright© 2014 Terence Tse
44
The newly established European Stability Mechanism is expected to authorise
€700 billion or $1 trillion of capital to rescue the Eurozone (cont’d)
Copyright© 2014 Terence Tse
45
The Eurozone crisis is really no joking matter …
http://www.youtube.com/watch?v=q5FT47kLZfs
Copyright© 2014 Terence Tse
46