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European Financial Crisis Sai Kumar Swamy Course Director, T.I.M.E. PGPM IIM Bangalore Agenda Genesis Sub-Prime Crisis Contagion Effect European Financial Crisis Iceland Principal Actors PIIGS Portugal Ireland Italy Greece Spain Current Status Future Scenario Genesis EU Economic & Political Union of 27 member states 500 Mn citizens GDP - $16Tn and 30% of total world output Free movement of people, goods, services & capital Schengen – Free movement – Abolition of passport controls Treaty of Maastricht – 1st Nov 1993 Salient Features Common Currency - Euro EMU SGP - Stability & Growth Pact Convergence Criteria – Article 121 Inflation; Deficit & Debt; Interest rates Fiscal Monitoring of members Article 122 EC can take measures to help an ailing country Sub-Prime Crisis Sub-Prime loans Housing Bubble Fuelled by Low interest rates Supply Glut Foreclosures MBS CDS Failure of Banks Credit Crunch Reduced Output – Unemployment Government Bail-outs Stimulus Packages Fannie Mae and Freddie Mac Keynesian model adopted – Deficit Spending Contagion effect – Global linkages European Financial Crisis Principal Actors - Iceland Pre 1990s Natural resources Tourism – Fiords, Glaciers and Geysers Fishing – Salted Cod David Oddsson Mayor of Reykjavik Prime Minister in 1991 Promised to end the boom and bust cycles based on Fish catch Privatization - $2Bn Privatized banking industry Thrust on Biotechnology Software Principal Actors - Iceland Banking Tapped Overseas markets Landbanski – ‘Icesave’ Scheme High interest rates Banking accounted for 75% of stock market Kaupthing Bank Assets – 208Bn Krn in 2000 6600Bn Krn in 2008 Loans & Assets were 10 times Iceland GDP High inflows Strong kronor Consumption led economy Global Financial Crisis – large scale outflow of funds Haarde in US for assistance Central bank had €2Bn – Loans were €70Bn Defaults by Glitner bank – €600Mn Govt. bailout for Glitner – Landsbanski - Kaupthing Principal Actors - Ireland Economic Transformation in the 90’s Low Taxes – Educated workforce – Entry of MNCs Bridge between US and Europe GDP Growth rate of 6.5% Celtic Tiger Housing Boom Cheap Loans – Tax Incentives House prices increased 3 fold in a decade 40% of houses built in 1996-2006 Housing Bubble Over Supply Speculative nature of demand ‘Sub-prime echoes of the US Multi unit loans to property developers with ‘sub-prime’ characteristics Principal Actors - Greece Cause Economic downturn post 2008 Tourism & Shipping badly hit Govt. revenues decreased significantly Govt. expenditure increased – worsened debt situation Huge spending – Deficit Budgets Cheap lending Lack of financial reform Government cooking the accounts Effect €300 billion Debt Budget Deficit – 12.7% Violation of Growth & Stability Pact Accumulated debt – Estd. at 160% in 2011 Credit Rating downgraded Bond Yield – 34% Principal Actors - Greece Steps Taken/To be taken Cut in spending Austerity measures Increase in Taxes Better Tax collection Public Sector Pay cuts Increase in retirement age by 2 yrs – Later by 4 yrs Denationalization to raise money Fears Civil Unrest Sovereign Debt default Orderly Default – Debt write off - 50% Euro under pressure Principal Actors - Spain GDP contracted in 2008 Construction Sector – 10% of GDP Housing Bubble Price increases of more than 200% Bubble started in 1995 and sustained till 2007 28% of houses vacant Fuelled by tax incentives similar to India High indebtedness High Inflation High Oil prices High Interest Rates pricks the bubble Large scale unemployment ~ 25-30% Severe pressure on Banking system Bond Yield – 5% Principal Actors - Portugal GDP – $220Bn Tourism, Cork, Fishing, Wine High Debt to GDP Ratio – 113% Mostly external debt Socialist Govt. with excess spending Very low GDP growth rates Debt Servicing Issues Unable to generate new loans Required a bailout from EU Bond Yield – 12-15% Severe unemployment – 12.4% in 2011 Emigration Austerity measures Social Unrest Italy 7th largest economy GDP - $2 Tn Manufacturing & Services led economy Big brands – Quality products Current Issue Huge Debt to GDP ratio – roughly 120% in 2010 Similar to Greece Key difference is that most of it is internal Recession Contraction of almost 7% in GDP Political Weakness High Govt. Spending – Profligacy Black market economy Organized crime – 7% of GDP Protection money Bond Yield – 5-6% Current Status Greece Austerity measures Looking for a bail-out Germany against such a bailout – France in favour Portugal Govt. trying to raise money to prop up banking system Failed Bond Auction to raise €500Mn Spain & Ireland Reduce fiscal deficit Rollback Keynesian debt fuelled monetary policies Future Scenario Sovereign Debt Crisis looms Euro under threat The concept of ‘United States of Europe’ in grave danger Political Union of Europe unlikely Issues of Solidarity & Responsibility Return to ‘Non-Keynesian’ policies can further deflate the economies Double Dip recession possible Common Fiscal Policy for the EU Two Solutions EMF – Fund for Bailouts - EFSF European Treasury – Single authority for Tax policy Govt. Spending Annexures Foreclosures Sub-Prime Vicious Cycle Geyser Economy PIIGS S&P Ratings Belief in God Euro Zone Interest Rates – Govt. Bonds US vs. the Eurozone Greece Debt Portugal – Sick Man of Europe Public Debt and Debt as % of GDP Public Debt as % of GDP - World Housing Prices - Ireland 100% Loans