Sovereign Debt Crisis of the Eurozone

Submitted By:
Prateek Gupta Varun Agarwal Ankur Patel Akshaydeep Hemraj Ina Kapoor Ashu Agarwal Sandeep Kaur Parul Sharma

Table of Contents

Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8

Introduction Cause of Crisis Course of Events Remedial Measures Taken Impact on other countries across the World Lesson Learnt Conclusion Bibliography

Terminologies
Austerity Measures: An official action taken by the government in order to reduce the amount of money that it spends or the amount that people spend sometimes coupled with increases in taxes to pay back creditors to reduce debt.

Bailout: A bailout is an act of loaning or giving capital to an entity (a company, a country, or an individual) that is in danger of failing, in an attempt to save it from bankruptcy, insolvency, or total liquidation and ruin; or to allow a failing entity to fail gracefully without spreading contagion.

Financial Contagion: A situation in which a faltering economy in one country causes otherwise healthy economies in other countries to have problems. Financial contagion often becomes a large problem for the direct or regional neighbors of the troubled economy.

Sovereign Debt: A government bond is a bond issued by a national government. Such bonds are often denominated in the country's domestic currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds.

Chapter 1- Introduction
A period of time in which several European countries faced the collapse of financial institutions, high government debt and rapidly rising bond yield spreads in government securities. The European sovereign debt crisis started in 2008, with the collapse of Iceland's banking system, and spread primarily to Greece, Ireland and Portugal during 2009. The debt crisis led to a crisis of confidence for European businesses and economies From late 2009, fears of a sovereign debt crisis developed among fiscally conservative investors concerning some European states, with the situation becoming particularly tense in early 2010. This included euro zone members Greece, Ireland and Portugal and also some EU countries outside the area. Iceland, the country which experienced the largest crisis in 2008 when its entire international banking system collapsed has emerged less affected by the sovereign debt crisis as the government was unable to bail the banks out. In the EU, especially in countries where sovereign debts have increased sharply due to bank bailouts, a crisis of confidence has emerged with the widening of bond yield spreads and risk insurance on credit default swaps between these countries and other EU members, most importantly Germany. A government bond is a bond issued by a national government. Such bonds are often denominated in the country's domestic currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. Government bonds are sometimes regarded as risk-free bonds, because national governments can raise taxes or reduce spending up to a certain point; in many cases they "print more money" to redeem the bond at maturity. (Some governments are not currently entitled to print money directly, but only through a Central bank at interest. Investors in sovereign bonds denominated in foreign currency have the additional risk that the issuer may be unable to obtain foreign currency to redeem the bonds. While the sovereign debt increases have been most pronounced in only a few euro zone countries they have become a perceived problem for the area as a whole. In May 2011, the crisis resurfaced, concerning mostly the refinancing of Greek public debts. The Greek people generally reject the austerity measures and have expressed their dissatisfaction through angry street protests. In late June 2011, the crisis situation was again brought under control with the Greek government managing to pass a package of new austerity measures and EU leaders pledging funds to support the country. Concern about rising government deficits and debt levels across the globe together with a wave of downgrading of European government debt created alarm in financial markets. On 9 May 2010, Europe's Finance Ministers approved a comprehensive rescue package worth 750 Billion

(then almost a trillion dollars) aimed at ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF). In 2010 the debt crisis was mostly centered on events in Greece, where the cost of financing government debt was rising. On 2 May 2010, the Eurozone countries and the International Monetary Fund agreed to a 110 billion loan for Greece, conditional on the implementation of harsh austerity measures. The Greek bail-out was followed by a 85 billion rescue package for Ireland in November, and a 78 billion bail-out for Portugal in May 2011. This was the first Eurozone crisis since its creation in 1999. As Samuel Brittan pointed out, Jason Manolopoulos "shows conclusively that the Eurozone is far from an optimum currency area". Niall Ferguson also wrote in 2010 that "the sovereign debt crisis that is unfolding...is a fiscal crisis of the western world". Axel Merk (FT) argued in a May 2011 article that the dollar was in grave danger than the euro. The European sovereign debt crisis was brought to heel by the financial guarantees by European countries, who feared the collapse of the euro and financial contagion, and by the International Monetary Fund (IMF). Ratings agencies downgraded the debt of several Eurozone countries, with Greek debt at one point being moved to junk status. As part of the loan agreements, countries receiving bailout funds were required to meet austerity measures designed to slow down the growth of public sector debt.

Countries Involved
The following countries of European Union (EU) were involved in the Sovereign Crisis of the Euro Zone: Greece Ireland Portugal Spain Italy Belgium And many other European countries like UK, Iceland and Switzerland.

Chapter 2- Cause of the Crisis

While everyone is focusing on the so-called obvious factors, they have missed the most important factor; the real reason behind the crisis. The crisis started in Greece and the top EU members knew they were going to bail out Greece and potentially any other member that needed help, but they pretended that they would not. One of the obvious reasons for the bailout was not to protect Greece, but to save the bond holders; most of the bond holders are foreigners. Thats the same reason the banks were bailed out in the US, to protect the large shareholders; its all a game of smoke and mirrors. That is the cause of this crisis. Our hypothesis is that the main reason that the Euro crisis was allowed to evolve was to deflate the Euro. Note that we have stated many times in the past that we have now entered into the competitive currency devaluation era, where the theme is or will soon be devalue or die. Or maybe we should add devalue or die trying to, for nations are going to do whatever it takes to keep their products competitive in the global market. Germany was knocked out of the top place and replaced by China as the worlds largest exporter and that must have hurt. Thus by allowing the crisis to progress, the EU could, in fact, devalue the Euro without actually issuing new currency. And then when things started to look really bad, they could pretend to help by approving a huge package, but this package would now devalue the euro even more. Thus with one stone they killed two birds in the sense that it produced double the effect. If they had approved a bailout package immediately, the euro would not have shed as much as it did. In a matter of months the Euro dropped almost 24%; in the currency markets, this is considered to be a very large move. Another factor to consider is that no government wants to pay its debt in a stronger currency; governments borrow money so that they can pay it back with cheap currency. Thus while one currency might appear to be appreciating against another; the truth is that they are all falling down, some faster than others. Take a look at some long term commodity charts, and you will notice that most of them are in up trends, regardless of which currency they are priced. For example, a 3 year chart of Gold priced in any currency shows that it's in an uptrend. The race to the bottom has picked up in intensity. We would not be surprised now if some sort of crisis hits Asia; this would complete the circle perfectly. A position in precious metals is recommended. View this as a hedge/insurance against another potential crisis; if you have no position wait for strong pull backs before deploying new money. The Greek economy was one of the fastest growing in the euro zone from 2000 to 2007; during that period, it grew at an annual rate of 4.2% as foreign capital flooded the country. A strong economy and falling bond yields allowed the government of Greece to run large structural deficits. According to an editorial published by the Greek right-wing newspaper Kathimerini, large public deficits are one of the features that have marked the Greek social model since

the restoration of democracy in 1974. After the removal of the brutal right-wing military junta, the government wanted to bring disenfranchised left-leaning portions of the population into the economic mainstream. In order to do so, successive Greek governments have, among other things, customarily run large deficits to finance public sector jobs, pensions, and other social benefits. Since 1993 debt to GDP has remained above 100%. Initially currency devaluation helped finance the borrowing. After the introduction of the euro in Jan 2001, Greece was initially able to borrow due to the lower interest rates government bonds could command. The late-2000s financial crisis that began in 2007 had a particularly large effect on Greece. Two of the country's largest industries are tourism and shipping, and both were badly affected by the downturn with revenues falling 15% in 2009. To keep within the monetary union guidelines, the government of Greece (like many other governments in the Euro zone) had misreported the country's official economic statistics. In the beginning of 2010, it was discovered that Greece had paid Goldman Sachs and other banks hundreds of millions of dollars in fees since 2001 for arranging transactions that hid the actual level of borrowing. The purpose of these deals made by several subsequent Greek governments was to enable them to continue spending while hiding the actual deficit from the EU. The emphasis on the Greek case has tended to overshadow similar serious irregularities, usage of derivatives and "massaging" of statistics (to cope with monetary union guidelines) that have also been observed in cases of other EU countries; however Greece was the most publicized case. In 2009, the government of George Papandreou revised its deficit from an estimated 6% (8% if a special tax for building irregularities were not to be applied) to 12.7%. In May 2010, the Greek government deficit was estimated to be 13.6% which is one of the highest in the world relative to GDP. Greek government debt was estimated at 216 billion in January 2010. Accumulated government debt was forecast, according to some estimates, to hit 120% of GDP in 2010. The Greek government bond market relies on foreign investors, with some estimates suggesting that up to 70% of Greek government bonds are held externally. Estimated tax evasion costs the Greek government over $20 billion per year. Despite the crisis, Greek government bond auctions have all been over-subscribed in 2010 (as of 26 January). According to the Financial Times on 25 January 2010, "Investors placed about 20bn ($28bn, 17bn) in orders for the five-year, fixed-rate bond, four times more than the (Greek) government had reckoned on." In March, again according to the Financial Times, "Athens sold 5bn (4.5bn) in 10-year bonds and received orders for three times that amount.

Chapter 3- Course of Events

Monetary deflation
If one or more governments defaulted, northern European banks, which were large-scale investors in government debt, would have massive loan and capital losses. The result of these losses would be banks going out of business, calling in outstanding loans, or both, thereby reversing the money multiplier process and causing a decline in the money supply. The falling money supply deflation would make the euro more, not less, valuable. However, a more realistic threat to the euro is that some governments might shed it and return to their own domestic currency. Fed up with the (prudent) restraint of money creation imposed upon them by the ECB, indebted governments might want to be able to print their way out of their trouble. But even if one or more countries walked away from the euro in favor of their own currencies, the euro could still be protected by the ECB. This is because the ECB could exchange a particular country's old, previous currency for the euro, thereby adjusting the euro money supply so that the volume of Euros in the remaining countries remained the same. This operation would not alter the quantity of money in the economy; it would simply swap one type of money for another, keeping the overall purchasing power constant.

Monetary inflation
The ECB has decided to take on the job, because European governments will not allow themselves to face the political consequences of a banking collapse and the subsequent economic problems that a debt deflation would bring about. Instead, they will, as all politicians do, delay the day of reckoning and let taxpayers and future politicians suffer larger problems down the road. Printing money and increasing taxes and debt to the tune of more than a trillion dollars on the (northern) European taxpayer in order to prevent bank losses is called by some "saving the euro." But a question in case of would be why the euro worth paying such a price is? With the higher prices and lower standards of living that "saving the euro" entails, all Europeans except bankers and politicians would be better off shedding the euro and returning to a "less expensive" currency. At the least, individual countries should decide if they want to force their own citizens to suffer the consequences of printing money and over borrowing. Under the current scenario, German and French citizens (mostly) will have to pay on behalf of the profligate Portuguese, Irish, Italians, Greeks, and Spanish.

Chapter 4- Remedial measures taken Bailout plan

European governments and the International Monetary Fund (IMF) have stunned global stock markets with a 750bn-euro ($975bn; 650bn) package of standby funds designed to see off financial meltdown. The 27 countries of the European Union (EU) will contribute 500bn Euros towards the financial safety net. They have been joined by the International Monetary Fund (IMF), which is providing other 250bn Euros. The vast bulk of Europe's contribution comes from the 16- nation Euro-zone bloc, which is promising 440bn in loan guarantees. The European Commission is providing 60bn Euros immediately.

Germany and the Euro rescue plan

Germany's parliament has approved the country's contribution to a 750bn euro ($938bn, 651bn) rescue deal for the Euro-zone. The German contribution is key to the plan, and would amount to up to 148bn Euros. Chancellor Angela Merkel warned that the Euro would be "in danger" without strong action. The role of Greece Greece has outlined plans to cut its budget deficit, or the amount its public spending exceeds taxation, to 8.7% of its GDP in 2010, and to less than 3% by 2012. Just before the massive bail-out package was announced the Greek government pledged to make further spending cuts and tax increases totaling 30bn Euros over three years - on top of austerity measures already taken.

Chapter 5- Impact on other countries across the World

Strong economic growth and domestically-funded fiscal deficit are likely keep the country's debt position stable even if the financial crisis in Europe worsens "Although India, with a fiscal deficit forecast at 8.5 per cent in 2010, may seem vulnerable to any worsening of the European fiscal crisis, its strong growth trajectory should ensure that its debt dynamics remain stable, while its deficit is primarily domestically-funded,". Eurozone nations like Greece, Spain and Portugal are facing financial crisis because of heavy borrowings by their governments, leading to erosion in investor confidence across the world. There has been widespread belief that the European crisis could affect other parts of the world, especially those countries which have high deficits, mainly on account of international borrowings. Citi's first Global Emerging Markets Strategy Report, covering 22 nations, puts India in "neutral" category along with China, Chile, Mexico and South Africa. Listing its top picks, the report says, "our "overweight" calls are Taiwan, South Korea, Russia, Brazil, Turkey, Thailand; we are "neutral" in China, India, Chile, Mexico and South Africa." It projects India's economic growth at 8.5 per cent during 2010 and estimates the overall size of the Indian economy (GDP) at USD 1.67 trillion. It estimates that the country's inflation would be 8.4 per cent during the year, and lead to tightening of policy rates by the Reserve Bank. "India scores well on earnings and GDP growth... However, rising inflationary pressures may force a more rapid tightening of policy," the Citi report said. As for China, it cautioned about a property bubble and said the government's efforts to bring the prices down would cut Chinese GDP growth by 3 percentage points in a full year. For Asia as a whole, the report says the region is its favorite and assigns it in the "overweight" category. However, it cautions: "Asia is at risk from slower export growth to Europe, if the crisis intensifies, and the effects on growth of a property collapse in China." For the overall forecast for the emerging markets, which constitute 29.6 per cent of the global GDP at USD17.8 trillion, the report said, "our forecast is for around 15 per cent returns in emerging equity markets in 2010, with a continuing pattern of volatility within a rising trend."

It said its long-term positive/bullish outlook on the emerging markets is based on the fact that the global economy is in the early stages of a new upswing and an anticipation of strong corporate earnings growth.

Ireland
The Irish sovereign debt crisis was not based on government over-spending, but from the state guaranteeing the six main Irish-based banks who had financed a property bubble. On 29 September 2008 the Finance Minister Brian Lenihan, Jnr issued a one-year guarantee to the banks' depositors and bond-holders. He renewed it for another year in September 2009 soon after the launch of the National, a body designed to remove bad loans from the six banks. The December 2008 hidden loans controversy within Anglo Irish Bank had led to the resignations of three executives, including chief executive Sean Fitz Patrick. A mysterious "Golden Circle" of ten businessmen are being investigated over shares they purchased in Anglo Irish Bank, using loans from the bank, in 2008. The Anglo Irish Bank Corporation Bill 2009 was passed to nationalise Anglo Irish Bank was voted through Dil ireann and passed through Seanad ireann without a vote on 20 January 2009. President Mary McAleese then signed the bill at ras an Uachtarin the following day, confirming the bank's nationalisation. In April 2010, following a marked increase in Irish 2-year bond yields, Ireland's NTMA state debt agency said that it had "no major refinancing obligations" in 2010. Its requirement for 20 billion in 2010 was matched by a 23 billion cash balance, and it remarked: "We're very comfortably circumstanced. On 18 May the NTMA tested the market and sold a 1.5 billion issue that was three times oversubscribed. By September 2010 the banks could not raise finance and the bank guarantee was renewed for a third year. This had a negative impact on Irish government bonds, government help for the banks rose to 32% of GDP, and so the government started negotiations with theECB and the IMF, resulting in the 85 billion "bailout" agreement of 29 November 2010. In February the government lost the ensuing Irish general election, 2011. In April 2011, despite all the measures taken, Moody's downgraded the banks' debt to junk status. Debate continues on whether Ireland will need a "second bailout".

Portugal
A report published in January 2011 by the Dirio de Notcias demonstrated that in the period between the Carnation Revolution in 1974 and 2010, the democratic Portuguese Republic governments have encouraged over-expenditure and investment bubbles through unclear public-private partnerships and funding of numerous ineffective and unnecessary external consultancy and advisory of committees and firms. This allowed considerable slippage in statemanaged public works and inflated top management and head officer bonuses and wages. Persistent and lasting recruitment policies boosted the number of redundant public servants. Risky credit, public debt creation, and European structural and cohesion funds were mismanaged across almost four decades. The Prime Minister Scrates's cabinet was not able to forecast or prevent this in 2005, and later it was incapable of doing anything to improve the situation when the country was on the verge of bankruptcy by 2011. Robert Fishman, in the New York Times article "Portugal's Unnecessary Bailout", points out that Portugal fell victim to successive waves of speculation by pressure from bond traders, rating agencies and speculators. In the first quarter of 2010, before markets pressure, Portugal had one of the best rates of economic recovery in the EU. Industrial orders, exports, entrepreneurial innovation and high-school achievement the country matched or even surpassed its neighbors in Western Europe. On 16 May 2011 the Eurozone leaders officially approved a 78 billion bailout package for Portugal. The bailout loan will be equally split between the European Financial Stabilisation Mechanism, the European Financial Stability Facility, and the International Monetary Fund. According to the Portuguese finance minister, the average interest rate on the bailout loan is expected to be 5.1% As part of the bailout, Portugal agreed to eliminate its golden share in Portugal Telecom to pave the way for privatization. Portugal became the third Eurozone country, after Ireland and Greece, to receive a bailout package. On 6 July 2011 it was confirmed that the ratings agency Moody's had cut Portugal's credit rating to junk status, Moody's also launched speculation that Portugal may follow Greece in requesting a second bailout.

Spain
Shortly after the announcement of the EU's new "emergency fund" for eurozone countries in early May 2010, Spain's government announced new austerity measures designed to further reduce the country's budget deficit. The socialist government had hoped to avoid such deep cuts, but weak economic growth as well as domestic and international pressure forced the

government to expand on cuts already announced in January. As one of the largest eurozone economies the condition of Spain's economy is of particular concern to international observers, and faced pressure from the United States, the IMF, other European countries and the European Commission to cut its deficit more aggressively. According to the Financial Times, Spain has succeeded in trimming its deficit from 11.2% of GDP in 2009 to 9.2% in 2010. It should be noted that Spain's public debt (60.1% of GDP in 2010) is significantly lower than that of Greece (142.8%), Italy (119%), Portugal (93%), Ireland (96.2), and Germany (83.2%), France (81.7%) and the United Kingdom (80.0%).

Belgium
In 2010, Belgium's public debt was 100% of its GDP the third highest in the Euro zone after Greece and Italy and there were doubts about the financial stability of the banks. After inconclusive elections in June 2010, by July 2011 the country still had only a caretaker government as parties from the two main language groups in the country (Flemish and Walloon) were unable to reach agreement on how to form a majority government. Financial analysts forecast that Belgium would be the next country to be hit by the financial crisis as Belgium's borrowing costs rose. However the government deficit of 5% was relatively modest and Belgian government 10-year bond yields in November 2010 of 3.7% were still below those of Ireland (9.2%), Portugal (7%) and Spain (5.2%). Furthermore, thanks to Belgium's high personal savings rate, the Belgian Government financed the deficit from mainly domestic savings, making it less prone to fluctuations of international credit markets.

United States:A THREAT TO THE U.S. ECONOMY The United States has a vital interest in assuring that the crisis across the Atlantic is contained. The country is tightly linked to Europe via trade, investment, and financial markets, and the Euro crisis is already affecting the U.S. economy. If the crisis were to spread further across Europe, the sound conduct of U.S. monetary and fiscal policy could also come under threat. The United States has taken action to help ease the crisis, restarting the Federal Reserves dollarswap line in early May and supporting the IMFs participation in the European rescue plan. The United States should also accept a weaker euro for some time. In exchange, it can exercise moral suasion to encourage fiscal consolidation and structural adjustment in the vulnerable Euro area countries and more expansive policies in the surplus ones. Effects on the United States The trade and investment links between the United States and the European Union (EU) are significant. Europe consumes twenty percent of U.S. exports and holds more than 50 percent of U.S. overseas assets, while the United States holds close to 40 percent of Europes foreign assets. Lower growth and higher volatility in Europe could therefore have serious consequences for the United States, hindering export growth and endangering assets. Europe has already shown itself to be the laggard in the global and the situation may well get worse before it gets better. The crisis will likely lead the euro to depreciate further in the coming months. The euro has already fallen more than 20 percent against the dollar since late Novembertwo months before Obama unveiled his goal of doubling exports in the next five yearsand it may fall to parity. In sectors where U.S. and European exports overlap (e.g., aircraft, machinery, professional services), a lower euro will hinder the competitiveness of U.S. goods on the global market. The depreciation will also reduce the purchasing power of European tourists traveling to the United States and make European goods relatively cheaper in U.S. markets at a time when policy makers are hoping to avoid a return to high current account deficits. With imports likely to rise and exports likely to fall, the U.S. bilateral trade balance with Europe will likely deteriorate. By definition, the profitability of U.S. companies operating in Europe will be affected by the Euro crisis when profits and assets on the balance sheets are expressed in dollars. U.S. companies selling in Europe and sourcing in dollars will see even sharper profit declines, though U.S. companies selling into the dollar area and sourcing in Europe will benefit. Despite the negative effects a weaker euro would have on U.S. job creation, the most important consequences of the Euro crisis in the United States will operate through financial and, more specifically, banking channels. Though the exposure of U.S. banks to the most

vulnerable countries in Europe is limited to $176 billion, or 5 percent of their total foreign exposure, their indirect linkages to these countries, which operate through all of the international banks, are much larger. Not surprisingly, European banks hold large amounts of their own countries bonds and, according to a recent World Bank report, these holdings exceed reserves in some instances. A string of bank failures in Europe could well trigger another global credit crunch. The crisis has already significantly increased stock market volatility; the VIX volatility index more than doubled in the last two months. The confidence that banks have in doing business with each other has also plummeted, with the TED spread, the difference between the three-month inter-bank lending rate and the yield on Treasury bills, reaching a nine-month high of 35 basis points in May, up from 10.6 basis points in March. Stopping the Spread These worries come against a background where the crisis has been largely confined to Greece, a country that accounts for 2.6 percent of the Euro areas total GDP. One can only imagine what would happen if the crisis spread to Spain or Italycountries 5 to 6 times larger. The trade, investment, and financial problems would clearly balloon, but a spreading Euro crisis would also hurt U.S. interests in three other fundamental ways: 1. Although a spreading Euro crisis could initially lead U.S. government debt to fall in price due to a safe haven effect, it will place the spotlight on the high and rapidly rising debt levels of the United States. This could force a large rise in the yield that investors demand to hold U.S. debt, aggravating the countrys unstable debt dynamics. At the same time, the United States does enjoy obvious advantages compared to individual European countries, given that the dollar floats freely. 2. If the crisis were to spread, it would prolong the timeframe during which the European Central Bank maintains low policy rates, making the United States less likely to raise its own rates. This could aggravate the liquidity overhang with difficult-to-predict consequences as well as accentuate imbalances in the economy. 3. Were a spreading Euro crisis to trigger defaults and lead a number of European countries to leave the Euro area, it could undermine the viability of the wider European project, including the accession of several countries in the East. This could create a new frontier of geopolitical instability all around the European periphery and further the decline in confidence. Thus, for the United States, the dangers involved in a spreading Euro crisis clearly outweigh the costs of supporting the European adjustment by accepting a lower euro, expanding the

resources available to the IMF, and expanding the Feds currency swap operations. In return, the United States can add its weight to the push for necessary adjustments within Europe.

India and other Developing Countries:The Euro crisis threatens the economic stability of much more than the Euro area alone. A weakened Europe implies slower export growth in developing countries as well as increased financial volatility. The Euro crisis may also be only the first episode in which post-financialcrisis vulnerabilities converge to such devastating effect, implying that similar dangers for developing countries could emerge from sovereign debt crises in other regions or another global credit crunch. Policy makers in emerging markets can take a variety of steps, outlined below, to limit the potential consequences right now. In addition, the crisis underscores the importance of the IMF as a lender of the last resort. Impact of the Crisis on Developing Countries Exports: The Euro crisis is likely to deduct at least 1 percent of growth, and potentially much more, from Europea market that consumes more than 27 percent of developing countries exports, In addition, the euro has already devalued more than 20 percent against the dollar since November 2009 and the two could reach parity before the crisis is over. A lower euro will sharply reduce the profitability of exporting to the European market and will also increase competition from Europe in sectors ranging from agriculture to garments and low-end automobiles. Tourism and Remittances: A lower euro will reduce the purchasing power of European tourists traveling to developing countries, and the value of remittances originating from Europe. Domestic Competition: At the same time, a lower euro may provide opportunities for consumers and firms to import from Europe at a lower cost. Capital Flows: The Euro crisis will force the European Central Bank to maintain a very low policy interest rate for the foreseeable future. Similarly low rates in Japan and the United States, combined with low growth in Europe, may lead even more capital to flow to the fastest-growing emerging markets. This will lead to inflation and currency appreciation pressures, as well as increase the risk of asset bubbles and, eventually, of sudden capital stops in emerging markets. Market Volatility: The Euro crisis will add greatly to the volatility of financial markets and will lead to sharp bouts of risk-aversion. The VIX index, which measures the cost of hedging against the volatility of stocks, has more than doubled in the last two months. This, in turn, has increased the level and volatility of spreads on emerging market

bondswhich have risen by more than 130 basis points since Apriland will make currencies more volatile across the globe. Credit Availability: The Euro crisis may constrain trade and other bank credit available to developing countries as it raises questions about the viability of European banks especially those based in vulnerable countries whose assets likely include large amounts of their own governments bonds. But all international banks will be viewed as having either direct or indirect (through other banks) exposure to the vulnerable countries. The confidence that banks have in lending to each other has already fallen; the TED spread (the difference between the three-month inter-bank lending rate and the yield on threemonth Treasury bills) reached a nine-month high of 35 basis points in May, up from this years low of 10.6 basis points in March.

Policy Implications Though there are no one-size-fits-all prescriptions for developing countries given their very different starting points, some general policy conclusions emerge: Developing countries will need to rely less on exports to the industrial countries and more on their own domestic demand and South-South trade. In some cases, greater caution may be called for in reversing stimulus policies. In other cases, even greater prudence may be called for in containing fiscal deficits and moderating the accumulation of public debt. Given the sharp rise in exchange rate uncertainty, matching the currencies of foreign liabilities with those of export proceeds and reserve holdings will become even more important. The Euro crisis also calls for great caution in the way surging capital inflow is managed. In some countries, regulations to moderate the inflow of portfolio capital and to instead encourage the more stable form of foreign direct investment may be warranted. Countries with large external surpluses and that receive large capital inflows may allow their currencies to appreciate, as this may help both stimulate domestic demand and moderate inflationary pressures. Close monitoring and tight regulation of the operation of foreign banks and of their links with domestic banks may be prudent in the current circumstances. Two other important policy lessons flow from the Euro crisis experience to date: one is a reinforcement of the message that strictly pegged exchange rates together with open capital accounts and the ability to borrow abroad in foreign currencies are often a dangerous combination. Just as a tight peg to the U.S. dollar led to significant GDP contraction in Argentina

(18.4 percent from 1998 to 2002), countries that are not part of the Euro area but had pegged their currencies to the euro many years ago have seen their GDP decline sharply. GDP in Latvia, Estonia, and Lithuania, for instance, will have contracted by 24.8 percent, 16.5 percent, and 14.1 percent, respectively, from 2007 levels by the end of 2010. Countries with flexible exchange rates, such as Poland or Brazil, and those with pegged exchange rates but tight capital controls appear to have dealt with the dislocation caused by the crisis more successfully. Last but not least, the crisis has exposed the limitations of regional mechanisms in dealing with financial crisiseven among countries with deep pocketsand underscored instead the vital role that a global lender of last resort, in the form of the IMF, can play. Not only can the institution bring more resources and broader expertise than would plausibly be available to a regional institution, but its distance from potentially divisive regional politics can also be a big asset.

Chapter6- Lessons Learnt

There are two fundamental groups of countries in the Eurozone, the first bloc comprises of countries in Northern Europe, such as Germany, Norway or Finland. The shared characteristics of these countries are high productivity, modern technology and surplus of current account. The other group is formed by countries in Southern Europe, such as Greece, Spain and Portugal. They all have lower productivity than the north and have deficit of current account. We can see how serious imbalances in the Eurozone developed by taking Germany and Greece as representatives of two groups. Economically strongest member of the north, Germany, has been lacking domestic demand, because of high propensity to save of its households. Therefore it has followed export-led growth with many of the exports going to Greece and other countries in south of Europe. However, Greece was not able to produce any goods or services that German consumers would be interested in. German banks solved the problem by taking savings generated by thrifty German households and lending them to households and government in Greece. Current account deficits of Greece were compensated by its capital account surpluses, that means by lending from German banks. This is how serious imbalances developed. Both sides hugely benefited from these transactions. Germany benefited from high economic growth and low unemployment, its households could continue to save and accumulate financial wealth. Greeks also benefited, as they could enjoy much higher living standards than they would otherwise have. They could basically consume goods produced by Germans in exchange for promises to pay for them in the future. The existence of single currency further exacerbated the imbalances by enabling Greek and other South European governments to borrow at the same interest rate as German government, as bonds of all Eurozone countries were perceived to have the same low risk of default as German bonds. Interest rates set by the ECB for the entire Eurozone were very low and this cheap credit enabled massive property and lending booms in the European periphery. This way Greeks and other nations in the periphery ran up massive debts, in case of Greece it was mostly government debt, in case of Spain and Ireland it was private debt. On the other

hand, Germans accumulated huge piles of financial assets which made them feel wealthy. Martin Wolf wrote an excellent and witty comment on this topic in the Financial Times where he uses the traditional fable of ants and grasshoppers to explain situation in the Eurozone. He compares hardworking Germans to ants and careless Greeks and other South Europeans to grasshoppers. However, moral of his story is different than the one of the original fable. However, at a certain point investors decided that debt in Greece was unsustainable, or as Wolf writes trees do not grow to the sky. German government suddenly realised that if Greece defaults on its debt, German banks would lose a great deal of money. Significant part of savings of German households would suddenly be at risk. Therefore German government would have to bail out its banks to protect domestic savers. However, German government was worried that thrifty German savers would be absolutely frightened and angry if they realised that their hard-earned savings were effectively spent by wasteful and lazy Greeks. There was also a risk of panic and of collapse of the fragile European banking sector. Therefore German government decided to adopt different policy and make yet more loans to the Greek government. However, the loans came with a set of tough conditions, Greeks have to basically prove that they can behave like Germans. That means fiscal discipline, deep cuts in government spending, tax rises, structural reforms, wage deflation, all extremely painful and unpopular. The loan to Greece was followed by a bailout of Ireland and bailouts of Spain and Portugal are still possible. This is where we are now. My main point is that Germans and Greeks, or north of Europe and south of Europe, are both responsible for the current crisis. They both benefited from the boom and they should both share the consequences of their foolish behaviour. Germans should have known that lending to careless Greeks was never going to be a way of accumulating enduring wealth. Greeks willingly accepted those loans and lived beyond their means for many years, so it is right that they know face period of difficult transition. However, there is a third group of countries in the Eurozone that had nothing to do with this boom, that did not benefit from it, but is now asked to pay the bill as everyone else. Slovenia joined the Euro in 2007, Slovakia in 2009 and Estonia in 2011. These countries have been asked to take part in a proposed solution to the crisis which are the loan to Greece and Eurozone

Stability Mechanism, where all Eurozone countries have to contribute towards emergency loans to troubled countries. The unfairness of this situation is especially stark in the case of Slovakia which joined the Eurozone just after the party stopped and was asked to pay the bill for a feast that it did not take part in. The crucial thing is that Slovakia does not fit to any of the two dominant groups in Eurozone, as it is neither a current account deficit or a surplus country. Its current account deficit is very small, it is only 1.3% of GDP. By comparison, Germanys current account surplus is 6% of GDP, Netherlands surplus is 5.7% of GDP, Greece suffers from enormous 10.8% current account deficit and Portugal is not doing any better with deficit of 9.98% of GDP. Leaving the Euro and returning to Slovakias former currency, koruna, would be a radical policy associated with enormous transition costs, but might actually be the least bad of all options. What are the solutions to this crisis? Bailouts of Greece and Ireland are not solving the fundamental issue of solvency, they are only providing liquidity. The only thing that can save these economies in the long run is economic growth, without grout they will not be able to service their debt, or prove their ability to repay it in the future. The only alternative other than default is that these economies grow out of their debts. As governments and households in troubled countries are in difficult process of de-leveraging, slowly paying off their debt, their economies suffer from lack of aggregate demand. Therefore the only possible source of rising demand in the following years can be external demand from countries like Germany. In the next couple of years Greece and other countries in similar situation will have to pursue strategy of export-led growth. However, right now Greek and other south European producers are very uncompetitive compared to German producers. During the last decade German economy experienced wage growth much slower than growth in productivity which meant that German international competitiveness has been rapidly rising. At the same time there was rapid growth in wages in countries like Greece without significant increases in productivity. The consequence was widening gap in competitiveness.

Greeks and others now need to quickly regain competitiveness by wage deflation, cuts in wages should result in lower production costs and higher competitiveness of Greek producers in relation to German producers. Because of Euro both Germans and Greeks are in a fixed exchange rate regime where differences in competitiveness cannot be solved by movements in the exchange rate. If Germans had Deutschmark and Greeks their Drachmas then Greek currency would simply depreciate as a result of worries about Greek government finances which would make Greek exports cheaper. However, in this situation is not possible and therefore Greece, Ireland, Spain and Portugal have to go through painful process of internal devaluation through reductions in nominal wages. Instead of admitting their share of responsibility, German government argues that the whole crisis was caused by irresponsibility of governments in southern Europe and that fiscal indiscipline was the only cause of the sovereign debt crisis. They prescribe policy of austerity and fiscal tightening to the countries in periphery. By doing this they put the entire burden of adjustment on countries like Greece. Basically they want people in Southern Europe to behave like Germans. This approach can never work. If all European countries behaved like Germany then Europe would become a big Germany with huge current account surplus. Who would buy all those exports? Europe would have to start exporting to Mars, there would simply not be enough demand in the world for all the European exports. German model of current account surplus is unbalanced and unsustainable in the same way as Greek model of current account deficit. It is the other side of the same coin. The only viable model for the Eurozone in the long run is that Germans would become a bit like Greeks and Greeks would become a bit more like Germans. To put it simply, Germans need to spend more and Greeks need to save more. Countries in the periphery cannot carry the entire burden of transition, countries in the economic core of Eurozone, such as Germany have to help them. German government should allow wages to grow faster, at perhaps 5% per year and tolerate much higher than 2% inflation. On the other hand, Greek government has to push through painful wage deflation and cuts in nominal wages across the board at perhaps 10% per year. This way both parties would share the burden of transition.

Chapter7- Conclusion
In conclusion , Europe will be given the financial means in the short medium term, allowing him to emerge from the crisis of sovereign debt and longer-term research a new compromise policy (economic governance and fiscal policy in common) that which implies that the market works in step with democracy, or it will implode with all the consequences we can imagine. The future of the United States of Europe has never been more uncertain. The ongoing European sovereign debt crisis continues to shake financial markets and the Euro zone. The International Monetary Fund and the European Union (EU) have acted swiftly to diminish panic and uncertainty by providing emergency assistance to Greece, Ireland and Portugal. However, uncertainty remains and queries have arisen over the vigor and effectiveness of multi-lateral institutions like the EU. In the wake of the crisis, financial analyst asserted that a lingering flaw of the European Commission is its inability to address problems until they become crises. This crisis has warned governments throughout the globe of the dangers of fiscal wanton. Britain along with other European nations introduced a salvo of austerity measures to prevent a debt crisis. The US is currently contemplating numerous options to cut the deficit, which if implemented, could have profound consequences for our social and political future. Johnson goes on to claim that only when crisis erupts can the EU can come together to develop solutions. If so, the question now is how the EU can succeed in the long-term if it does not have the capacity to address problems early? Perhaps, the most important lesson of this episode was the realization that public policy challenges can no longer be postponed as they used to be. The wages of evasion are clearly too caustic for any country or region to pay. A new public policy ethos is essential if progress is to be made. However, if this lesson is ignored, the EU or other nations may face a future crisis or problem. It is hard to then imagine the ramifications on the region and the rest of the world.

The crisis in Europe shows that there are always potential risks for any region that implementsa single currency among countries that have huge economic, monetary social, historical,cultural and religious differences.

Chapter8- Bibliography
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www.imf.org/external/pubs/ft/survey/so/2010/CAR051010A.html IMF, Executive Board Concludes 2010 Article IV Consultation with Italy, May 26, 2010 OECD, Economic Survey of the European Union 2009: Policies to overcome the crisis, BBC, Greece rejects debt restructuring. BBC, (September 12, 2010), sec. Business. http://www.bbc.co.uk/news/business-11276623. http://www.bbc.co.uk/blogs/thereporters/gavinhewitt/2010/11/the_euro_puzzle.html The Economist, And then there were three The Economist ( Apr 7th 2011) http://www.economist.com/node/18530601 Lefteris Papadimas and Jan Strupczewski, EU, IMF agree $147 billion bailout for Greece Reuters.http://www.reuters.com/article/2010/05/02/us-eurozone-id US Katinka Barysch, A New Reality for the European Union, Council on Foreign Relations, (September 2010).