19 February 2010
Euro, the single currency adopted by 16 of the 27 EU members, faces the biggest crisis since the European monetary union came into existence in 1999. It is a confidence test for both the euro as an international currency and for the solidarity between the 16 eurozone countries. The trigger was the ballooning budget deficit of Greece which stood at 12.7% of GDP. Given that the Stability and Growth pact has set a limit to budget deficit of 3% of GDP in the eurozone, the situation has been perceived as critical. Greece has been given time until 16 March to take austere measures to reduce its deficit. Further denting confidence is the fact the EU regards Greek statistics, in the words of Swedish Finance Minister Borg, “basically fraudulent”.
Meanwhile, it is still unclear how much the rest of its eurozone partners are willing and able to help the Greeks. Although the EU leaders pledged to support Greece while meeting for an informal summit in Brussels last week, they mostly reiterated that Greece would need to take additional austerity measures, while remaining reticent on specific assistance. This reticence reflected EU’s concern not to create a moral hazard by bailing out Greece. This could also set a precedent that would encourage other weak economies to seek aid in the future. It is perhaps also to do with the politicians wariness of the response from its own public. A poll done in Germany (reported in Reuters) showed that 67% of Germans did not want to pay to bail out Greece, and 53% felt that Greece should, if necessary, be expelled from the eurozone.
By giving Greece only 30 days to cut its ever-raising deficit and debts, the eurozone finance ministers have clearly showed that Greece is expected to demonstrate a persuasive effort to regain market confidence. Luxembourg’s Prime Minister and chairman of the eurozone Jean-Claude Juncker expressed his concern over the irrational behaviour of financial markets. The investor’s nervousness also showed in the euro’s continuous slide to a nine-month low against the US dollar. Besides, bond markets have punished Greece for years of financial overspending, pushing yields higher. As a result, Greek bonds are now trading three percentage points above German bonds (The yield on the German 10-year bond was at 3.19% on 15 Feb, while the Greek 10-year yield was at 6.15%).
It is obvious that the EU cannot afford bankruptcy of one of its Member States. It is of little importance that Greece’s share of the EU’s GDP is only 2.6%. There are also financial interests involved as Greece owes US$75.5bn to French banks, and US$43.2bn to German banks. Altogether, Greece owes foreign financial institutions US$302.6bn.
There is also fear that the crisis in Greece could trigger a domino effect in the EU. Public finances are also weak in Portugal, Spain and Italy. Experts have indicated that Spain could become the next, even bigger threat to the stability of the euro, because the Spanish economy is four times of the size of Greek economy. The fact that the competitiveness of Spain and Portugal has been going down since the introduction of the euro, is of particular worry. However, instead of putting in place necessary reforms, low euro-zone interest rates in recent years have motivated these countries to rely heavily on borrowing. Ireland is faced with similar situation as it also has large public deficit. Nevertheless, the quick measures taken by the Irish government eased the fears of national default. Investors are worried that the eurozone countries that are stable for the time being, such as Germany, Finland or the Netherlands could eventually be affected; that they may be forced to pay for the financial errors of Greece and the others; that the euro will continue to slide against the US dollar. This would bring certain benefits to European exporters who have been complaining for years about a too-strong euro, but it would also mean paying more for imports.
Greece is not the only problem facing the eurozone at the moment. As a result of the financial crisis, public debt has gone up across the continent. In fact, only seven out of 27 Member States are currently complying with the eurozone rules on budget deficit. Plummeting tax revenues together with expensive economic stimulus packages have severely stretched the budgets. The general worry for the eurozone is that the growth last year was to a great extent induced by government spending, reflecting ongoing fiscal stimulus. In addition, it is doubtful that consumer spending has had any considerable input to the economic growth considering that retail sales within eurozone fell by 0.2% quarter-on-quarter.
This threat to the EU single currency is in not just a short-term one. Even if Italy and Spain avoid bankruptcy threats for the time being, the question remains about the ability of their governments to push through the necessary reforms. The protests have already started in Portugal and Greece as a result of budget cuts. No doubt, profound reforms are needed to avoid that the gap between the strong and weak members of the eurozone becomes ever wider.
Sources and links to further information:
Research papers, policy briefs