I have followed the European Debt Crisis in detail for over a year now and I have been intending to write about it for a while. However the European situation is so dynamic that successive drafts have graced the dustbin. I wanted that the piece I finally publish should be insightful, I was not content to simply write a report on the crisis giving an overview of the debt yields or the debt to GDP ratios of the affected nations. I wanted to present an insight and original view of what direction the crisis is taking, what decisions should have been made and what the future may look like if the right decision are made. So after months in the making, I finally present to you my analysis of the European Sovereign Debt Crisis. Feedback most welcome at: mananvyas93@gmail.com

My analysis of the European Debt crisis revolves around the following points: (1) There is an essential difference between solvent but illiquid nations and insolvent nations. (2) This is a crisis of creditor confidence. To regain creditor confidence, you need to listen to what the creditor is saying. (3) The European Debt Crisis is a crisis at whose heart lies a risk of contagion from hopeless economies such Greece to major global economies such as Italy and Spain. Were it not for the credit market fear of contagion, the crisis would be much smaller and localised in scale. How do we mitigate this risk? Read on.

I shall be examining the 5 crucial nations at the heart of the crisis – (the PIIGS): Portugal, Italy, Ireland, Greece and Spain. Essentially speaking Italy and Spain are solvent in the long run. They have the capability to repay their creditors. Greece is not. There are questions on Portuguese debt sustainability. And Ireland might just pull through. Ireland is expected to tap the credit markets only in late 2013. Thus it close to 2 years to gets its economy back on track and reach the growth path. Ireland already had one of the most liberal economies in the world so there was not much more it could do by way of reforms. Fiscal austerity is hitting the nation hard though. Yet the finance ministry believes that the inherent advantages in the Irish economy including low regulations and an educated and flexible workforce would allow it to re-finance itself once the bailout package ended. Thus I believe that at this moment, the events in Ireland are not going to rock the European boat. Moving onto Portugal. Portugal is a veritable ticking time bomb. It enters the credit markets in the second half of 2013 when its bailout package ends. Its debt to GDP ratio is unsustainable in the long run. The Prime Minister is bold and has passed extensive reforms. However these are enshrined into legislation only in the first half of 2013. The benefits of these reforms may take years to materialize. Thus its plans to enter the credit market in 2013 have been met with skepticism all around. I believe that ideally the Troika – The European Union, the European Central Bank and the IMF, should extend the loan period to 2014 and then negotiate loan restructuring plans. I shall give the rationale for this later. Moving onto Greece. Despite the haircut on its private debt, analysts believe that Greek debt is still unsustainable in the long run and I am personally inclined to agree with them. At some point in the future, Greece is going to need a second haircut to its debt. I believe this date should be pushed back as much as possible. Ideally 2015. I repeat, the quest here is to mitigate the risk of contagion. Now moving onto the key issues. Spain and Italy. Essentially both economies are solvent. Spain in fact boasts of one of the lowest debt to GDP ratios in the European Union at just 71%. I am not saying that the economy is healthy, its overall debt to GDP ratio (not just government debt) is a staggering 363% and one of the highest in the world. Moving onto Italy. At 120% of the GDP, Italian debt is massive. Its the third largest bond market in the world, trailing only the United States and Japan. However intrinsically the economy has a potential to repay its debts. In fact both Spain and Italy’s debt trajectory over the past  decade showed declining debt levels till the global financial crisis erupted in 2008 and the economies had to step up rescue efforts.

The basic point to be understood is that the crisis has achieved these proportions because of fears that the long term debt sustainability of Italy and Spain may be under threat if they continue to re-finance at these interest rates. In recent months both economies have flirted with the psychologically crucial 7% mark. When a nation borrows long term in the range of 7% or above, it spells trouble for long term sustainability. The key then is basically for Spain and Italy to be able to borrow cheaply. With the intrinsic strength in their economy, both nations are on track to re-pay their creditors in the long run. What they are facing currently is a crisis of confidence due to the troubles in Greece and Portugal and due to their recent high levels of fiscal deficit. Spain and Italy both took steps to regain creditor confidence. The wrong ones. Creditor confidence decreased further. Spain and Italy basically opted for fiscal austerity to cut their fiscal deficit. Now I am not saying that fiscal austerity was un-necessary. Fiscal austerity is essential when faced with such debt and deficit levels. Yet credit markets remained unmoved. Why so? As every student of Keynesian economics knows, you increase spending in a recession and balance your budgets during boom time. These governments are following the exact opposite strategy. They increased their debts during the boom time and are desperately attempting to balance their budget in times of deep recession. This would essentially result in a vicious cycle of lower spending, higher un-employment, lower demand for goods, yet lower spending and obviously, lower government taxation  revenue. So fiscal austerity during a recession even hurts the government balance sheets due to lower revenue. Instead, what these governments should have been doing was to listen to the credit markets. What is the voice of the credit market? It is the much reviled credit agency. S&P, the most prominent of the big 3 rating agencies, in the middle of January cut the credit ratings of 9 European Nations. I examined their reports in great detail and herein lies the crux of my analysis. The credit rating agencies and creditors in general are looking for growth. They are crying out for reforms. The Italian and Spanish economies have some of the most rigid labour laws in Europe. They make it extremely hard for an employer to fire an employee. Employees are over-paid, highly privileged, retire young and generally easy going. The laws were skewed against employers and productivity was not comparable to the model of European growth – Germany. This is what creditors feared in the long run. If the gap between German and Spanish-Italian productivity would continue to remain high in the coming decade, the debt to GDP ratio was likely to increase and the intra-continental growth gap would expand.

In an ideal world, Spain and Italy would pass sweeping labour reforms and liberalise their economy. These moves would in turn stimulate growth that would create a virtuous cycle of higher employment and eventually higher tax revenues. Meanwhile after these reforms have been passed, austerity measures can run alongside providing a two prong approach to dealing with the debt crisis.

In the real world however, Spain and Italy started off with austerity measures. They misread the message from credit markets. They started cutting their fiscal deficits. This drove their economy into a recession and increased unemployment and created a vicious cycle. Observing the recession, high levels of unemployment and the high debt to GDP ratio, the yields on their bonds rose slowly to a point where the crisis escalated to a whole new level. However I believe that the situation is not as grim as it looks. Basically events with Ireland and Portugal safely under the bailout package till the second half of 2013, they should not present any major shocks to the European situation. Provided Greece’s negotiations with the International Institute of Finance go well, it should have no trouble receiving its next tranche of bailout loan from the Troika. From that point onward, Greece too should not pose any major shocks to the international markets. Greece is not poised to enter credit markets at any time in the near future. This basically leaves Spain and Italy facing the bond markets. While Italy refinances Euro 337 billion, Spain must rollover debt worth Euro 130 billion.

Thus it is upto the Spanish and Italian economies to convince the bond markets that they are worthy. While the Italian PM, Mario Monti has already passed a range of comprehensive reforms through his cabinet in consultation with labour unions and employers, tougher challenges await. Italy’s largest labour union walked out of the talks (the 2nd largest labour union remained at the negotiating table giving credibility to the cabinet resolution) while associations of individual professions that have lost their protected status are already up in arms. Italy is likely to face months of protest and negotiation before these reforms become legislation. And that is where I drive home my point. Had Italy’s primary focus been reforms that have a positive long and short term effect, rather than austerity, then by January 2012 it would have been poised at a stronger position. However Mario Monti’s professional government has been gaining fans in the European Union with German Chancellor Angela Merkel expressing admiration at the intent shown by the government. There is hope yet. The very act of unveiling the comprehensive reform package should help buck up the confidence level in the credit markets. The Spanish government has promised to unveil  labour, budget stability and financial sector reforms by February.

I believe that ideally the Troika and Germany should try to ensure that Italy and Spain have at least until the end of 2013 to  get their economies back in shape. By then their economies should be in better shape and the reforms process would have given an impetus to growth. Post 2013 if Portuguese and Irish (unlikely) debt is considered unsustainable in the long run, restructuring must take place. I believe that by this time the markets should be able to recognise the difference between stable and liberal economies Spain and Italy and contagion should not spread to them. Moreover Portugal is relatively small on the international scene and its debt restructuring can be handled in a manner that localises its effects as much as possible.

To recap: Italy and Spain must give reforms and liberalisation priority over austerity. This is what the credit markets demand. Once reforms transform into solid legislation, credit markets will relent, bond rates will come down and Italy and Spain will slowly creep out of the danger zone. Ireland is doing reasonable well and is secure till 2013. Its inherent strength might allow it too to creep out of the danger zone. This will leave the spot-light on Portugal. Portugal has passed substantial reforms and must be given an extended year by the troika to allow these to work. Greece is under the bailout loan package for an extended term and the Troika must ensure that the Greek long term debt sustainability issue is not brought back into the open until atleast mid 2014. By this time there will be only Portugal (maybe not) and Greece left in the red zone – all alone.

The European Sovereign Debt Crisis has centered around 5 nations – Portugal, Ireland, Italy, Greece and Spain giving this grouping of economies an unfortunate but somewhat deserving acronym – PIIGS. Greece and Italy are the two economies from this group that have attracted the  largest amount of international attention in the past year. Greece because it has the most unfavourable percentage of government debt to GDP ratio at approximately 159% (2011-12 forecast) and Italy because it has the largest government debt in Europe and is the 3rd largest government bond market in the world. There are several fundamental differences between their debt situation. Examination of these differences allows us to analyse and predict the way forward for the beleaguered Italian government.

The two main points to consider are scale and recovery. In terms of sheer scale Italy’s 2.5 trillion dollar debt dwarfs the $470 billion Greek debt. While Italy’s debt exceeds the GDP of all but 2 nations of Europe (Germany and France), there are 10 countries in Europe with a GDP (nominal) higher than that of Greece. Greece has been developing fundamental faults in its economy since 1974, when it first became a democracy. To appease the socialist leaning populace, several populist schemes (beyond the capacity of the government exchequer) were introduced. The excess spending over the past 3 and a half decades was hidden by successive governments till 2009-10 when George Papendrou’s government unleashed a storm on European financial markets with revelations of government debt levels crossing the 120% threshold. The credibility of European Union regulators was badly damaged. In contrast the Italy economy has been developing cracks in its steady growth story only over the last decade. Lack of reforms and political will coupled with fierce competition from growing neighbours Germany and France put more pressure on the Italian economy. Silvio Berlusconi’s stranglehold on the economy further damaged the economy. Fundamentally however the Italian growth story remains intact. Milan and its neighbouring districts are still amongst the richest regions in the world while the Italian auto industry continues to dominate the segments that it targets. The point of essence is the rot in the system. While bureaucracy and poor political leadership have stalled Italy’s growth, the Greek story is entirely in tatters. As economists examine the history books of spectacular Greek growth in the 1990s through 2000, more and more are concluding that the growth was based more on the investment multiplier fueled by spending (spending that was sourced directly from borrowing). The Greek economy has its areas of strength, tourism and shipping being their primary industries, contributing more than 15% of the Gross Domestic Product, but the economy is over-dependent upon them and in times of recession, these are the first industries to be affected. Greece is ranked above 100 in terms of the ‘Ease of doing Business’ Ranking, a statistic that does not bode well for long term investors in the country.

Looking at the long term prospects of the two nations it is easy to see that Italy is fundamentally superior. It is a highly modernised and liberal economy with GDP contributions being spread across several sectors. With a change in the political leadership and a shake-up of the bureaucratic structure, Italy, with its massive coastline, strong geographical presence, solid industrial base and a new found vigour, the Italian economy may one day challenge the prosperous Germany. Investors recognise this.

Greece

In Greece, several factors converged to bring about the present situation. As it had been borrowing easy money since the entry to the European Union, its debt burden was massive. If the debt burden is $450 billion dollars then even at a conservative interest rate of 4% p.a. the Greek economy was paying interest equal to 6% of the GDP. This factor coupled with the international recession hit the Greek economy hard. Shipping suffered while tourism saw a massive slump. In this backdrop the Prime Minister announced the debt levels. Instantly the interest rates soared. Beyond a particular point no government can afford to buy debt. The dynamics of the financial system post millennium have leaned towards short term financing. With extensive debt up for roll over, the Greek economy was not yet insolvent, just illiquid. However as bond yields were/are so high, the Greek economy could not borrow from the open market. A direct default would have plunged the delicately poised international markets in a depression. Keeping this in mind the European Union closed ranks and produced a majestic rescue package. This rescue package however was simply meant to be a liquidity back-stop, to reassure investors that the financial might of the EU would ensure that their debts would be paid back. Ideally investors would have been reassured and would have held on to their debt, or rolled it over at the reasonable rates. However deeper examination of the Greek situation made many realise that the economy was beyond repair and long term prospects looked bleak. Prominent economists, analysts and even The Economist stated that a default was the only way forward for the Greek economy. Credit rating agencies were on a constant watch of the situation and would downgrade the debt with alarming frequency. Debt started being transferred from private investors to European governments. The scale of Greek debt and the fear of extensive contagion made a Greece bailout package possible. A large extent of the debt (more than 70%) had been held by foreign investors. This is also defined as ‘flighty capital’, money that would vanish at the first risk of default. Rescue packages and external aid was essential to reassure these influential investors.

Now we shall compare the Italian situation with the Greece debt crisis.

Italy

The first difference is scale. Italian debt is huge – $2.5 trillion, of which $1.1 trillion (44%) is held by foreign investors. Traditionally national investors would hold government debt at a greater risk of default than foreign investors. International investors roam the globe for the best returns at a minimum risk and are swift in withdrawing. With the scale of debt that faces Italy, it is not possible to design a rescue package sufficiently large enough to convince investors to stay put. Bailouts are politically unpopular, rescues of undisciplined financial entities with tax-payer money is not what voters wish from their representatives. First there were the rounds of banker bailouts, wherein highly paid bankers retained their jobs even as workers across other industries were adversely affected, and then followed the bailout of the Greek economy. Known for sun, sand and leisure, hard working Europeans may have secretly envied the Greeks. Yet their lazy and unethical work culture came startlingly into the limelight in 2009 even as the more prosperous governments, Germany and France had to reluctantly open up their purse strings to the economy that had built up its prosperity on borrowed money. Similar packages were given to Portugal and Ireland. Political sentiment against bailouts run so high that a Finnish party recently came to power with the promise of voting against more bailouts. In this context, it is politically impossible to pass another bailout package for Italy, which has also come under international ridicule for voting to power, year after year, the irrepressible Silvio Berlusconi, known more for his exploits outside his Presidential office than inside it.

If Italy is to issue a 10 year bond today, it would be paying $143.75 billion a year in interest burden alone. Therefore after the interest rates cross a certain threshold it is difficult for the government to roll over its debts. Yet the Italian economy remains fundamentally sound. 2 year bond yields are at 6.9% as compared to 28% for the Greek economy while 10 year bond yields are still within some control at 5.76%. Our analysis tells us that in the Italian case, it has to be the government that calms down markets. No external forces can play a role. The Italian government has to take a tough stand, cut spending and restore faith in investors. They can learn from the Spanish economy that was able to successfully cut spending and pushed through key reforms. While the 56% domestic debt holders do act as a buffer, every 1% increase in bond rates may increase the interest burden by anywhere between $5 billion to $25 billion. Because of the scale of debt, the effect of smaller increases in interest rates is substantially larger.

Politics will play a key role. Thats what differs Greece from Italy. Domestic politics did not have so much of a role in Greece as the role of external aid and the vast mountain of debt. The situation was deemed to be beyond repair by many. In Italy however effective political leadership and a solid promise of reforms, backed by practical plans may yet save the day. A united move to cut the deficit, coordinated by all political parties will restore faith in investors.Nowhere, and in no other financial debt crisis, has the role of domestic politics been so important. If Italian politicians get their act together, the bond yields will subside, the crisis shall pass and crisis-enabled reforms will push the economy to greater heights. If they should fail however, the consequences will disastrous.

IMF’s Director – India must support Christine Lagarde

After Dominique Strauss Kahn’s ignominious exit from the top post at IMF, analysts and policy makers across the globe have debated and speculated on the successor to the top post. Christine Lagarde, the French Finance Minister has emerged as the most prominent contender for the post and has been on a tour across the most powerful nations in the world to drum up support for her bid. Traditionally a European has headed the IMF while an American has headed the World Bank in an unwritten pact since the formation of the two institutions at the legendary Bretton Woods Conference. Recently however the BRICS (Brazil, Russia, India, China and South Africa), a grouping of emerging nations, has spoken out against this practice that fails to recognise the growth poles of the world and have been clamouring to end the domination of Europe and USA at major multi-lateral institutions, a tradition that many view as colonial and out-dated. The Europeans are firmly backing their candidate while the United States has been non-committal so far. The emerging nations, despite their concern have not yet been able to rally together to support a single candidate. Stanley Fischer from Israel and Augustin Carsten from Mexico are other prominent contenders in the race.

I am however of the opinion that India must support Christine Lagarde for her bid. There are several reasons for this. Firstly, India stands to gain very little by supporting a candidate from the BRICS nations. India’s own candidate, Montek Singh Alhuwalia has been deemed to be too old for the job, with the age limit being 65. Few Indians are surprised; our leaders are amongst the oldest in the world with most top posts being occupied by men over the age of 70. The head of governments in both USA and UK are under the age of 50 showing the willingness of the electorate to accept young and energetic leaders. The BRICS nation is a grouping based on growth rates and economic sizes, not similarity in policies. Brazil is a mineral exporting nation; China is a mineral and energy importing and manufactured goods exporting nation; South Africa exports minerals, prominently diamonds while Russia exports crude and defence technologies; while India, the poorest nation of the lot is an energy importer and outsourcing centre. The nations are diverse in terms of size (Russia is around 6 times larger than India), standard of living, political scenario (China is Communist), currency policy, trade deficit and fiscal deficit. India may in fact stand to lose a lot if a Chinese candidate ascends the top post as Chinese currency policies (The Chinese government keeps the renminbi low on purpose to encourage exports) are hurtful to Indian domestic manufacturers. India may however stand to gain significant goodwill with the European world if India remains neutral or goes all out in support for Christine Lagarde. That is the first argument for supporting her. Secondly, the IMF is an institution that is largely irrelevant across most parts of the globe. Presently engaged in European fiscal rescue operations, the IMF is largely relevant to Europe but otherwise useful to only a bunch of fiscally struggling nations spread all across the globe. Thus India must not seek influence at the IMF, it has little to gain. Furthermore, clout at the IMF, the voting system, is based on the amount of capital contributed by member nations. Rather than increase India’s contribution at the IMF to increase our influence at that global body, India, a poverty stricken nation with high inflation would do better off using the money at home in poverty alleviation schemes. Or if India wishes to expand its foreign policy footprint it must directly engage with nations and continents the way it is doing in Afghanistan, Myanmar and Africa with a good degree of success.

The most important argument however is the European Sovereign Debt Crisis. Brought about by years of indiscrete expenditure by a few European governments, encouraged by their integration to the Euro and accentuated by the Global Financial Crisis, the European Sovereign Debt Crisis is the most serious issue that the IMF has been involved in since its inception in 1945. The IMF has extended bi-lateral loans to Greece and Portugal and has promised to extend credit facilities to any other struggling nation in the European Union if requested. The IMF has already broken several of its precedents and by-laws in its charters by lending in this manner to the fiscally struggling European Nations but it is vital to continue doing so. If any one of the PIIGS (Portugal, Italy, Ireland, Greece, Spain), a grouping of European nations that are struggling with their government debt and fiscal deficit, is not able to re-pay its obligations, it will spark off a crisis that would result in multiple bank failures, collapse of banking systems, collapse of the European Central Bank and a recession so ferocious that it would make the Global Financial Crisis look like small change. The emerging nations however share a myopic view of the situation. While Dominique Strauss Kahn, a citizen of EU’s second largest nation (France) had a complete grasp over the situation and a commitment to continue extending support, an emerging nation’s head may not extend full support. Without the full support of the IMF, which has pledged credit upto 220 billion Euros, the European economy would most probably implode setting off a crisis that would affect all prominent economies.

In conclusion I suggest that is better for Christine Lagarde, another French citizen to ascend the position as the French are at the centre of the fiscal rescue efforts and she would have a complete commitment to the cause of bringing Europe to fiscal and financial stability once again.

India: Support Christine Lagarde.

Manan Vyas explains in lay-man’s language the factors that led Greece to accumulate a government debt burden that surpasses the GDP of more than 170 nations ($467 billion) while deconstructing the political, economic, regulatory and enforcement failures of the government of Greece and the European Union.

Until 2009 Greece was just another beautiful Mediterranean country that evoked images of the stunning blue Sea, of a rich history, of Athens and the Parthenon and of a laid back populace that took things easy. However in the middle of 2009 the Greek economy was in the center of a storm after George Papandreou’s government revised the fiscal deficit estimate from 6% (for the year 2009-2010) to 12.7%. This was further revised to 13.6%. Further revelations regarding the country’s fiscal health led the three prominent ratings agencies (Moody’s, Standard and Poor’s and Fitch) to downgrade Greek debt to ‘junk’ status. By 2011 government debt was a gigantic Euro 327 billion constituting close to 140% of the economy and estimated to rise to Euro 340 billion in 2012 constituting 159% of the economy.

How did Greece accumulate so much debt?

1) Democratic government, Socialist population: To appease the left leaning electorate the newly restored Democratic government in the year 1974 introduced a wide range of welfare schemes including increased allocation towards pension schemes, healthcare, additional layers of governance, hiring of more government staff and increase in the salaries of all public staff. Greek citizens are used to the idea of heavy government spending and were supportive of the idea of “Big Government”. They initially encouraged the role of the public sector in the economy. The socialist tendencies were the first step towards fiscal indiscipline.

2) Taxation: The Greek taxation system has since long been accused of being overly complex in nature. This complexity is combined with high taxes. This combination has led to high tax evasion with the Prime Minister declaring in 2011 that Greece was losing around 30 billion Euros a year on tax evasion and evasion of social security contribution. That accounts for close to 14.6% of the  GDP. Present government revenues account for 39.1% of the GDP or 81.9 billion Euros. This means that the government is losing out on tax revenues equal to  36.6% of the gross government revenue. The Greek government ran a budget deficit of more than 5%  almost consistently through 1993, leading to a situation where the government has accumulated a debt that is more than the GDP of 170 countries including Greece. Revised estimates suggest the 2009 budget deficit was 15.6% of GDP. Had tax evasion been completely eradicated the government would be running a modest 1% budget deficit (in the year 2009) that is acceptable under any circumstances. Considering that the government has on an average been running deficits of around 5%  between 2001 and 2008, had the government even managed to reduce tax evasion by 33.3% they would be presenting a balanced budget year-on-year (between 1993-2008). Taking the more optimistic assumption, had the Greek government completely eradicated tax evasion they would have been presenting a budget surplus of 10% year-on-year (1993-2008). This surplus could have been used to reduce tax rates and simply the taxation system. Reduced tax rates would have resulted in higher levels of foreign and private investment, creation of more jobs, encouragement to entrepreneurship and subsequently a growth in the economy that would have resulted in even higher government revenues allowing the government to invest in infrastructure that would lead to long term broad based growth. I have always held the view that reduced taxes and an ultra-simple taxation system encourages 100% tax compliance and exponentially increases the level of private sector investment and kick-starts a virtuous cycle that eventually leads to higher tax revenues even at very low tax rates. I personally advocate a uniform tax rate of 10% direct tax, i.e. 10% corporation tax and 10% income tax applicable to anyone earning more than Rs 2,00,000 per annum regardless of age or gender. This would lead to a tremendous increase in the income of the people as well as private and foreign investment. The income tax department’s judicial scope must be widened and special courts to try cases on tax evasion must be setup. Further tax breaks can be given for charity and investment in infrastructure and green technology. Reformation of the taxation setup is a critical factor if India must rival China’s growth and USA’s might.

3) Culture of tax evasion: Greece is a unique case in terms of tax evasion. It has a deep rooted culture of tax evasion stemming from a historical period of foreign rule. During the reign of the Ottoman Turks in 19th century Greece, non-payment of taxes was a form of resistance with patriotic undertones. Unfortunately this culture has spilled onto the 21st century too where the citizens of the nation believe that if they are not getting public service commensurate with their high taxes, they would rather not pay. It is true, the public sector is bloated and inefficient and does not provide the service that such high taxes would command. With income tax rates almost close to 40% and indirect tax rate close to 20% the Greeks were supposed to be paying a tremendous amount in taxes. However they noticed that a substantial portion of the taxes was disappearing into the public sector in, amongst other things, the salaries of the employees. I mentioned culture of tax evasion. This may be a unusual usage, but is especially true in Greece as everybody co-operates to evade taxes. This is specific to indirect taxes. Bills are avoided in transactions, with the retailer and buyer both colluding to keep the transaction taxless and recordless. Thus unfortunately the Greek culture of paying taxes is morally skewed with the citizens resorting to an economically damaging form of resistance towards inefficient governance.

4) Government spending focussed on consumption expenditure: Greek government expenditure is equal to 49% of the GDP or approximately 104 billion Euros year-on year. Government expenditure is categorised into two parts – investment exp. and consumption exp. Government expenditure stimulates further consumption and investment in the economy that stats a virtuous growth cycle. However every government tries to maximise its investment expenditure as this has a long lasting positive impact. For example, investment on roads, schools and dams. However the Greek government was spending a large portion of its revenues on interest payments. The exact figure of sums spent on interest payments is not available due to secrecy of the government in borrowing so that it would not attract attention to the massive deficits that it was running. However it is known that approximately 75% of non interest spending was diverted towards salaries of public sector employees, pensions and social benefits (of the entire population). After deducting interest and social benefits it may be concluded that less than 20% of government revenues were being diverted into long term investment expenditure. This figure works out to be around 21 billion Euros as compared to say 83 billion Euros on interest and welfare.

5) Structural Defects: Inefficient public sector administration combined with layers of regulation, governance, bureaucracy, high wages and a complex taxation system combine to serve as a deterrent to investment. It is not surprising to observe that tourism and shipping dominate the economy as these are areas where Greece has an exceptional natural advantage due to geography. Greek performance in other sectors is not impressive and certainly not enough to rival advanced European neighbours such as Germany, France and Italy. Despite this Greece was able to attain an impressive per-capita GDP of $29,000 which placed it at 17th in Europe, ahead of 27 other European countries including Portugal and Poland. The Greeks were enjoying a lifestyle that they did not deserve. Essentially it was a party that lasted three decades and finally reality has dawned. Thus domestic protests in Greece against austerity measures raise indignation across Europe where hard-working and educated citizens bear the burden of bailing Greece out of its fiscal mess.

6) Under ground Economy: The formation of an underground economy occurs to circumvent taxes and regulation. In Greece the business atmosphere was so stifling that it spawned an unrecorded economy. Greece ranks 107th on the World Bank Ease of Doing Business Rank. The under ground businessmen had several advantages. By dealing with similar unrecorded dealers they bought raw materials for lower rates by avoiding the hefty VAT. Subsequently they were able to sell their products at a cheaper rate and keep all the profits for themselves by not paying any taxes. This gave them a distinct advantage over legitimate tax-paying businessmen. The fundamental problem was the lack of risk premium. Risk premium is a concept introduced when discussing illegal activities with financial motives. For examples the risk premium involved with staging an armed robbery and looting a bank is enormous. While the robbers may get their hands on millions of Euros overnight the risk associated with getting caught is so high that few rational citizens would consider such an activity. This is a credit to the Greek police force. However the risk premium associated with evasion of formal  registration of business and evasion of tax is extremely low. This is a major discredit to Greek enforcement agencies such as the income tax department and the Greek judicial system. This means that while the financial benefits are enormous – avoiding regulation allows faster business decision making, lower cost of raw materials, fewer quality checks and the most obvious advantage, almost zero income tax - the risk premium is low. This means that it pays to be a part of the underground economy. Many Greek businessmen have observed this risk-returns trade off and subsequently the Greek underground economy is today equal to anywhere between 25 to 37% of the actual economy.

7) Fraudulent Government and Fiscal Indiscipline: Arguably the most important reason for Greece to accumulate the gigantic mountain of debt that was the precursor to the crisis we now refer to as the European Sovereign Debt Crisis. Successions of Greek governments are culpable for accumulating debt beyond levels that the Greek nation was capable of paying. The Greek economy is a paradox. It stimulated the economy through several years of stable economic conditions to arise at a situation when the government is withdrawing expenditure in a recession while all other nations are stimulating the economy. The Greek economy is in a place where it suffers the double blow of the recession and withdrawal of government expenditure at the same time which exacerbates the recessionary nature of the economy. In 1974, with the advent of the democratic government that pandered to a population with a socialist mindset the government introduced a host of welfare schemes. Since the government had introduced welfare schemes that the taxation revenue could not cover up it secretly borrowed every year from a host of private and foreign investors. The finance ministry presented a budget with little deficit while secretly borrowing on the side. The Greeks were oblivious to the government’s secret undertakings and obviously believed that the economy was in a healthy condition. The government’s borrowing programs did however suck credit from the market leading to decreased supply for the private sector which pushed up the cost of borrowing. As the government was usually considered a safe borrower by its lenders, it never suffered from higher interest rates while the private sector found it harder to borrow.  As and when the debt burden loomed too large the government would resort to monetary expansion or currency devaluation both of which would reduce the value of the debt. The Greek government debts were denominated in domestic currency (before 2001) so that devaluation of currency would reduce the value of the debt in foreign currency. Inflation, spurred by monetary expansion would have a similar effect, reducing the real value of the debt while leading to the growth of the economy. Since 1993 however the government has consistently carried a public debt to GDP ratio of more than 100%. Cooking up the fiscal accounts however allowed the government to keep borrowing more from across the world at reasonable rates. The political dimension must be understood. Whenever a new government would ascend to power they would be presented with the legacy of the debt burden. The ruling party leaders would have the option of drastically cutting back on a large portion of the welfare measures undertaken without fiscal backing or it would have the option to keep quiet about it and continue borrowing. Drastically cutting back on the welfare would have been political suicide though it was the only sensible economic option to follow. Throw open the nation’s messy public finances for all Greek citizens to see and explain the need for drastic fiscal measures. This would require political courage and astute leadership. Unfortunately for Greece its leaders decided to take the easier path and continued borrowing even as the gap between revenue and expenditure mounted, the interest burden mounted and the public debt to GDP ration expanded. When the revelation finally came in 2008-2009, it was already too late.

8) European Regulators – The Big failure: The Maastricht Treaty was signed on the 7th of February 1992 and was subsequently the basis for the formation of the European Union. It specified ‘convergence criteria’; economic criteria that regulated the entry of only economically sound countries into the European Union. The criteria relevant to this scenario are ‘Annual Government deficit’ and ‘Government Debt’. While the Maastricht Treaty stipulated an annual government deficit rate of under 3%, the government debt was supposed to be under 60% for entry to the European Union. At the time of entry to the European Union (EU), Greek government debt exceeded 100%. Between 2001 and 2007, at a time when Greece was part of the EU its annual government deficit exceeded 5% every year. The Eurozone average deficit was 2%. Consequent to its high government spending the Greek economy grew at an average rate of 4.3% per annum as compared to 3.1% p.a. for the Eurozone. Debt, interest rates and trust are mutually dependent. Debt depends upon interest rates. Interest rates depend upon trust. And trust depends on the ability to repay. Lenders discharging debt to Greece in the period between 2001 and 2007 assumed that the Greek government was adherent to the criteria set by the Maastricht Treaty. The treaty’s criteria ensured that only fiscally healthy nations were admitted into the EU. Thus when Greece was admitted it was naturally accepted that the regulators of the European Union had taken the necessary steps to ensure that Greece was compliant. Thus trust was generated by entry to the European Union. It may be inferred that the creditors trusted the European Union regulators. Thus they assumed that Greece was fiscally sound and lent at low rates that would generally go to very strong European economies like France and Germany. The low interest rates fueled the demand for debt as the Greek government continued borrowing, either to finance deficits or to roll-over maturing debt that it was in no position to repay. In 2004 the European Commission initiated an excessive deficit procedure against Greece when Greece stated that for the year 2003 the deficit was 3.2%. At that time it was noted that the quality of the public data was not satisfactory and that Eurostat had not verified the figures at the time of joining the EU. Subsequently it was exposed that Greece had been violating the 3% limit every year since it joined the Euro and its public debt had been above 100% at the time of joining the EU. The European Commission finished their proceedings in 2007 convinced that permanent measures had been taken and that the country’s deficit would be 2.6% of the GDP in 2006 and 2.4% in 2007. The Commission also proclaimed that it was satisfied with the Greek statistical organisations that had pledged to improve the quality of their data. However the European Commission must be blamed for ignoring the vast mountain of debt that Greece had already built up by that time. Had the Commission paid closer attention to the alarming public debt situation it would have consulted the European Central Bank as well as the governing council of the European Union and concentrated efforts in the period of 2004-2007 would have perhaps allowed the Greek government deficit to come down to a more acceptable 75% of GDP. The Greek economy was growing so the government had more leeway to reduce budget layouts and to reduce a few unnecessary social welfare schemes. It could have reformed the economy and aggressively taken up tax evasion as a priority issue for fiscal health. It wasn’t to be however. There was no focussed pressure on Greece to reform and show results. The 1997 Stability and Growth Pact stated that if a country exceeded the deficit and after that did not adhere to the European Union’s corrective measures then it was liable to be fined 0.5% of its GDP. Sadly this rule was never implemented. 30 instances of excessive deficit procedures have been taken (in the European Union) but never has financial sanction been imposed. Had financial sanction been imposed on the Greek economy, or other stringent measures taken, the debt burden could have been controlled. The European Commission again woke up in 2009 (a good 5 years after it had imposed deficit proceedings) to the fact that the Greek budget was not under 3%. The data that the European Commission received revealed a fiscal deficit of 3.5%. This figure was subsequently revised to 12.7% by the Greek government and to 13.6% by international agencies. Between 2004 and 2009 the European Commission had failed to take action against a rising fiscal deficit fueled by creditors that trusted these very same regulators to ensure fiscal discipline in the European Union.

Summary of Failures:

• Greek government: Fiscal indiscipline and fraud. Drove up interest rates. Misguided policies and inefficient administration. Did not invest in infrastructure or education.
• Income tax department of Greece: Could not prevent tax evasion that made up 14.6% of the economy and 36.6 of government revenue.
• Enforcement agencies and judicial system of Greece: Could not play a role in tax evasion and evasion of social security contribution evasion. Should have been able to drive up the risk premium associated with tax evasion, failed to do so.
• Greek bureaucracy: Discouraged the private sector with excessive regulations. Could not encourage foreign investment.
• People of Greece: Evading taxes is morally wrong. A large number of Greeks failed to recognise this as a part of their code of ethics and morals. Ironically these are the same people that violently protested in 2010 when reality finally caught with up with them and the government implemented long over-due budget cuts.
• Eurostat and European Commission: As trusted and credible international bodies they both failed in enforcing stringent regulations. They could potentially have prevented the situation from getting snowballing into a much wider crisis that threatens the very existence of the European Union.

The Global Financial Crisis: The American Origin

The Subprime Crisis and the Liquidity Crunch

Introduction:

The true extent of globalisation could be accurately expressed by the current financial crisis whereby contagion in the United States of America spread across the globe affecting all globalised economies.   The linkage with the Asian Financial Crisis illustrates how globalisation has crossed not only national boundaries but even the time dimension and explores how past financial events have a bearing on the current scenario.  The new banking ideology is studied and the factors which made the banking system vulnerable and unstable showcased. The effect of high liquidity in the market and the shift from medium and long term financing to short term financing including the emergence of commercial paper and repo agreements is also observed. The factors leading to the Subprime Housing Crisis and the Housing Bubble are amplified with the ensuing cascade effect also studied. That leads to the final and ongoing part of the crisis: The Liquidity Crunch. A link is drawn out between the fundamental changes in the banking sector, the shift to short term financing and the liquidity crunch.

Asian Financial Crisis:

Occurring in the late 90’s the Asian Financial Crisis was a currency crisis revolving around the emergence of the South East Asian countries as major exporters and the subsequent fiscal measures adopted by the government. Exporting nations are significantly dependant upon exchange rates and an unfriendly rate could have a major impact on the economy.  Desiring a stable exchange rate the governments chose to peg the dollar against their currency which could insulate against fluctuations and thereby shield the exporting sector-the lifeline of the economy. Internal factors however such as inflation (partly induced due to export activities as lower supplies are available to the domestic market) and a falling stock market induced pressure on the governments. Thailand was the first to be affected followed by Malaysia, Taiwan, Philippines and subsequently other South East Asian countries.  Rising foreign debt was also a cause of concern. Being weakened by internal factors the governments were not able to maintain the dollar peg and shifted towards a floating exchange rate. The currencies floated rapidly downward. While positively affecting exports in the short term the negative effects are numerous. Firstly inflation, already a cause of concern would worsen as price of essential imported commodities such as petroleum and steel would increase. And secondly the foreign debt would enlarge to unaffordable levels. Crashing exchange rates were a cause of worry and concern and the Asian countries were looking for a mechanism which could give them greater influence upon the exchange rate.

With the dawn of the new millennium the Asian countries had found their instrument of influence- US securities. This could work in both directions- assist in maintaining an export friendly rate and act as a mechanism against excess depreciation.

On buying the US securities they would be converting their domestic currency to dollars consequently leading to an excess supply of their currency and a reduced supply of dollars in the exchange market. This would lead to their domestic currency depreciating and the value of the dollar appreciating. This would promote an export friendly exchange rate.

On the other hand the excess depreciation would be extremely damaging as was exemplified by the financial crisis of the 90’s. To prevent this government could sell US securities, get paid in dollars, and convert the dollars to their domestic currency which would lead to an excess supply of dollars and a reduced supply of their domestic currency in the forex market.

Thus Asian countries started actively investing in America which led to a substantial increase in the liquidity scenario, a prime factor in the ensuing housing bubble.

Changes in the American Banking Sector:

Introduction of Subprime Loans:

A significant transformation occurred in the American banking sector with the introduction of off balance sheet Special Purpose Vehicles, the securitization of loans and the surge in short term asset backed financing instruments.

Originating approximately in the financial year 2004-05 the grouping of loans and receivables into pools and their subsequent sale to SPVs (Special Purpose Vehicles) freed up an enormous amount of capital for banks. This excess capital allowed banks to issue more loans and caused lending standards to decrease. Since banks were facing only a ‘pipeline risk’ over the loans being issued, a further drop in lending standards occurs. This excess capital allows banks to start a new trend-subprime loans. These loans are given to that section of the borrower’s market that has an unstable income, a poor credit history and few assets. These loans however command a higher rate of interest due to the risks involved. Previously banks had avoided this demographic but since banks started offloading risks onto SPVs this sector steadily rose to prominence. The rising real estate prices further nullified the associated risks (a mortgage default prior to the Burst of the Real Estate Bubble would have been highly profitable to the lender as mortgage values exceeded the loan given) and banks introduced attractive installment schemes to expand their subprime loan section. These installment schemes included those with a special ‘introductory period’ of marginal installments, this period usually stretched upto 2.5 years and was a major stimulus to borrowers(In this period borrowers paid only a fraction of installments they would pay at the end of the introductory period). In accordance to the American economics model based largely on consumption fueled by debt these loans were a major hit with the subprime borrowers.

In conclusion to this section we observe that subprime loans had rapidly gained a significant share of the loan market chiefly due to offloading of risk and freeing up of capital (By virtue of the sale of these loans to SPVs). We now move on to the next section to where we examine this process of securitization in detail.

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The New York Stock Exchange

Securitization:

The first step taken in this direction was the formation of ‘off-balance sheet’ vehicles/entities which came to be known as Special Purpose Vehicles. The second step taken towards securitization was creation of diversified portfolios of mortgages, other types of loans such as car loans personal loans and receivables such as credit card receivables. This step worked towards the transformation of illiquid assets into transferable securities. The diversified mortgage pool was bought by SPVs and subsequently sliced or tranched into different classes according to their credit risk.

The SPV obtained finance though the issuance of asset backed securities. These asset backed securities were debt instruments and were classified into different groups in accordance to the collateral supporting the commercial paper. The different classifications were super senior ‘AAA’, senior ‘AA’, mezzanine ‘BBB’ and subordinated ‘B’.  The lower rated securities were backed by a mix of risky and low rated mortgages and subsequently paid a higher rate of interest.

Take for example the case of a pension fund. Regulations allow pension funds to invest only in very low risk securities. The SPV sells ‘AAA’ rated securities to the pension fund for a short term period of 3 months. The assets backing the securities sold to the pension fund are the prime loans with a low risk rating. Since there is a low risk rating therefore the interest paid out is proportionately lower. For securities backed by more risky subordinate ‘B’ tranches the proportionate interest rate paid is higher.

To obtain a higher rating for the securities issued  by it the SPVs use various methods ( A lower risk rating on it’s asset backed securities resulted in a lower interest being paid on the securities) which included obtaining ‘liquidity backstops’ and buying Credit Default Swaps from the originating bank. A liquidity backstop meant that in case the SPV was unable to honour it’s obligations to the holdersof the asset backed securities issued by it the bank providing a liquidity backstop would guarantee payment to the SPV’s creditor’s.  Credit Default Swaps followed a similar function of neutralizing the risk for investors.

SPVs followed a system of short term financing which meant that they had to roll over their debt regularly. Investors usually prefer assets with short term maturities and thus issuance of short term commercial paper made sense as there was a larger market for them and it was easier to obtain finance.  The roll over of debt depended on the risk level associated with the underlying loans which were kept as collateral. A fall in value or an increase in the risk rating of the collateral would be detrimental factors as investors would steer clear of risky or under-collateralized securities. Thus SPVs depended upon the value of the underlying loans to obtain finance.

Repo financing was another method financing used by SPVs. They were also known as repurchase agreements. In this system conduits temporarily sold their assets with a contractual agreement to buy them back at a later date. This mode of finance was also short term and had to be rolled over regularly.

Cash Flow:

Banks: On sale of mortgage pools to SPVs banks recorded a cash inflow.

This capital was used to give further loans and was recorded as cash outflow.

SPVs: On buying the mortgage pools they recorded a cash outflow. However the mortgage pools are assets which  generate inflows. To finance the procurement of these assets the SPVs issue securities and subsequently result in cash inflows. The cash inflows from the underlying pool of assets (which are kept as collateral) is used to repay the interest on the securities issued. There is however a difference between the cash inflow received by the SPV from its assets (the mortgage pool) and the cash outflow in lieu of its liabilities (the asset backed securities) which turns out to be the profit for the SPV.

Repo finance: They record cash inflow by temporarily selling their assets on a contractual agreement to buy them back. Cash inflow is recorded at the time of sale and outflow is recorded at the expiry of the term agreement.

Investors: Their cash outflow is recorded when they buy the asset backed securities and their inflow is recorded when they redeem these securities at the end of the term. Their cash inflow is higher than their cash outflow as they are paid interest by the SPVs.

The Housing Bubble:

In the section relating to subprime loans we observed that excess capital and supposed (the real risks of mortgage defaults had never left the banking sector as we shall observe in the next section) offloading of risk allowed banks to make a large number of loans to the subprime sector.

However in the following years as the introductory period of low installments ended the subprime borrowers gradually started defaulting on their payments. The volume of subprime loans was large and subprime borrowers were spread throughout the nation. As the borrowers defaulted their mortgages came in possession of the owners of the loans-the SPVs. Due to this firstly a part of the inflow of SPVs was reduced.  They came in possession of the mortgage. They put up the mortgages up for sale at the prevailing market conditions. However subprime borrowers had now started to consistently default and the consequently the SPVs put up more and more real estate on the open market. There wasn’t a proportionate amount of demand for these properties for 2 reasons: (i) They were over priced. The credit boom had resulted in a surge in real estate prices which was not backed by the sound fundamentals of demand-supply.  (ii) Subprime borrowers who were the untapped potential of the market had raised the excess demand for real estate. With subprime borrowers defaulting across the US there weren’t enough buyers for the excess property on the market.

However a major market failure took place. Real estate prices which would steadily have come down in lieu of the excess supply sustained those astronomical levels. And steadily as more and more supply piled up on the market there was increasing pressure on the real estate prices to lower.

Finally in the last months of 2007 the US housing bubble burst and real estate prices across the US crashed uniformly. This had an enormous cascading effect which we shall examine in a narrow sense in the next section-The Liquidity Crunch.

The Liquidity Crunch:

This section shall analyse how the US real estate debacle was the first step to a global financial crisis. SPVs possess loans (which are assets). SPVs use varied methods of financing but here the effect of the housing debacle on the 2 prominent credit channels is examined : (1) Asset Backed Commercial Paper. (2) Repo financing.

These loans are financed through issuance of short term asset backed securities. However the assets backing the securities issued by banks are the loans in possession of SPVs. With the large number of defaults the SPVs were left with mortgages, the sale of which would have resulted in a cash inflow. However the burst of the bubble converted these mortgages into non-performing assets (NPA). It was now increasingly difficult for the SPVs to procure finance since the sale of asset backed commercial paper depended upon the risk rating and value of the underlying collateral. Since a large amount of their collateral was now converted into NPAs the investors abstained from investing in the asset backed securities issued by SPVs.

Repo financing was similarly affected. With large decrease in the value of assets held by SPVs it was very difficult to obtain sufficient financing through this medium. This was a situation of liquidity crunch whereby it was difficult for financial institutes to raise money.

The SPVs are now in possession of a large amount of NPAs financed on short term debt. With the inability to raise sufficient funds the conduits turned towards the ‘originators’ or ‘monolines’ which had guaranteed liquidity backstops. This directly transferred the supposed off-balance sheet risk onto banks. The banks consequently had to sell a large number of assets held by them throughout the globe to provide the liquidity backstop.  This large scale sale of assets across the globe conveyed negative sentiments from the largest economy in the world. Panic sales followed in financial markets throughout the world. Banks unable to raise funds in the liquidity crunch scenario had to declare bankruptcy.

The amount of outstanding liabilities of the banks was massive and widespread sales caused rapid downward spirals which meant banks had to sell a larger amount of assets to settle their outstanding liabilities.

Conclusion:

On conclusion it is noted that a higher level of transparency and regulation is required to prevent such a widespread global crisis in the future. The American model of deregulation needs to be reformed to reduce the opaqueness of the financial system and a greater level of awareness is required with regard to the complex derivates which have gained prominence in the recent years.