The European Sovereign Debt Crisis

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Factors specific to each country also led to the crisis. Greece managed their public finances poorly with rampant tax evasion and high government spending on public sector jobs and benefits, among other factors. Ireland had an oversized banking system. A government guarantee for Irish banks created a budget deficit of over 30% in 2010, causing public debt levels to rise by more than 40% between 2009 and 2010. Portugal’s economy has suffered from a lack of competitiveness, and was the slowest growing economy in the Eurozone during the “boom” decade preceding the global financial crisis. Spain ran budget surpluses in the mid-2000s, and had relatively low public debt levels, but capital inflows fueled an unsustainable real estate bubble. Italy has a long history of high public debt, consistently running debt levels in excess of 100% of GDP in the “boom” years leading up to the financial crisis, making it vulnerable to tighter credit conditions.

4. Implications of the Eurozone Crisis

Implications for the advanced countries: The creation of the European Union and the euro zone has been part of the European dream of integration. A breakup of the euro would be painful in economic terms and in terms of its political fallout.

The two European giants Germany and France are facing a serious challenge because the banks of both these countries face large exposures as already indicated. The markets have been relentless in pricing them down. Even the United Kingdom, which technically remains outside the Eurozone, does not have the choice of remaining a passive spectator for the same reason as British banks also have a substantial exposure to debt in the troubled countries of the Euro zone.

As at present, the United States has a large financial stake in Europe. American banks have over $600 billion of exposure in the troubled economies of the euro zone as per BIS data. There are close trading links as Europe is US’s largest trading partner and the largest destination for investment by U.S. corporations. Following the collapse of the Lehman brothers in 2008, the US opened short-term loans to European banks. In 2009, the US Fed went in for the second round of quantitative easing by buying treasury bonds and pushing down long-term interest rates. By August 2011, its own debt position has become a matter of concern. The capacity of US to accommodate liquidity in order to support the euro zone economies, this time around may be more limited.

Implications for the Asian Giants, China and India: For both China and India, Europe and the euro zone accounts for a significant market. Therefore stagnation or worse, a downturn in the euro zone will dent their export growth.

In regard to China, the threats and the opportunities are somewhat interestingly balanced. China has been looking for opportunities to diversify its foreign exchange assets. The current situation provides China an opportunity to make bargains during a fire sale that may follow to gain political mileage and acquire useful and perhaps strategic assets by simply offering to hold troubled assets of the troubled euro zone States. These assets could be in the form of sovereign debt as well as real assets like interest in public sector units that may be privatized. The manner in which the euro zone and the EU would respond to this possibility remains to be seen.

As far as India is concerned, the European Union is a major trade partner accounting for as much as 20.2 per cent of India’s exports (in 2009-10) and 13.3 per cent of India’s imports. European Union countries imported roughly € 33.1 billion worth of Agriculture products, Fuel and mining products, machinery and transport equipment, chemicals, semi manufactured products textile and clothing products in 2010 from India. The EU exports to India amounted to €34.8bl, majority of which was machinery, chemical products and semi manufactured items which was almost 2.6 percent of EU exports. Bilateral trade between the two has been growing on an average of 9.6 per cent during 2006-10. EU services exports to India during 2010 was €9.8 billion and EU imports from India was €8.1 billion. That apart, the total FDI from EU during 2010 amounted to €3.0 billion while India also invested about €0.6 billion in the EU. In other words, a slowdown in the euro zone and the EU is likely to have a major adverse impact on India’s exports.

5. Why the “Troika” bailout packages have failed to improve the situation?

The dominant conventional approach to sovereign debt crises has been for international organizations to lend more money to the affected countries, with strings attached. The ‘Troika’ of the EU, the ECB and the IMF, together with the governments of the crisis-afflicted countries, has authorized the Eurozone rescue packages. When comparing these Eurozone packages with the traditional IMF lending such as the one applied in the Asian crisis (1997-1999) many similarities are found, but also one fundamental difference.

When it comes to similarities both IMF packages and the Troika packages have attached conditions to their rescue loans. These have emphasized fiscal consolidation, i.e. significant cutbacks in public spending. This makes sense under the ceteris paribus assumption that fiscal retrenchment will not reduce GDP or at least not by more than it reduces the deficits or national debt. Other similarities of include the ‘recommendations’ concerning the sell-off of national assets; the closure/merger/sell-off of particular, named banks to ‘foreign strategic partners’; the tackling of large-scale bad debts in the banking system or corporate sector by socializing private sector liabilities and burdening the tax payer; and supply-side policies in the form of structural reforms towards greater deregulation, liberalization, privatization and cut-backs in the role and influence of the public sector bureaucracy.

Thus the packages contain many common policies that tend to result in a reduction of domestic demand or an increase in supply, which impart deflationary pressures on the economy. However, there is an important difference: The conventional IMF loan packages have since the 1980s almost always contained a significant pro-growth element. It is this feature that is lacking in the Troika programme in Europe.

Since the mid-1980s, IMF and World Bank packages have included currency devaluation as part of the macroeconomic policy mix, offering a boost to exports and thus mitigating the otherwise significant emphasis on austerity by allowing for at least one avenue of macroeconomic policy to deliver economic growth.

Economic growth is important for the sustainability of public