Syed Ashraf Ali
For some years now, the world is in the grip of financial crises of grave proportions. The worst one, known as financial meltdown that hit the world economy in 2008, was triggered by the bursting of the United States housing bubble. The bubble was contrived by the banks and other financial institutions through generous supply of loans to subprime borrowers and recycling the underlying mortgages several times over in the form of derivatives. The inverted pyramid they built with artificial assets collapsed at the first sign of trouble and engulfed the world economy in an extended period of recession.
The scars of recessionary trends set in by the meltdown had barely healed when the euro zone was hit by a new round of crisis of its own making. The problem this time around emanated from piling of huge amounts of mostly sovereign debts by many euro zone countries which in the end they found themselves unable to repay.
WHAT THE EURO ZONE IS? The euro zone is a sub-group of countries belonging to the 27-member European Union (EU). The EU adopted a new common currency, the euro, from January 01, 1999. Following the expansion of the EU through induction of new members and joining of some of the new entrants in the common currency zone, the number of euro zone members has swelled to 17. They are collectively referred to as 'euro zone'.
The criteria for joining this single currency zone included adherence to a number of economic imperatives in terms of budget deficits, inflation, interest rates and other monetary parameters. The EU guidelines also restricted the governments from borrowing more than 3 per cent of their annual output and also put a 60 per cent cap on the amount of sovereign debt.
BENEFITS OF USING A COMMON CURRENCY: The idea behind adoption of a single currency is that it promotes intra-regional trade, facilitates and reduces the costs of cross-border payments and strengthens ties among the participating countries. These benefits did occur in the EU too but the new status of euro zone membership also provided a big handle to the weaker members to borrow money from international financial markets at lower rates. Some of them grabbed this new opportunity with both hands and borrowed heavily by breaking the 3.0 per cent borrowing rule.
GREECE'S SPENDING SPREE: The worst offender was Greece. They, in fact, resorted to dubious means to earn the qualification for admission in the euro zone by adjusting the economic data to conform to the Zone's guidelines. At a later stage, Greece even reportedly hired Wall Street firms, most notably Goldman Sachs, to help hide its debt to avoid the scrutiny for transgression of the rules concerning sovereign debt.
Using the strong euro zone platform Greece borrowed money from the international lenders with abandon and proceeded to go on a spending spree for, among other things, on such projects as the 2004 Olympic Games. Heavily laden with accumulated debt, Greece found the going quite heavy when the financial meltdown hit the world in 2008. By 2009, its debts had escalated to 113 per cent of its GDP (gross domestic product), almost double the euro zone limit of 60 per cent. At this stage they threw up their arms and asked EU-IMF for bailout.
CONTAGION EFFECTS IN IRELAND: The Greek debt crisis resonated throughout the euro zone and a panic set in the weaker members. Some of them had the sovereign debt problems while others had problems of different kinds. For instance, Ireland did not have a debt problem but it witnessed a huge real estate bubble. Before the crisis, 25 per cent of its economy was involved in the real estate sector, significantly higher than 10 per cent in normal economies. When the financial crisis hit in September 2008, the inevitable happened; the bubble burst and sent the Irish economy on a tail spin.
PANIC IN PORTUGAL: Unlike Ireland and Greece, Portugal had one of the best recovery records during the first part of the economic crisis. However, panic due to the Greek debt crisis hit the country in late 2009 and early 2010. By November 2010, the market had pushed interest rates to a point where the country was under pressure to ask the EU for a bailout.
SPAIN AND ITALY-HEAVY PRIVATE SECTOR BORROWINGS:
Both Spain and Italy had large debts before the crisis of 2008, but government borrowing was not the main cause of their debt crises. It was due to borrowing by the private sector (mortgage borrowers and companies). It means that even if the governments of Spain and Italy did not break the 3.0 per cent borrowing rule, heavy private sector debts may trigger a crisis.
BAILOUT PACKAGES: Fearing the dire consequences and the ripple effects of failure of an EU member, the EU and the International Monetary Fund began to bailout Greece. By 2010, they agreed to a 100-billion-euro bailout package. On its part, the Greek government committed to adopt certain austerity measures like deep cuts in pensions and public service pay as also to increase of taxes. Greece found it very difficult to implement the planned reforms due to violent public protests and outbreak of riots.
In November of 2010, the EU and IMF agreed to an 85-billion-euro bailout package to the Republic of Ireland, followed by a May 2011 bailout of 78 billion euro to Portugal. In July of 2011, a second bailout package of 109 billion euro was agreed to for Greece. Due to heightened fear of default on their public debts, Portugal, Ireland, Italy, Greece and Spain have been given the acronym of PIIGS.
EUROPEAN STABILITY MECHANISM: In the initial stages bailout packages consisted mainly of funds provided by Germany and France on bilateral basis. In quest of a permanent solution to rescue the troubled members, EU has recently set up European Stability Mechanism (ESM). It consists of 500 billion euro to be used for bailing out the weaker economies. Nearly half the money in the ESM comes from Germany and France. A second version of the treaty establishing the ESM was signed on February 02, 2012, and is now engaged in collecting funds from the members and the money market to build up common pool to carry on the rescue operation.
THE DILEMMA OF REFORMS: There is no straightforward solution to the euro zone crisis. One solution that has been suggested is that heavily indebted members may return to their original currency. However, this may undermine credibility of the euro which may even lead to the collapse of the euro system. Similarly, spending cuts, especially by bigger members like Spain and Italy, would lead to lower wages and swell the number of unemployed people. These will suppress demand in the economy which will affect the government revenue and increased expenditure of the government on account of unemployment benefits.
BANGLADESH PERSPECTIVE: The ripple effect of a economic collapse in the EU has also reached our own shores. The protracted recession in Europe may affect our export of merchandise and manpower. EU is a big buyer of our apparel products while Italy, Spain and Greece host a large number of our migrant workers whose earnings and home remittances will be affected.
There are also a number of lessons we should learn from euro zone trauma. One is to avoid frequent heavy budget deficits and resorting to borrowing from external and domestic sources to cushion the gap which tend to crowd out private sector borrowers. Another is to avoid expenditure in pursuit of unproductive goals and projects. The expansion of the bureaucracy to create a vast pool of idle cadres of government functionary is an area, among others, that needs to be given proper attention.
Another is the question of creating a single currency area in the SAARC (South Asian Association for Regional Cooperation) region. A few months back our Finance Minister had given a symbolic nod to an Indian proposal for adoption of a single currency. We should be aware of what it means before proceeding further.
We should also be mindful of the bubbles that at times generate in the capital market, real estate and other sectors and take timely measures to defuse the bubbles before they assume monstrous size.
The writer is a former central
bank official.
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