Eurozone crisis explained – Greek debt

6/13/2012

Exposure to Greek debt

Eurozone crisis explained

After months of refusing to countenance the possibility of Greece leaving the euro, eurozone politicians are slowly beginning to acknowledge there may be no option but to let the country go.

Greece’s political parties have failed to form a working coalition following voters’ rejection earlier this month of austerity measures insisted upon by the European Union and the International Monetary Fund, so the Greeks will return to the polls in June.

The vote is being seen as a referendum on the euro. Syriza, which came second in the recent election, is promising to freeze payments to creditors and renegotiate the terms of the bailout from the EU and IMF – terms that demand austerity measures to bring down Greece’s debts.

Germany has said the loan terms are not negotiable.

But even if the pro-austerity parties win the election, Greece may still be forced to give up the euro.

Why is Greece in trouble?

Greece was living beyond its means even before it joined the euro. After it adopted the single currency, public spending soared.

Public sector wages, for example, rose 50% between 1999 and 2007 – far faster than in other eurozone countries.

And while money flowed out of the government’s coffers, its income was hit by widespread tax evasion. So, after years of overspending, its budget deficit – the difference between spending and income – spiralled out of control.

When the global financial downturn hit, therefore, Greece was ill-prepared to cope.

Debt levels reached the point where the country was no longer able to repay its loans, and was forced to ask for help from its European partners and the International Monetary Fund (IMF) in the form of massive loans.

In the short term, however, the conditions attached to these loans have compounded Greece’s woes.

 

What has been done to help Greece?

In short, a lot.

In May 2010, the European Union and IMF provided 110bn euros ($140bn: £88bn) of bailout loans to Greece to help the government pay its creditors.

It soon became apparent that this would not be enough, so a second, 130bn-euro bailout was agreed earlier this year.

As well as these two loans, which are made in stages, the vast majority of Greece’s private creditors agreed to write off more than half of the debts owed to them by Athens. They also agreed to replace existing loans with new loans at a lower rate of interest.

However, in return for all these loans, the EU and IMF insisted that Greece embark on a major austerity drive involving drastic spending cuts, tax rises, and labour market and pension reforms.

These have had a devastating effect on Greece’s already weak economic recovery – in the first three months of this year, initial official estimates suggest the economy shrank by a frightening 6.2%. Greece has already been in recession for four years.

Without economic growth, Greece cannot boost its own income and so has to rely on aid to pay its loans. Many commentators believe even the combined 240bn euros of loans and the debt write-off will not be enough.

 

What happens next?

All eyes are now on elections being held on 17 June.

If the anti-austerity parties win, Greece will attempt to renegotiate the terms of its loans from the EU and IMF. Unless German Chancellor Angela Merkel softens her stance on austerity, it will probably fail in doing so.

Greece may also freeze loan repayments to its creditors, which would undermine yet further confidence in the eurozone banking sector and in other highly-indebted countries’ ability to repay their debts (see below).

This may result in Greece being forced to leave the euro.

If pro-austerity parties – or rather those willing to meet the terms of the bailouts in order to remain within the euro – win the election, then austerity will continue and Greece’s economy will continue to suffer.

If the economy continues to contract sharply, Greece may not be able to repay its debts, meaning it will need further help. If the rest of Europe is no longer willing to provide it, then Greece may be forced to leave the euro.

There is of course the possibility that the Greek people, fed up with rising unemployment and falling living standards, will make it impossible for the government to continue with austerity. In this case, again, Greece may be forced to leave the euro.

However, European leaders are hoping that the Greek economy will slowly begin to recover thanks to the wide-ranging reforms insisted upon by the EU and IMF, allowing Greece to make its repayments and, once again, stand on its own two feet.

Why does this matter for the rest of Europe?

It matters a lot.

If Greece does not repay its creditors, a dangerous precedent will have been set. This will make investors increasingly nervous about the likelihood of other highly-indebted nations, such as Italy, or those with weak economies, such as Spain, repaying their debts. If investors stop buying bonds issued by other governments, then those governments in turn will not be able to repay their creditors – a potentially disastrous vicious circle.

To combat this risk, European leaders have agreed a 700bn euro firewall to protect the rest of the eurozone from a full-blown Greek default.

Equally, if banks that are already struggling to find enough capital are forced to write off money over and above that which they have already agreed to, they will become weaker still, undermining confidence in the entire global banking system. Banks would then be even more reluctant, and less able, to lend to one another, potentially sparking a second credit crunch, where bank lending effectively dries up.

For example, Greece owes French banks 41.4bn euros, German banks 15.9bn euros, UK banks 9.4bn euros and US banks 6.2bn euros.

This problem would be exacerbated by savers and investors taking money out of banks in vulnerable economies, such as Greece, Portugal and Spain, and moving it to banks in safer economies such as Germany or the Netherlands. This could lead to more banks defaulting on their loans.

These potential scenarios would be made immeasurably worse if Greece were to leave the euro. The country would almost certainly reintroduce the drachma, which would devalue dramatically and quickly, making it even harder for Greece to repay its debts.

http://www.bbc.co.uk/news/business-13798000

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