Pushkal Pandey Report

8/2/2019 Pushkal Pandey Report

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Financial crisis

The term financial crisis is applied broadly to a variety of situations in which some financial

institutions or assets suddenly lose a large part of their value. In the 19th and early 20th

centuries, many financial crises were associated with banking panics, and many recessions

coincided with these panics. Other situations that are often called financial crises include stock

market crashes and the bursting of other financial bubbles, currency crises, and sovereign

defaults.Financial crises directly result in a loss ofpaper wealth; they do not directly result in

changes in the real economy unless a recession or depression follows.

Many economists have offered theories about how financial crises develop and how they could

be prevented. There is little consensus, however, and financial crises are still a regular

occurrence around the world.

European sovereign debt crisis

The European sovereign debt crisis is an ongoing financial crisis that has made it difficult or

impossible for some countries in the euro area to re-finance their government debt without the

assistance of third parties.

From late 2009, fears of a sovereign debt crisis developed among investors as a result of the

rising government debt levels around the world together with a wave of downgrading of

government debt in some European states. Concerns intensified in early 2010 and

thereafter,leading Europe's finance ministers on 9 May 2010 to approve a rescue package worth

750 billion aimed at ensuring financial stability across Europe by creating the European

Financial Stability Facility (EFSF). In October 2011, the eurozone leaders agreed on another

package of measures designed to prevent the collapse of member economies. This included an

agreement whereby banks would accept a 50% write-off ofGreek debt owed to private creditors,

increasing the EFSF to about 1 trillion, and requiring European banks to achieve 9%
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capitalisation. To restore confidence in Europe, EU leaders also agreed to create a common fiscal

union including the commitment of each participating country to introduce a balanced budget

amendment.

While sovereign debt has risen substantially in only a few eurozone countries, it has become a

perceived problem for the area as a whole. Nevertheless, the European currency has remained

stable. As of mid-November 2011, the euro was even trading slightly higher against the bloc's

major trading partners than at the beginning of the crisis. The three countries most affected,

Greece, Ireland and Portugal, collectively account for six percent of the eurozone's gross

domestic product (GDP).

Overview

Since the fall of 2009, the European Union has been struggling with a slow-moving but

unshakable crisis over the enormous debts faced by its weakest economies, such as Greece and

Portugal, or those most battered by the global recession, like Ireland.

A series of negotiations, bailouts and austerity packages have failed to stop the slide of investor

confidence or to restore the growth needed to give struggling countries a way out of their debt

traps. By August 2011 European leaders found themselves scrambling once again to intervene in

the markets, this time to protect Italy and Spain, two countries seen as too big to bail out.

The crisis has produced the deepest tensions within the union in memory, as Germany in

particular has resisted aid to countries it sees as profligate, and has raised questions about

whether the euro can survive as a multinational currency, since countries like Greece have been

unable to boost their exports by devaluing their own currency.

It has posed great risks to many of the continents banks, which invested heavily in government

bonds, and forced deep and painful cuts in government spending that drove up unemployment
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and put several countries back into deep recessions, leading a growing number of economists to

call the austerity policies self-defeating.

The economic crisis gradually became a political one as well, leading to the ouster of

governments in Ireland, Portugal, Greece and Italy. Protests by traditional interest groups like

public sector unions were joined by crowds of young people who camped out in Madrid and

Athens in imitation of the Arab Spring demonstrations.

In the fall of 2011, even as European leaders struggled to come up with a new bailout plan for

Greece, much larger fears loomed. Interest rates soared for Italy, the continents third largest

economy, and rose for France, whose banks hold large amounts of Italian government bonds, and

where government finances are strained. The continents economy was teetering on the brink of

a second recession.

A growing number of economists called for the European Central Bank to step forward as a

lender of last resort, as the Federal Reserve has done, to stop the contagion. But the bank, whose

mandate is focused solely on preventing inflation, has resisted, saying a political solution is

required.

As the crisis deepened, banks in Europe began to hoard capital, straining the finances of their

counterparts and hurting companies across the globe that depend on them for loans.

In December, leaders of the countries that use the euro agreed to an intergovernmental pact

adopting tighter fiscal controls. All 17 of the countries that use the euro agreed to join, as did six

others. But Britain refused, raising questions about its future in which it has become increasingly

isolated.

The agreement, which can be adopted more quickly than a change to the European Union treaty

and without Britains consent would reassert rules limiting deficits to 3 percent of gross

domestic product and total debt to 60 percent. Violators would be hit with sanctions unless a

majority of other countries agreed.
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After the summit, the familiar pattern of market relief followed by new market worries was

repeated. But on Dec. 21, banks borrowed more than $600 billion from the European Central

Bank at the extraordinarily easy terms of 1 percent interest for a three-year loan. Analysts

suggested that the Bank had hit upon an indirect method of stopping the market spiral

threatening Italy, Spain and other governments, by flooding banks with money they could use to

lock in guaranteed profits by buying sovereign debt.

The next week, Italys short-term borrowing costs fell by half, in the most concrete indication of

market confidence yet.

Background

The debt crisis first surfaced in Greece in October 2009, when the newly elected Socialist

government of Prime Minister George A. Papandreou announced that his predecessor had

disguised the size of the countrys ballooning deficit.

But its roots of the crisis go back further, beginning with a strong euro and the rock-bottom

interest rates that prevailed for much of the previous decade. Greece took advantage of this easy

money to drive up borrowing by the countrys consumers and its government, which built up

$400 billion in debt.

In Spain and Ireland, government spending was kept under control, but easy money helped turn

real-estate booms there into bubblesa process helped in Irelands case by the aggressive

deregulation of its banks that helped draw investment from around the world. After the bubble

burst, the Irish government made the banks problems its own by guaranteeing all theirliabilities.

After the extent of Greek debt was revealed, markets reacted by sending interest rates up not

only for its debt, but also for borrowing by Spain, Portugal and Ireland.

In early 2010, the European Union and the International Monetary Fund put together a series of

bailout packages for Greece that totalled 110 billion euros ($163 billion) in a process that critics
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said ended up costing more because European leaders failed to get ahead of the curve. In May,

leaders approved a contingency fund of 500 billions euro (about $680 billion) for the union at

large.

The hope was that the fund would never have to be tapped, as its existence would calm investors.

But in the fall of 2010 interest rates began creeping up again, as countries that reduced spending

to meet tough deficit targets found themselves falling farther behind, as their economies slowed

and revenues declined. In November, European officials arranged a bailout of 85 billion euros

(roughly $112 billion) for Ireland, after overcoming the resistance of Irish officials to the move,

which they saw an attack on sovereignty. (In fact, news of the deal led Prime Minister Brian

Cowen to announce that he would step down after passing a new round of budget cuts, and his

party was ousted at the next election).

In the spring of 2010, after much hesitation, the European Union and the International Monetary

Fund combined first to offer Greece a bailout package of 110 billion euros ($163 billion),

followed by a broader contingency fund of 500 billions euro (about $680 billion). The hope was

that this show of financial force would reassure markets about the solvency of euro countries.

But the new loans, combined with the effect of the austerity measures demanded of Greece,

Ireland and Portugal, drove them into recession and did little to ease their debt burdenGreeces debt load even increased. As the debt crisis renewed over the winter of 2010 and spring

of 2011 it led to the fall of governments in Ireland and Portugal, and saw unrest rise in Spain,

where unemployment remained close to 20 percent.

Contagion Fears Return

By the summer of 2011, it was clear that Greece would need a second big bailout package, and

worries rose again about contagion, as Italy and Spain saw the interest rates charged on its

borrowing rise steeply. The European Central Bank responded by buying large amounts of

Italian and Spanish bonds, as leaders put together a plan that would increase the powers of the
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European Financial Stability Facility to head off a run' on governments seen as in danger of

default.

By September, with growth slowing, stalled or in reverse across the continent, European leaders

were increasingly discussing the creation of a central financial authoritywith powers in areas

like taxation, bond issuance and budget approvalthat could eventually turn the euro zone into

something resembling a United States of Europe.

But talk of long-term solutions did little to calm markets worried about the weakness of banks in

France and elsewhere that held large amounts of debt from Greece and other shaky governments.

And the resignation of Jrgen Stark, a top German official at the European Central Bank,

highlighted the depth of policy discord among senior policymakers. Mr. Stark, like many

German officials, had opposed the banks large-scale purchases of government debt.

Another potential crisis bubbled up in September, as European officials angrily warned Greece

that the next installment of its bailout funding would be withheld in Octobera step that would

lead to certain bankruptcyunless further radical cuts in government spending were pushed

through.

Earlier that summer, Greece, which had started the crisis, faced its more dire fiscal emergency,

as it stood to run out of cash in August without a new installment of money from the first bailout.

European leaders refused to release the funds until a second, more drastic round of austerity

measures were adopted, including the sale of $72 billion in state assets. The government of

Prime Minister George Papandreou teetered, but the measure was pushed through after days of

giant street protests.

The basic conflict over the shape of a new bailout plan was between Germanys chancellor,

Angela Merkel, who insisted that private banks pay part of the cost by taking losses on Greek

bonds, and the European Central Bank, who opposed even a voluntary haircut' for banks,

saying it would be seen as a default.
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European Debt Crisis: Implications and Lessons

for ASEAN

With the global economy still coming out of its misery in 2008-2009, Greece got badly exposed

for its years of unrestrained spending and failure to implement financial reforms. The countrys

statistics revealed a national debt of US$414 billion, bigger than the countrys economy, and a

fiscal deficit of 12.7 percent of the GDP. Greece' credit rating has been downgraded, implying s

worsening investors confidence for the economy. This has raised fears that Greeces problem

will infect other eurozone economies, especially the weaker members like Portugal, Ireland, Italy

and Spain (or the PIIGS). The 16 nations sharing the euro currency came up with an emergencyrescue plan of US$1 trillion on 9th of May to prevent the crisis from spreading through the

region and to keep the euro currency from imploding. The package included loans, guarantees,

bond purchases and US$318 billion of assistance from the International Monetary Fund (IMF).

What does this mean for ASEAN economies? ASEAN exports in the short term could face some

problems from the Greek debt contagion. As the Eurozone governments try to get their budget

deficits back to the blocs 3 percent limit, Europes export demand could take a hit if fiscal

spending has to be cut significantly. The ASEAN region would also be affected as the banks may

get guarded on its lending activities and businesses may find it difficult to raise capital through

unpredictable stock markets in next couple of months. All this would lead to higher borrowing

costs in the region. However, the impact is likely to be minimal in the long run. The EU bailout

plan is expected to contain the spread of the debt crisis. In the case of ASEAN, its Asian

neighbors play a more significant role, accounting for 33 percent of the total Groupings export.

This is against EUs share of only 13 percent. Moreover, most ASEAN exports go to larger

European economies like Germany and France and thus the crisis in the smaller economies of

PIIGS would not be felt much by the exporters in the region.


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The ASEAN financial markets may witness higher volatility as uncertainty remains about the

sovereign debt crisis engulfing the eurozone. There are also several concerns about the financing

package. Firstly, the richer European members have to convince their taxpayers to help the

troubled economies, which is difficult to carry on in practice. Secondly, the bailout package

includes conditionality that the PIIGS would implement austerity measures related to reining

in fiscal excesses. This is not easy to implement as it may generate social unrest in the domestic

economy. Most of the stock indices of ASEAN (Thailand, Singapore, Malaysia and Indonesia)

plunged 1-5 percent since April 2010, but bounced back briefly after the announcement of the

EU package. The fall in equity markets was primarily due to capital flight out of the country into

safe havens like US Treasuries, and mirrored the sell-off on Wall Street. Officials in Indonesia

and the Philippines have however ruled out imposing capital controls immediately. Singapores

central bank said that it will continue to monitor international developments and will respond to

the market turmoil if there is a need. The ASEAN policy makers believe that the economies are

strong fundamentally. It has ample foreign reserves and fiscal affairs are relatively stable. Hence,

fast remedies due to problems elsewhere could affect investor confidence and encourage selling

in many countries. The ASEAN economic recovery from the 2008 financial crisis is unlikely to

be derailed by the European debt crisis, albeit it may slow it temporarily. The rebound in global

economic activity in the last twelve months was mainly led by the resurgence of Asia. According

to the IMF, the growth rates in the emerging and developing economies are expected to reach

around 6.3 percent in 2010-2011, as against 2.2 percent growth in the advanced world. A

stronger economic framework and appropriate policy response are helping most of the Asian

economies to cushion imported shocks and re-attract capital flows quickly. On the other hand,

the economic growth rates in European economies are still not on a firm footing as they continue

to suffer from balance sheet problems of households, banks, and the government. What is likely

to happen is that the ASEAN Central Banks that started raising the policy rates or have not

started their tightening cycle as yet are likely to maintain a looser stance, at least until


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the policy makers see clear signs of stability in the euro economies. For example, Bank Negara

Malaysia, who had raised the Overnight Policy Rate to 2.5 percent recently, is likely to wait for

the next few months. Bank Indonesia and the Bank of Thailand, who were maintaining low

interest rate policies till recently, will display extreme caution in raising policy rates anytime

soon. The US$1 trillion emergency package is expected to bring back some stability to the Euro

and is expected to calm the financial markets, preventing a repeat of 2008s disaster. But what

ASEAN must learn from the Greek crisis? Excessive debt build-up without a solution to

minimize it will extract a high price in the future. Among the ASEAN members, Malaysia has a

public debt of 54 percent of GDP and the Philippines, 62 percent of GDP. While their economic

condition is nowhere near that of the troubled European economies, they should still head the

lesson from the current crisis before things run out of hand. At the current juncture, when the

ASEAN member countries are comfortably coming out of the last years recession, slashing

budget deficits is not an easy task to accomplish. Cutting public expenditure too soon is likely to

reduce consumption and may hamper economic growth. It is therefore important to introduce

measures to increase the efficiency in tax collection and find ways to minimize the big subsidy

bill that is incurred by most of the ASEAN governments on an annual basis. ASEAN is

undergoing its own regional economic integration process. ASEAN leaders are aiming to

establish an ASEAN Economic Community by 2015. However, it has its own challenges and one

of them is the issue of the development divide, especially since the admission of Cambodia,

Laos, Myanmar and Vietnam. ASEAN must be able to narrow the divide at least partially by

2015 because with economic integration the member countries would be more dependent on

each other in terms of export and investment, securities and property markets, and even

consumer and investor confidence. This implies that any disturbance or problem of one country

can eventually lead to disruption in another. Thus, in an increasingly integrated region the policy

planning must take into account the issues of the weaker members so that a situation similar to

EU does not occur in ASEAN. The writer is Lead Researcher for Economic Affairs at the Asean

Studies Centre, Institute of Southeast Asian Studies.

Documents

Pushkal Pandey Report