European Debt Crisis Part 2

Here is an expanded version to my previous post European Debt Crisis Synopsis

European Debt Crisis – Expanded Version

The global economy experienced a boom during the years of 2005-2007.  Many countries around the world experienced this boom.  Even countries in Europe to an extent.  An economic boom can produce temporary surging revenue for the federal governments of the European nations.  And what do governments love to do?  Spend money!

Almost all countries tend to run some form of budget deficit, whether large or small.  So when you see the Unites States spending billions of dollars or hundreds of billions of dollars, they don’t actually have the money on hand.  They don’t have the cash to pay for it.  So if they don’t have the cash to pay for it, and they still want to spend the money, they will go and borrow it.

Now when a country wants to borrow money, they aren’t going to go ask for a traditional bank loan.  Instead the country is going to issue a financial instrument called bonds.

So, if Germany wants to spend $20 billion, they don’t have the cash on hand, so they need to issue bonds.  They need to sell the bonds to the public, who in turn will lend them the money.  The bond is a fixed interest rate and they borrow the funds for a defined period of time.  They pay the interest every year, but will only give back the principal upon the maturity of the bond.

So, let’s say Greece goes to borrow $10 billion dollars in 2005, with a 5 year maturity date.  Let’s say back in 2005, they paid an interest rate of 4%.  So Greece would pay the bondholders $400 million per year, every year for five years, then at the end of the 5 years, they would be required to pay back the principal, or $10 billion in this case.

Usually, countries can easily make the initial interest payments.  The initial interest payments are low compared to the amount that they want to borrow.

Also politicians, usually, love to spend money now and attempt to buy votes, as the consequences of their actions will only be manifested when they are long gone from office.

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Bond Eventually Matures

After a country issues a bond and when they eventually mature, they are required to pay back the principal.  They can do a few things.  They can choose to pay back the principal with cash that they have saved up in preparation for the bond repayment.  Or they can choose to borrow money again to pay back the previous bonds which are coming due.  Or they can choose some mix of the two, where they may pay back some percentage of the principal with cash on hand, then go borrow the rest that they need.

Most countries do not have enough cash on hand to pay back all the maturing debt.  So what the countries love to do, including plenty of western democracies like the United States and Britain is when the bonds come due, they will rollover the debt.  Rolling over the debt meaning they are attempting to pay the debt which is about to mature with newly issued debt.

There is a rollover risk associated of course.  If Greece borrowed money during the good years for 5 years at 4% interest rates, then in five years when they want to rollover the debt, they were obviously expecting to continue paying the low interest rates.  If interest rates rise however, then they will be forced to pay higher interest rates on the newly issued debt.

When Greece went to rollover the debt, they weren’t getting 4% interest rates.  Interest rates rose, depending in what year and for what type of maturity, they were paying out over 8%, or over 10% or higher in interest costs.

Why did they pay more in interest?  Well the interest rate that they pay is a function of supply and demand in the marketplace, which is heavily influenced by the perceived credit risk of the country.  If investors believe that a country has a high likelihood of repaying the debt, they will be willing to lend money for low interest rates.  As the perceived credit risk grows, then the investors will demand a higher interest rate to compensate for that increase in likelihood of default.

For example, if you are going to lend money to a country that has a perceived 1% chance to default over the next ten years, then you may be willing to lend them money at cheap interest rates.  On the other hand, if you were going to lend money to a country that has a perceived 25% chance to default over the next ten years, then you are probably not going to lend money to them at cheap interest rates.  You will want a higher interest rate to compensate for the 25% probability that you may not get back all the money you let them borrow.

Many countries in Europe thought they could borrow money cheaply forever, so they loaded up on debt.

Eventually, the global financial crisis came, and global growth slowed.  Refinancing the debt was done at higher interest rates.  So countries like Greece had to pay out much higher interest rates, as well as dealing with negative GDP growth and sky high unemployment.

Death Spiral

Eventually, this started to spiral out of control and Greece was paying out interest rates of over 10%.  This was unsustainable.  The countries in the EU recognized this and put together various aid packages.  They lent Greece money at below market interest rate, so Greece would not have to pay over 10% interest rates.  Let’s say the EU lent Greece money at 5%.  This gave them temporary relief, but in reality the death spiral had already started.

The EU said they will lend Greece money but with strings attached.  The strings attached included forced cuts to public spending, various increases in taxes, and reforms in the economy.  Greece agreed to them and they started to implement the measures.  Eventually they had to meet various benchmarks in order to keep receiving new tranches of funds.

Greece started to fall behind and then they came up with a new plan.  They told the Greeks to sell various state assets to raise money.  Supposedly the Greeks had $50 billion worth of privatization options.  If they could have actually got it done, then it would have helped immensely, but that would have required perfect execution and that wasn’t going to happen.

Greece Will Accelerate State Asset Sales to Stem Debt Crisis as Bonds Drop

But, there was so much red tape that they were never going to get it done in time.  And the Greeks aren’t too thrilled about selling off state assets at firesale prices.

Their previous attempts at slashing the spending and raising taxes were not enough.  For the economy already entered a destructive cycle of negative growth where they can continue to struggle to get the revenue necessary as unemployment stays high as well as tax evasion staying high as well.

They have maxed out their credit cards, and are just struggling to meet the minimum payments.  They are struggling to meet the interest payments and thus, will struggle to pay off any principal.

Options To Choose From

When a country can’t pay its debts, there are a few things that can happen:

1.  The central bank can print the money and bail them out.  Greece is part of the Euro, so the ECB needs to make that decision.  They don’t want to do this because they would lose credibility and inflation would get out of control.

2.  The other European countries can bail them out.  This is what the other bigger and more stable countries like France and Germany started to do.  Problem is that they have started to have their own problems with their credit ratings are deteriorating and their citizens aren’t too happy they are bailing out their southern neighbors.

3.  They can write down the debt.  It is sort of like a default, but the debt gets written down.  They are trying to get a voluntary write down with the bond holders for like 50% of the debt.

The reason they want to prevent a full blown default is because there are a lot of banks in Europe that have exposure to Greek debt.  Theoretically, they should have been preparing for the possibility of losses for months and years now, and should have raised sufficient cash to absorb losses, but you never know what stupid things the financial sector can do.  If they cause excessive losses in too short of a time frame, then that can weaken confidence in the banks and potentially start a bank run.

Also, I have heard that there are a lot of banks, institutions, and pension funds in Greece which have invested in their own debt.  And if that causes further catastrophic losses to the pension funds, that could cause a whole other crisis within Greece.

Without The Euro?

When a country adopts the Euro, it gives up its monetary policy to the European Central Bank.  They lose many of the traditional monetary policy tools.  The country cannot fight inflation by raising interest rates.  It cannot stimulate growth by devaluing its currency or cutting interest rates.  For those decisions are made collectively for the whole of the Eurozone with the bigger economies obviously having more weight.

What would typically happen if a country like Greece got into trouble, is that the central bank of Greece would lower interest rates to stimulate the economy.  That would generally cause the drachma to depreciate in value.  That depreciation of the currency will tend to help the export sectors of the economy and economic growth could pick up.  And then with that pickup in economic growth, they could try to pay off the debt.

But now with the ECB, the decisions are made for the Eurozone as a whole.  While Greece may have required an interest rate cut over a year ago, the ECB had to take into consideration the whole Eurozone situation.  They actually raised interest rates two times this year, before finally reversing them over the past two meetings.

Now you may wonder why don’t they just leave the Euro then?  Well leaving the Euro entails all sorts of uncertainty and pain as well.  Going from the drachma, to the Euro, and then back to the drachma all within a 12 year period is not an easy task.  It creates all sorts of uncertainty as people have various assets and liabilities within Greece denominated in Euros, and there is all the uncertainty about what the exchange rate between the Euro and drachma would be, as well as risk of being ostracized within Europe.

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