Tuesday, June 4, 2013

DEBT CRISIS

The debt crisis of Greece started after the global financial crisis affected the different world economies. Greece was not able to pay its sovereign debts thus arise in the levels of the debts of the government. There debt crisis led to the development of low confidence of the investors in the Greece government as well as the economy. Of particular concern were the widening risk insurance on credit default swaps (CDS) and the spreads on bond yields in Greece as compared to the other countries. The genesis of the debt crisis can be attributed to the large capital from foreign countries which flooded the Greece economy ensuring a growth rate of 4.2 per cent. This strong economy coupled with the dwindling value of the yields on the government bonds, led government to run an uncontrolled structural deficit in the form of finance for public jobs, and other social benefits to the populace (Arghyrou & Tsoukalas, 2010). The essay is a discussion of the Greece debt crisis and its effects on the world economy. Apart from the uncontrolled spending by the government that is discussed as part of the introduction, the crisis can also be attributed to fiscal policies which are unsustainable in the long run. Due to the excess money that was in circulation in the economy, there was speculative pegging of the value of the currency. This led to the depletion of the foreign reserves below critical threshold. Investors take this opportunity to buy the remaining foreign reserves from the government thus a forced devaluation of the currency of the country. The crisis was also caused by the withdrawal of the fiscal guarantees to the various liabilities of the financial intermediaries. When the guarantees were in operation, the financial intermediaries were able to borrow funds in the short term at low interest rates especially from the global markets. These borrowings were used to finance highly speculative investment in Greece. These projects were majorly of the nature of small expected returns with very low probability of high returns in some instances. The borrowers and the investors ran very low risks in cases of failures in the ventures. Huge numbers of investors therefore flock to have a stake in these projects in the process increasing the value of the projects above their fair prices. When the returns on the projects are finally revealed, the prices of the assets reduce and the value of the different financial intermediaries also reduces. In most cases, the firms that are overleveraged are often faced with bankruptcy as the international sources of finance deny them the much needed funding. Finally the government tries to bail out the subsidiaries. The process described above is cyclic and thus it reached a level where the government could no longer bail out the financial subsidiaries thus leading to more closures of the intermediaries, forced devaluation of the currency, flight of capital and a financial crisis (Arghyrou & Tsoukalas, 2010). The final cause of the crisis that can also be noted is the falsification of the deficit that the Greece government was running especially to the European commission. This kept many countries from knowing the exact deficit situation of the country until the situation reached level where the government could not fund some of its basic functions. There was a problem with the enforcement of the EU rules particularly the Stability and Growth Pact which was adopted by the members of the EU in 1997. The rules stipulated that the deficits of any government within the economic zone should not exceed 3 per cent of their GDP’s and the public debt on the other hand should also not exceed 60 per cent of the GDP. The Greece deficit exceeded the limits but the EU did not levy any sanctions in 2004 and this led to the worsening of the deficit to stand at 13 per cent of the GDP in 2010 (Arghyrou & Tsoukalas, 2010). The Greek crisis has impacted the world economy in a number of ways. The public debt of Greece by February 2010 stood at 404 billion dollars representing about 113 per cent of the country’s GDP (Bandyk, 2010). Due to the down grading of the credit rating of Greece by Standard and Poor and other credit rating agencies, the ability of Greece to command any significant funding from external bodies such as the International Monetary Fund (IMF and the World Bank (WB) has greatly been reduced. This is due to the fact that the country is now considered a high risk investment destination. Although Greece received bail out packages, they have not alleviated the situation much and thus the little progress made by Greece will lead to further instability in the world financial conditions and especially the markets due to the burgeoning debt levels. The debt crisis The crisis in Greece would also lead to the worsening of the debt concerns in the whole of European Union zone especially the countries that have adopted the use of the Euro. The possibility of a spillover to the other countries was particularly informed by the financial crisis which engulfed the whole of Asia due to the different activities of the investors (Lynn, 2011). The impact of the debt crisis on the economy of the United States was also massive due to the intricate relationship between the economy of the US and that of majority of the countries of the EU. Du to the loss of the confidence of the investors in the Eurozone, the value of the Eurozone currency (the Euro) will reduce and thus its value would depreciate against the United States dollar (Bandyk, 2010). The value of the Euro depreciated by almost 15 per cent between December 2009 and May 2010 thus leading to the widening of the US trade deficits due to an increase in the imports from the US to the Eurozone and a reduction of US exports to the Eurozone. There would also be a noted transfer of capital and investment from US to Eurozone due to the fact that investments in Europe would be cheaper in US dollar terms. The default in Greece also poses risks to the commercial interests of the United States especially due to the fact that over 16.6 billion dollars of the debt obligation of Greece are owed to US creditors (Nelson, Belkin & Mix, 2010). The effects of the crisis on china would be hard as the most important market for the exports from China were affected by the falling value of the euro as compared the US dollar. The other emerging market were also affected for instance through their connection with the developed economies. The low interest rates would lead to an increase in capital flows from the developed countries to the developing countries. This would lead to the development of very huge pressures on the industrial sectors of these countries due to the rising rates of exchange thus worsening their external competitive positions (Bandyk, 2010). The final effect would be on the level of the global economic recovery which may be slower due to the weakening of the Eurozone which is one of the world’s major financial blocs. The EU will most probably have a very limited contribution to the world’s financial situation. The US on the other hand will also be under unfavorable conditions as they will not be able to increase their export levels due to the high strength of the dollar and the very low import demands by the EU countries. The situation is further worsened by the fact that the EU seeks to minimize its imports and maximize on its exports so that they can reduce the effects of the crisis (Prasad, 2010; Bandyk, 2010). Although the crisis in Greece can be attributed to different causes, it can be noted that the government of Greece played much role in its development for instance through the falsified reports that they gave to the EU so that they could not face the financial penalties associated with the exceeding of the limits of deficit that were allowed. The government also caused the crisis through the fiscal policies which proved unsustainable in the long-run. The effects of the crisis has been felt all over the world in one way or the other and thus the need for major world financial organizations to work on bail out plans if the world economic situation before the crisis is to be maintained. References Arghyrou, M. G. & Tsoukalas, J. D. (2010), "The Greek Debt Crisis: Likely Causes, Mechanics and Outcomes", Cardiff Business School Working Paper Series, 1-32. Bandyk, M. (2010), How Greece's Debt Crisis Affects America [Online], http://money.usnews.com/money/business-economy/articles/2010/03/11/how-greeces-debt-crisis-affects-america (Accessed 29 November 2010). Lynn, M. (2011), Bust: Greece, the Euro, and the sovereign debt crisis, Hoboken, N.J.: Bloomberg Press Nelson, R. M., Belkin, P. & Mix, D. E. (2010), "Greece’s Debt Crisis: Overview, Policy Responses, and Implications", Congressional Research Service, 1-29 Prasad, E. (2010), Why the Greek Debt Crisis is a Problem for the Entire World Economy, [Online], http://www.brookings.edu/opinions/2010/0524_greek_debt_prasad.aspx (Accessed 29 November 2010).