Theme:”Why the events in Greece have such an impact on the World Economy”

Russian New University

Faculty of Economics, Management and Finance

 

 

 

 

Coursework

Of subject:”Professional English”

Theme:”Why the events in Greece have such an impact on the World Economy”

 

 

 

 

 

 

 

Work performed:

Student 3^rd year,

Group WE-3

Brigge D.K.

Work reviewed:

Lecturer Androsova L.M.

 

 

 

 

 

Moscow

 

2012

As Greece embarks on tough economic reforms it is facing the prospect of deep social unrest, with tens of thousands of workers taking to the streets this week. The Greek debt crisis is spilling over to other European economies - and threatening international prospects for economic recovery.  
 
More strikes and social unrest. Tens of thousands of disgruntled workers spilled into Greek streets on Wednesday, registering their discontent with government austerity measures to control Greece's spiraling public deficit and debt. Greece's economic woes have posed the biggest challenge yet for  the decade-old euro currency - and the 16 nations, including Greece, that make up the eurozone economy.  
 
Greece has been a top subject in Brussels, where European Union leaders registered support for Athens and its economic reforms this month - but offered no financial assistance. 
 
The Greek government has promised to slash its public deficit from nearly 13 percent of gross domestic product to nearly nine percent of Gross Domestic Product by the year's end. Greece's debt is currently estimated at more than $404 billion - or about 113 percent of its GDP

                        Economy of Greece

 

The economy of Greece is the 32nd or 37th largest in the world at $312 or $309 billion by nominal gross domestic product or purchasing power parity respectively, according to World Bank statistics for the fiscal year 2009–2010. Additionally, Greece is the 15th largest economy in the 27-member European Union. In terms of per capita income, Greece is ranked 29thor 33rd in the world at $27,875 and $27,624 for nominal GDP and purchasing power parity respectively.

A developed country, the economy of Greece mainly revolves around the service sector (85.0%) and industry (12.0%), while agriculture makes up 3.0% of the national economic output.^[5]Important Greek industries include tourism (with 14.9 million international tourists in 2009, it is ranked as the 7th most visited country in the European Union and 16th in the world by the United Nations World Tourism Organization) and merchant shipping (at 16.2% of the world's total capacity, the Greek merchant marine is the largest in the world), while the country is also a considerable agricultural producer (including fisheries) within the union. As the largest economy in the Balkans, Greece is also an important regional investor.

The Greek economy is classified as an advanced and high-income one, and Greece was a founding member of the Organisation for Economic Co-operation and Development (OECD) and the Organization of the Black Sea Economic Cooperation (BSEC). In 1979 the accession of the country in the European Communities and the single market was signed, and the process was completed in 1982. In January 2001 Greece adopted the Euro as its currency, replacing the Greek drachma at an exchange rate of 340.75 drachma to the Euro. Greece is also a member of the International Monetary Fund and the World Trade Organization, and is ranked 34th on the Globalization Index.

2010–present government debt crisis

By the end of 2009, as a result of a combination of international and local factors (respectively, the world financial crisis and uncontrolled government spending), the Greek economy faced its most-severe crisis since the restoration of democracy in 1974 as the Greek government revised its deficit from a prediction of 3.7% in early 2009 and 6% in September 2009, to 12.7% of gross domestic product (GDP).

In early 2010, it was revealed that successive Greek governments had been found to have consistently and deliberately misreported the country's official economic statistics to keep within the monetary union guidelines. This had enabled Greek governments to spend beyond their means, while hiding the actual deficit from the EU overseers.

In May 2010, the Greek government deficit was again revised and estimated to be 13.6% for the year, which was one of the highest in the world relative to GDP. Total public debt was forecast, according to some estimates, to hit 120% of GDP during 2010,^[ one of the highest rates in the world.

As a consequence, there was a crisis in international confidence in Greece's ability to repay its sovereign debt. In order to avert such a default, in May 2010 the other Eurozone countries, and the IMF, agreed to a rescue package which involved giving Greece an immediate €45 billion in bail-out loans, with more funds to follow, totaling €110 billion. In order to secure the funding, Greece was required to adopt harsh austerity measures to bring its deficit under control.^[ Their implementation will be monitored and evaluated by the European Commission, the European Central Bank and the IMF.

On 15 November 2010 the EU's statistics body Eurostat revised the public finance and debt figure for Greece following an excessive deficit procedure methodological mission in Athens, and put Greece's 2009 government deficit at 15.4% of GDP and public debt at 126.8% of GDP making it the biggest deficit (as a percentage of GDP) amongst the EU member nations (although some have speculated that Ireland's in 2010 may prove to be worse).

The financial crisis – particularly the austerity package put forth by the EU and the IMF – has been met with anger by the Greek public, leading to riots and social unrest. Despite the long range of austerity measures, the government deficit has not been reduced accordingly, mainly, according to many economists, due to the subsequent recession. Consequently, the country's debt to GDP continues to rise rapidly.

 

 

Why Greece Matters

 

Greece’s problem is very simple: massive debts relative to its size that it cannot pay. The reason it matters ultimately comes down to this—Greece is connected to the world economy, including ours, like never before.

Think of Greece as a mountain climber. If Greece were climbing alone, it may slip and fall. That would be a tragedy for Greece, but only Greece. Instead, as a member of Europe’s currency union—the Eurozone—Greece is tethered to other countries, banks, businesses, and people each on its own mountain ledge, potentially pulling everyone down in a heap. Due to the interconnectedness of the world financial system, a Greek default could lead to the following four economic landslides, each with their own collateral damage:

1. European banks that own hundreds of billions of dollars of Greek debt would take massive losses on these loans which means they have far less money to lend to people and businesses;

2. Investors would doubt the ability of other weak peripheral Eurozone economies, such as Portugal, Ireland, Spain, and Italy, to pay their debts, driving down the value of these countries’ bonds. European banks would be forced to take even larger losses becausethe debt of these countries makes up a greater share of their portfolio then Greece’s. If Greece is Indiana, Italy is California—a much more difficult bailout with deeper consequences for the rest of the world;

3. The euro itself could dissolve if one or more of these weaker countries are forced or decide to leave the euro. This could lead to an unruly break up of the world’s second-most important currency, with a devastating impact on the global economy; and

4. American financial institutions that lend to European banks would take huge losses. This could cause a loss in confidence in the American financial system similar to the fall of Lehman Brothers in 2008, with severe implications for the overall U.S. economy and everyone from Wall Street bondtraders to widows on pensions.

Background: Why Greece is Greece

In 1997, before joining the Eurozone, interest rates on 10-year Greek government bonds stood at about 9.8%. These high rates reflected investors’ views of Greece’s economic stability at the time—which is to say, not at all positive. By way of comparison, rates on German bonds—considered the safest European bonds— averaged 5.7%. In 2003, just two years after joining the Eurozone, Greece could borrow at roughly the same rate as Germany—4.3% for Greek and 4.1% for German government bonds.

Yet nothing had fundamentally changed about Greece except one thing: membership in the Eurozone. There was a belief that rather than being on its own, Greece was part of the economic cocoon of Europe. Its debt was viewed as less risky because of a perception that the European Union would aid any euro nation in trouble. In addition, because entry in the Eurozone is contingent on a country having its economic house in order (manageable debt, low budget deficits and stable inflation), investors may have believed that Greece’s economy was healthier than it truly was.

What happens to a country whose borrowing costs drop nearly six percentage points in six years? In Greece, private and public borrowing exploded. As the IMF points out, “with . . . markets not differentiating between countries, the credit boom became difficult to stop once it had started.”

According to the Carnegie Endowment for International Peace, lower borrowing costs and the expansion of domestic demand boosted tax revenues for Greece. But instead of saving these tax revenues for the inevitable slowdown in growth, Greece signifcantly increased spending, particulaly on the public sector.When the financial crisis hit in 2008, the economy plunged into recession and interest rates on newly issued Greek government debt soared.

Lower growth further exacerbated the debt crisis, and once the country’s economy started to contract, Greece’s membership in the Eurozone limited its options to save itself from default. For example, it could not depreciate its currency (which would make exports cheaper) because Greece no longer has its own currency. It could not turn to a Greece Central Bank to take measures to adjust interest rates; they are now reliant on a European Central Bank.

The European Union and the International Monetary Fund (IMF) stepped in to provide a 110 billion euro loan package for Greece in May of 2010. They hoped this would give Greece time to get its fiscal house in order and resume borrowing in the private markets on reasonable terms. However, the austerity measures that were imposed upon Greece as a condition of receiving the loan package further contributed to its deepening recession and worsening debt. In 2010, its economy actually contracted by 4.5%.

Four Reasons Why Greece Matters

1) The Greece contagion could spread to European banks.

The extent of Greece’s debt is large, but compared to the world economy or the $13.5 trillion Eurozone economy, not enormous. Greece has about $465 billion in outstanding debt with roughly two-fifths held by Greek investors and banks and three- fifths held by foreign investors and banks. German, French, and British banks are the largest foreign holders of Greek debt, with the United States owning a small amount.

Greece recently passed an austerity package on June 29, 2011 that allowed it to receive another loan installment from the IMF and the European Union. However, Greece’s economy cannot create the cash flows necessary to sustain their current debt burden. Which is why many question whether Greece can pay its debts in their entirety, leading to a default. It is similar to a homeowner who has a $5,000 mortgage with only a $4,000 monthly income.

If Greece defaults, European banks are holding—collectively—what could be several hundred billion dollars in bad loans. Imagine that you read in the papers that your local bank had an enormous portfolio of potentially bad loans. You might feel compelled to move your money to a safer place. That’s what could happen with investors who have money in these large banks. They will get spooked and seek to remove their money which further threatens the solvency of these large European banks.

When banks become threatened with insolvency, they do not lend cash—they hoard it. They are compelled to increase their capital to cover potential losses and show investors that they have enough cash on hand to weather any approaching financial storm. This is especially true now, because European banks have not fully recovered from the financial downturn in 2008 and are still highly leveraged, meaning they have a high level of debt relative to their equity.

If these European banks must focus on their balance sheets, they will not lend as much money to businesses and consumers. This means fewer new investments in plants, equipment, products, and hires; fewer loans for a car or a home in Europe.

As the IMF reports, “Restoring confidence in the Euro area’s banking system is a prerequisite to turning the page on the crisis.” But a Greek default would have the opposite effect on confidence.

2) Greece is the tip of the iceberg for European sovereign defaults.

Greece currently has the worst credit rating of the 126 countries that Standard & Poor’s rates, even worse than Pakistan. But Greece is just the tip of the iceberg.

Countries such as Portugal, Ireland, Spain, and Italy—who combined have a total GDP almost 13 times the size of the Greek economy—also saw interest rates drop upon entry into the Eurozone and are now facing similar debt crises. Markets tend to view these countries similarly, and financial commentators often refer to them together when discussing debt problems within Europe, referring to them collectively by their initials—PIIGS (Portugal, Ireland, Italy, Greece, and Spain).

For example, both Ireland and Portugal received large bailout packages from the European Union and IMF to avoid default. Both countries have large budget deficits, high unemployment, and negative economic growth over the last year. Spain, too, has a budget deficit over 9% and an unemployment rate above 20%.

Of particular concern is Italy, the eighth largest economy in the world and third largest economy in Europe. Italy has a higher debt to GDP ratio than any European country besides Greece. According to Thomas Mayer, chief economist with Deutsche Bank in Frankfurt, “Italy is the 850-pound gorilla in the room . . . It is too big to be saved by the rest of Europe. It is a weight they cannot lift.”

If Greece defaults, it would quickly affect the value of these countries’ bonds. In fact, the current Greek turmoil is already affecting the value of these countries’  bonds, with yields on Spanish and Italian bonds reaching the highest levels since the launch of the euro. Given the much larger exposure of European banks to the debt of Ireland, Portugal, Spain, and Italy—the 90 major European banks that recently underwent a stress test conducted by the European Banking Authority have close to $1 trillion of exposure to these countries. Lower values for these bonds would pose exponentially more problems for the financial health of these institutions, with increasingly dire consequences for the European economy.

In fact, the European Central Bank is worried that “A default in one country might cause a general banking system collapse in Europe,” a concern shared by the new IMF Managing Director Christine Lagarde.

3) The Euro could be at risk.

The euro is an experiment.

Through the Eurozone, it brought together 17 historic rival countries with different languages, cultures, and economic might to form a loose confederation of nations under one currency. Now it faces its first true crisis that goes to the very existence of the euro itself.

The euro was officially launched in 1999 to increase both the political and economic integration of Europe. Before its creation, each European country had its own currency, which—proponents of the euro argued—hampered the efficient movement of capital, goods, and services across the European continent. The euro was meant to reduce barriers to economic efficiency for those countries that chose to join the Eurozone.

According to the European Central Bank, since its inception, the euro has served to reduce transaction costs, increase price transparency, eliminate currency fluctuations, and keep interest rates low and stable for countries in the Eurozone—all of which created economic growth.

However, the financial crisis exposed the weaknesses in the Eurozone. Some commentators have asserted that the euro may not be sustainable, arguing that a currency union with countries that have such varied economies as Greece and Germany was flawed at its inception and bound to fail. This is particularly true since this monetary union was not accompanied by a fiscal union—meaning the European Central bank controls monetary policy but has no control over the spending and tax policies of member nations. In addition, the European Union is not nearly as integrated as the United States where we are truly one nation and we expect one part of the country to help the other. The Eurozone is only 12 years old and is akin to the United States in 1801—a gangly collection of states searching for a common identity.

The euro is the second most important world currency, behind only the U.S. dollar as a reserve currency held by central banks around the world. Additionally, many assets throughout the world are denominated in euros. If countries begin to leave the euro and revert to their former currencies, it could cause widespread havoc in world markets as countries and financial institutions that hold euro denominated assets face unknown repercussions.

European leaders that support the euro want to avoid these scenarios at all costs. This is one of the reasons why European leaders are so committed to avoiding a Greek default and have already used taxpayer dollars to assist Greece, Ireland, and Portugal. They are worried about the consequences a Greek default would have for the future of the euro, and intend to preserve it.

American financial institutions—including investment banks, mutual funds, and brokerages—have only a trivial sum tied up directly in Greek debt. But U.S. financial institutions are tethered to European banks, and as a result, so are ordinary American investors.

There is a vast market of lending between financial institutions that involves enormous quantities of money. Each day, financial institutions lend top-rated companies, including highly-rated banks, trillions of dollars to keep the wheels of commerce running. Many of these loans are very short term—some lasting only one day—and many come from the United States. Finanical institutions allow ordinary Americans—through their pension funds, retirement accounts, and investment portfolios—to hold a portion of these loans through investment vehicles that are commonly known as money market funds.

4) American financial institutions and the wider American economy are exposed.

Investors view money market funds as a safe investment, similar to bank deposits. That is because short-term lending to top-rated companies and banks is considered rock solid. Prior to 2008, only one money market fund had ever experienced a loss. However, after Lehman Brothers failed, a major money market fund—the Reserve Primary Fund—suffered losses and investors fled. As The Wall Street Journal explains, “The fund ‘broke the buck’ as its net asset value fell below the $1 a share that money funds seek to maintain. For several days, the commercial-paper market, the lifeblood of global corporate finance, virtually halted.”

Many investors and regulators are worried about another loss for American money market funds, which own huge amounts of short term loans to European banks with exposure to European sovereign debt. In fact, “about 50 percent of the funds’  $1.6 trillion in prime money market assets is in the debt of European banks.”

Some fear that the contagion of bad Greek loans would spread to the United States through these short term loans to European banks and its impact on money market funds, which could go from safe to bad in a matter of days. Significant losses in American money market funds would shatter investor confidence in U.S. financial markets. Like the financial crisis of 2008, consumers would pull back spending and possibly remove deposits from financial institutions; this would result in American banks tightening their lending in order to maintain enough cash on hand to weather the storm. A very reluctant and tapped U.S. federal government may be summoned again to provide liquidity to the lending markets. Less lending—in everything from car loans to bank-to-bank loans—means less economic activity and slower growth.

In addition, the European Union is the largest trading partner of the United States. In 2009, the United States exported $287 billion in goods and services to Europe, and European direct investment in the United States totaled over $120 billion. Those numbers will be certain to fall as European economies falter. The debt crisis in Europe will also likely weaken the value of the euro which makes our exports more expensive, compounding the effects of decreased European demand for our products.

Potential impacts on global economy

Greece’s sovereign debt crisis directly affects its citizens, especially through fiscal-tightening measures. Despite many ongoing efforts from various institutions to find an appropriate solution, if comprehensive and sustainable solutions could not be reached, the crisis could have large impacts in global financial markets and could ultimately affect the world economy through the following channels: 

Investor confidence. Credit default swaps of PIIGS rose significantly during the past two months, resulting in higher financing costs of those peripheral countries. Rising borrowing costs adversely affect ability to repay, potentially leading to default.

Financial markets. Exposures to Greek debts by commercial banks in France and Germany, in terms of ultimate foreign claims to public and private assets, total approximately $57 billion and $34 billion, which are equivalent to 1.8 and 1.2 percent of total foreign claims, respectively. If Greece defaults, those commercial banks will unavoidably face capital losses. If the problem spreads to other PIIGS countries, it can lead to credit crunch. Moreover, the majority of Greek bonds are issued under Greek law, which can make claims by foreign investors difficult.

Trade. If the problem is contained within PIIGS, the impact on the global economy is expected to be limited as exports to the periphery countries account for only 8 percent of world exports, although EU intra-regional trade would be more affected as exports to PIIGS account for 13 percent of total EU exports. If core countries become affected, impacts on the world economy would be severe because the European market accounts for one-third of world exports. The sovereign debt crisis in Greece thus poses a significant risk to the global economy and world financial  markets if there is no concrete solution.

With regard to Thailand, the impact on the Thai economy is judged to be limited, as financial claims by Thai investors, including financial institutions, on European economies are minimal. The impact through trade is also marginal as Thai exports to PIIGS accounts for 1.8 percent of total Thai exports. Nonetheless, the Thai economy will be indirectly affected from volatilities in foreign exchange and stock markets worldwide. As the crisis is unfolding, future impacts will largely depend on the severity and the degree of contagion of the problem.

Conclusion

Because the world financial system is so interconnected, a Greek default—through financial contagion—could damage both the United States and world economy. How extensive will the damage be?