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Measures to contain the Euro crisis
A. Comment on the rationale for the formation of the European Union.
The European Union is a unique economic and political partnership between 27 European countries. The EU was created in the aftermath of the second world war. The first steps were to foster economic cooperation: countries that trade with one another are economically interdependent and will thus avoid conflict. Since then, the union has developed into a huge single market with the euro as its common currency. What began as a purely economic union has evolved into an organisation spanning all areas, from development aid to environmental policy (Europa.eu 2011).
Figure 1 The European Union
Source: Europa.eu 2011
Firstly, the European Union is a political dream shared by all the member countries (27 members currently). The European Union was created in the aftermath of the second world war, though there are claims that the European Union is an economy cooperation form rather than a political union, historically speaking, the destructiveness of the two world wars had caused many thoughtful Europeans to consider the need for some additional form of unity besides the set up of the military unification of Europe under the North Altantic Treaty Organization (NATO) in 1949. In this regard in 1957, France, West Germany, the Benelux countries and Italy signed the Treaty of Rome which gave birth to the European Economic Community (EEC) that later developed into the European Community (EC) and the Treaty on European Union in 1994 turned the EC into a true economic and monetary union of all EC members (Duiker & Spielvogel 2010, p.838). The political effect of the European Union could be seem from the influential roles that the union plays in the major international organizations. For example, the European Union’s has 27 members of the OSCE’s total of 55 member states, which accounts for 49 per cent of the all OSCE members can be found in the European Union. Having such a share of membership, one should perhaps expect a very considerate EU influence in determining the OSCE’s general mission and operational missions ( Jørgensen 2009, p.6). Similar cases could also be found in United Nations, WTO and Who and so on. In a world, the unification under the European Union framework has achieved the 27 members’ dream to have a strong political power and act as a competing political power against the super power, the United States and protect the members’ interests.
Secondly, one key function of the European Union is act as a monetary union among the members and promotes the common currency, i.e. the Euro, to be an alternative to the United States Dollars. There are several key benefits by joining the European Monetary Union and the most obvious one is the currency stability which will be enjoyed by each member. A single currency should end currency instability in the participating countries (by irrevocably fixing exchange rates) and reduce it outside them. And because the euro would have the enhanced credibility of being used in a large currency zone, it would be more stable against speculation than individual currencies are now. And the end to internal currency instability and a reduction of external currency instability would enable exporters to project future markets with greater certainty which could unleash great potential for growth (bbc.co.uk 1998). And also from the perspective of the tourism industry, the usage of a common currency would encourage the tourists to travel along the European Union countries due to the convenience the single currency provides. In addition, with the wide adoption of the Euro as major currencies in the international trade because of the collective importance of the market made up by the European Union member countries in the world economy, Euro could become a popular currency like the US dollar. And also because of the large international trade that involves the usage of Euro, many countries would also store up the Euro in the foreign reserve which will theoretically increase the fortune of the countries that adopt the Euro as their currency.
B. What is the Euro crisis and discuss the factors that has brought about the Euro crisis?
The Euro crisis happened in the Euro zone which refers to the European Union member states that have adopted the euro currency union as the third stage of the European Economic and Monetary Union (EMU) (Penzkofer 2006, p.2). Right now, the euro (€, code: EUR) is the official currency of the euro zone: 17 of the 27 member states of the European Union and it is used in a further five European countries and consequently used daily by some 332 million Europeans (Europa.eu 2011). Euro zone’s debt crisis refers to high budget deficits and debt levels with Greece, Ireland and Portugal, as the most affected countries. The crisis which followed the global financial meltdown is making investors demand higher interest rates from governments with higher debt levels or deficits, leaving governments to struggle to finance further budget deficits and service existing high debt levels (Digitaljournal.com 2011). The Euro crisis unlike the global economic crisis is a current crisis that has not yet been contained and it is still strongly felt by the people living in the Euro zone especially those most affected countries.
There are a number of reasons that had brought about the Euro crisis, some of them are analyzed here:
Firstly, there have been a rising government debt levels among the European countries. On 10 Dec 1991 when Maastricht Treaty agreed, it is agreed in setting up an “irrevocable” monetary union without a central finance ministry or a mechanism to leave the euro, and also member countries pledged to limit their deficit spending and debt levels (Bloomberg.com 2011). However, a number of EU member states, including Greece and Italy, were able to circumvent these rules and mask their deficit and debt levels through the use of complex currency and credit derivatives structures. The average fiscal deficit in the euro area in 2007 was only 0.6% before it grew to 7% during the financial crisis. In the same period the average government debt rose from 66% to 84% of GDP (Eiu.com 2011). According to Carmen M. Reinhart and Kenneth S. Rogoff (2011, p.28), the turmoil in Greece and other European countries can be importantly traced to the adverse impacts of the high level of the government debt (or potentially guaranteed debt) on country risk and economic outcomes. And at a very basic level, the high public debt burden implies higher future taxes (inflation is also a tax) or lower future government spending, if the government is expected to repay its debts. This is in consistence with other studies that identify the close relationship between the high debt levels and the bad subsequent growth. Though it is claimed that the high debt level contributed directly to the Euro crisis while the deficit problems were not serious before the financial crisis, it may be closer to the fact that the crisis became a crisis when the high debt level encounter the wide government deficit because the there had been urgent need of government spending in another crisis, the financial crisis.
Secondly, there is a lack of monetary policy flexibility. As known to us, the euro zone has common monetary policies, which are determined through the zone’s own institutional structures and at the heart of these monetary policies is a strong anti-inflationary ethos (Nugent 2006, p.364). While on one hand the common monetary policies which includes interest rate policies and other monetary policies would help stable price to the market, on the other hand the common monetary policies throughout the Euro zone also means the monetary policy inflexibility. The inflexibility in the monetary policy could be observed when a comparison is made. For example, when at the beginning of 2009, the Bank of England had already been urged to consider injecting money directly into the economy by printing more money, a process known as quantitative easing (Telegraph.co.uk 2009). The urge was followed by the bank followed and more money had been printed and unleashed into the market and also help avoid the debt crisis. In comparison, European Union member countries such as Greece and Italy could not print money simply like what the United Kingdom government did which push them into trouble of debs.
The loss of investor confidence also attributed to the happening of the current Euro crisis. No matter for government bond or companies stocks, a very simple premise should be accepted is that investors like returns and dislike risk. This premise suggests that there is a fundamental trade-off between risk and return: to entice investors to take on more risk, both the governments and the companies would need to provide the investors with expected returns (Brigham & Houston 2009, p.258). When the debts increased significantly in some of the European countries, there had been worrying in the market and among the investors about some governments’ ability control the crisis and also about the possible spreading of the crisis over other major economies, when investors felt that there were higher risks, based on the simple premise that higher risk accompanies higher compensation, there had been demand for higher yields of the relative government bonds. The demand for higher yields equates to higher borrowing costs for the country in crisis, which leads to further fiscal strain, prompting investors to demand even higher yields, and so on, this begins a very vicious cycle. And also a general loss of investor confidence typically causes the selling to affect not just the country in question, but also other countries with similarly weak finances – an effect typically referred to as “contagion” (About.com 2012).
One more reason of the current euro crisis is the current-account imbalances. Look at the United States which also has a number states which are relatively independent from each other in term of having their own tax and even legal systems. But the advantage of the United States is that it has a strong and powerful central government which could allocate the tax collected in all states into some states that need the money most. In European Union, the case is totally different. According to Paul Krugman (2011), there is serious current-account imbalances in the Euro zone, Germany and the northern countries are running huge current-account surpluses, and Greece, Italy, Portugal, Spain and so forth have been running very large current-account deficits. Under those circumstances, the southern countries are going to end up heavily indebted to the northern countries. The reasons for the current-account balances had much to do with the German export powerhouse and in the pre-2008 period with property investment in Ireland and Spain which attract investment flows. And also because of such current account imbalances between the Euro zone countries, it is not appropriate to apply a single monetary policy to solve the issues that happen only in some states.
C. Comment on the latest measures that have been introduced to solve or contain the Euro crisis.
Firstly, we talked about the most recent European Union summit in Brussels which aimed at locating the most suitable way to handle the current Euro crisis because of the some governments’ high percentage of debt to GDP which had created risk of bankruptcy for the relative governments. Though some views are agreed widely but the meeting did not come up with solutions endorsed by all the members. After ten hours of negotiations at the European Union summit in Brussels on 9 December last year, the heads of the 27 European Union countries reached a decision to forge ahead with a two-tier solution to the euro zone’s debt crisis. Crucially, the leaders of all 17 euro zone countries concluded that the only way to fix the euro’s flaws is by establishing a fiscal union that includes centralized control of national budget deficits. But Britain will not be part of the negotiations defining the new fiscal union, setting the stage for a two-tier Europe (Globalpost.com 2011). The reason given by Prime Minister of the United Kingdom, David William Donald Cameron, for the isolation of United Kingdom from the other members of European Union with the other 26 EU nations signed up to a pact for greater fiscal discipline in the end of the summit is that “”I said before coming to Brussels that if I couldn’t get adequate safeguards for Britain in a new EU treaty then I wouldn’t agree to it. What is on offer isn’t in Britain interests, so I didn’t agree to it” (News.com.au 2011) as quoted by the Prime Minister himself. From the fact that UK could decline a proposal and decision that had been accepted by the rest 26 members, we could probably conclude the most fundamental and critical reason for the current crisis that encountered by some of the most developed economies but still has not received a good handling: the reason lies on the loose and voluntary European Union decision making mechanism which is without overwhelming power to implement the decision agreed by the majority of the members. It is reasonable for United Kingdom to reject the solution and every other country or government in this position would do the same thing because it is not the country’s benefit to sign up such proposal which could probably attract disagreements from its people. Actually this problem would not be even be a problem when it comes to the United States or any other country, the problem is that European Union is not a country though it has high integration and unification in sharing the monetary policy and also with other similarities. In another word, in order to implement the changes and decisions more effectively, the London should be put under more responsibilities and pressure to accept a decision agreed by the majority of the members in the European Union.
Secondly, we look at the fiscal compact which had been designed to comfort the market which consists of a number of methods and some of them are listed below (WordPress.com 2011):
- Ø Constitutional amendment to balance the fiscal budget
- Ø The new “stability union” will adopt a “golden rule” to ensure structural deficits (i.e. adjusted for boom and bust of economic cycles) below 0.5% of GDP.
- Ø The 500-billion-euro European Stability Mechanism (ESM) to replace the existing bailout fund (EFSF) will be set up in March ’12 (instead of 2013).
- Ø A 200-billion-euro contribution to the IMF (International Monetary Fund) for on-lending to enhance the firepower of ESM to help Europe
- Ø No more “hair-cuts” for private holders of dodgy euro-zone sovereign debts
- Ø New treaty to change EU’s foundational pacts
There are still problems with this compact: on one hand, the European Union to some degree as a union become less helpful as not all the members agree with the compact and UK is one of the major influential economies had not be included; on the other hand, the market does not has confidence on the compact and also some of the methods will be effective only on March which disappoints the market.
D. Discuss the impact of the Euro crisis on investments, capital raising and exchange rates of the major currencies. 20 marks
To the investors, obviously they would be more cautious in making up the decision to invest in the countries especially in those that have been badly impacted by the current Euro crisis. For example, suppose that a company is going to enter into the market of Greece, then the company would have to build up cooperation relationship with the local wholesalers and retailers in the local market before the actual good could be sold in the shelves. And within the building up of such strategic cooperation relationship, enacting contracts would be a major method and the use negotiation of standard terms contracts could largely favor the company by adding special clauses into the contract terms. While the government of Greece is under certain political and financial risks because of the current Euro crisis, the company may probably add a clause into the contract saying that the contract would be governed by the contract law of the home jurisdiction rather than the target jurisdiction which is closer to the place where the actual business activities happen. In addition to the because of the fluctuation of the Euro, the adoption of Euro in defining the contract amount would create risks because the Euro could be devaluating continually which means a loss with time passes. Hence, there are two ways to avoid the potential risks and losses before signing up the contract. The first way is to avoid the risks to identify a more stable currency such as the United State Dollar as the transaction currency; the second way is to introduce a clause stating how the interest loss and exchange loss should be deal with into the contract.
Also as it is common found during the Euro crisis that individuals started to default on their mortgage and other credit payments, Bankrupt companies stopped paying their loans to banks. Asset prices such as stock prices collapsed (Mises.org 2011). As a consequence, the value of bank assets evaporated, reducing their equity and the price of assets would continue to fall. In this regard, the Euro Crisis provides both threat and opportunities to the investors. In the negative side, investors may be less willing to purchase expensive assets because their price tends to drop during the crisis which will bring loss to relative investment; and in the positive side, investors could make some strategic investment because some the price of the assets are low and even for those quality assets. In addition, it is also a good time to carry out some strategic merger and acquisition to buy some excellent assets and companies with a relatively low price than in the pre-crisis time. What is more, while evaluating the value of a project regarding the investment in some of the European countries affected by the Euro crisis, because high risk accompanies with the high compensation thus the foreign investors should claim more compensation to their investment using their increased bargaining power. In another word, the investment in these countries involves high risks and it is not advisable to make the investment if it only provides similar compensation than projects in other countries that have a healthier financial system. And because the developing countries such as China provide very good opportunities for future investment than many EU countries, there would be an expected reduced investment in the EU countries.
Regarding the capital rising, because the markets and regulators are pushing ahead and demanding that banks raise capital and reduce exposure to risky debt, the results expected from the bank are clear: cut exposure to the south. Banks need to do their best to raise capital, and will take advantage of cheap financing to roll over existing debts. Meanwhile, none of these banks are in a position to scale up lending to private businesses. The impact of the credit crunch on the real economy will make it very difficult to escape the difficulties in capital rising for the private business (Economist.com 2012). From the current severe situation found in the banks, capital rising through the arranging advances from the commercial banks would be much more difficult than the similar case in the pre-crisis period, while the method of capital rising through commercial banks is less reliable, investment of the companies’ own saving. Profitable companies do not generally distribute the whole amount of profits as dividend but, transfer certain proportion to reserves. This may be regarded as reinvestment of profits or ploughing back of profits. As these retained profits actually belong to the shareholders of the company, these are treated as a part of ownership capital. Retention of profits is a sort of self financing of business (Gov.in 2010). Also loans from the finance companies or raising loans from friends and relatives (for small business) would all be possible alternatives to the bank loans.
Regarding the Euro crisis’s impacts on the exchange rate of the major currencies in the world, let’s talk about the topic by analyzing some of the exchanges rates of the currencies below:
US Dollar to Euro Exchange Rate
Source: United States Federal Reserve Bank of New York
The ongoing crisis in the Euro zone has worried the investors a lot as the problems there are still not well controlled and to the investors they would becoming more indulging in a perceived “fight to safety” in the US dollar and hence as the figure above tells, the US Dollar to Euro Exchange Rate keeps declining slowly, meaning to say that the US dollar is more popular among the investors because of its good economy situation to provide better shelter to the investors’ fund and that is why the US dollar is becoming stronger.
Another currency that we talk about here is the Renminbi which is the currency of China. In June 2010, the temporary dollar peg was again abandoned, after the Renminbi had risen some 16% against the euro following the onset of the Greek fiscal crisis. However, the Chinese government has signaled that its currency will only be allowed to appreciate gradually against the dollar (Chinability.com 2011). The exchange rate of China Yuan is more under control of the government, and the government’s decision could offset the impact of the Euro crisis and also still the exchange rate with the US dollar is the main concern of the government.
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