EUROZONE CRISIS

The European sovereign debt crisis or The Eurozone crisis is an ongoing financial
crisis that has made it difficult or impossible for some countries in the euro area to
repay or re-finance their government debt without the assistance of third parties.
Causes of the crisis varied by country. In several countries, private debts arising from a
property bubble were transferred to sovereign debt as a result of banking
system bailouts and government responses to slowing economies post-bubble.
European banks own a significant amount of sovereign debt, such that concerns
regarding the solvency of banking systems or sovereigns are negatively reinforcing.
Concerns intensified in early 2010 and thereafter, leading European nations to
implement a series of financial support measures such as the European Financial
Stability Facility (EFSF) and European Stability Mechanism.
Beside of all the political measures and bailout programmes being implemented to
combat the European sovereign debt crisis, the European Central Bank (ECB) has also
done its part by lowering interest rates and providing cheap loans of more than one
trillion Euros to maintain money flows between European banks.
On 6 September 2012, the ECB also calmed financial markets by announcing free
unlimited support for all eurozone countries involved in a sovereign state
bailout/precautionary programme from EFSF/ESM, through some yield
lowering Outright Monetary Transactions (OMT).
The crisis also had a major political impact on the ruling governments in 8 out of 17
eurozone countries, leading to power shifts in Greece, Ireland, Italy, Portugal, Spain,
Slovenia, Slovakia, and the Netherlands.

CAUSES:

The European sovereign debt crisis resulted from a combination of complex factors,
including the globalization of finance; easy credit conditions during the 20022008
period that encouraged high-risk lending and borrowing practices; the 20072012 global
financial crisis; international trade imbalances; real-estate bubbles that have since burst;
the 20082012 global recession; fiscal policy choices related to government revenues
and expenses; and approaches used by nations to bail out troubled banking industries
and private bondholders, assuming private debt burdens or socializing losses.
One narrative describing the causes of the crisis begins with the significant increase in
savings available for investment during the 20002007 period when the global pool of
fixed-income securities increased from approximately $36 trillion in 2000 to $70 trillion
by 2007.
This "Giant Pool of Money" increased as savings from high-growth developing nations
entered global capital markets. Investors searching for higher yields than those offered
by U.S. Treasury bonds sought alternatives globally.
 The temptation offered by such readily available savings overwhelmed the policy and
regulatory control mechanisms in country after country, as lenders and borrowers put
these savings to use, generating bubble after bubble across the globe.
While these bubbles have burst, causing asset prices (e.g., housing and commercial
property) to decline, the liabilities owed to global investors remain at full price,
generating questions regarding the solvency of governments and their banking systems.
How each European country involved in this crisis borrowed and invested the money
varies. For example, Ireland's banks lent the money to property developers, generating
a massive property bubble.
When the bubble burst, Ireland's government and taxpayers assumed private debts. In
Greece, the government increased its commitments to public workers in the form of
extremely generous wage and pension benefits, with the former doubling in real terms
over 10 years. Iceland's banking system grew enormously, creating debts to global
investors (external debts) several times GDP.
The interconnection in the global financial system means that if one nation defaults on
its sovereign debt or enters into recession putting some of the external private debt at
risk, the banking systems of creditor nations face losses.
For example, in October 2011, Italian borrowers owed French banks $366 billion (net).
Should Italy be unable to finance itself, the French banking system and economy could
come under significant pressure, which in turn would affect France's creditors and so
on. This is referred to as financial contagion.[
Another factor contributing to interconnection is the concept of debt protection.
Institutions entered into contracts called credit default swaps (CDS) that result in
payment should default occur on a particular debt instrument (including government
issued bonds). But, since multiple CDSs can be purchased on the same security, it is
unclear what exposure each country's banking system now has to CDS.

RISING HOUSEHOLD AND GOVERNMENT DEBT LEVELS

In 1992, members of the European Union signed the Maastricht Treaty, under which
they pledged to limit their deficit spending and debt levels.
However, a number of EU member states, including Greece and Italy, were able to
circumvent these rules, failing to abide by their own internal guidelines, sidestepping
best practice and ignoring internationally agreed standards.
This allowed the sovereigns to mask their deficit and debt levels through a combination
of techniques, including inconsistent accounting, off-balance-sheet transactions as well
as the use of complex currency and credit derivatives structures.
The complex structures were designed by prominent U.S. investment banks, who
received substantial fees in return for their services.
CONVERGENCE OF INTEREST RATES IN EUROZONE COUNTRIES

The adoption of the euro led to many Euro-zone countries of different credit worthiness
receiving similar and very low interest rates for their bonds and private credits during
years preceding the crisis, which author Michael Lewis referred to as "a sort of implicit
Germany guarantee."
As a result, creditors in countries with originally weak currencies (and higher interest
rates) suddenly enjoyed much more favorable credit terms, which spurred private and
government spending and lead to an economic boom. In some countries such as Ireland
and Spain low interest rates also led to a housing bubble, which burst at the height of
the financial crisis.
According to their analysis, increased debt levels were mostly due to the large bailout
packages provided to the financial sector during the late-2000s financial crisis, and the
global economic slowdown thereafter.
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.

TRADE IMBALANCES

Commentator and Financial Times journalist Martin Wolf has asserted that the root of
the crisis was growing trade imbalances. Whereas German trade surpluses increased as
a percentage of GDP after 1999, the deficits of Italy, France and Spain all worsened.
A trade deficit can also be affected by changes in relative labor costs, which made
southern nations less competitive and increased trade imbalances. Since 2001, Italy's
unit labor costs rose 32% relative to Germany's.
Greek unit labor costs rose much faster than Germany's during the last
decade. However, most EU nations had increases in labor costs greater than Germany's.
Those nations that allowed "wages to grow faster than productivity" lost
competitiveness. Germany's restrained labor costs, while a debatable factor in trade
imbalances, are an important factor for its low unemployment rate. More recently,
Greece's trading position has improved; in the period 2011 to 2012, imports dropped
20.9% while exports grew 16.9%, reducing the trade deficit by 42.8%.

STRUCTURAL PROBLEM OF EUROZONE SYSTEM

There is a structural contradiction within the euro system, namely that there is a
monetary union (common currency) without a fiscal union (e.g., common taxation,
pension, and treasury functions).
In the Euro-zone system, the countries are required to follow a similar fiscal path, but
they do not have common treasury to enforce it. That is, countries with the same
monetary system have freedom in fiscal policies in taxation and expenditure. So, even
 though there are some agreements on monetary policy and through European Central
Bank, countries may not be able to or would simply choose not to follow it.
This feature brought fiscal free riding of peripheral economies, especially represented
by Greece, as it is hard to control and regulate national financial institutions.
Furthermore, there is also a problem that the euro zone system has a difficult structure
for quick response. Euro-zone, having 17 nations as its members, require unanimous
agreement for a decision making process. This would lead to failure in complete
prevention of contagion of other areas, as it would be hard for the Eurozone to respond
quickly to the problem.

MONETARY POLICY INFLEXIBILITY

Membership in the Euro-zone established a single monetary policy, preventing

individual member states from acting independently.
In particular they cannot create Euros in order to pay creditors and eliminate their risk
of default. Since they share the same currency as their (euro-zone) trading partners,
they cannot devalue their currency to make their exports cheaper, which in principle
would lead to an improved balance of trade, increased GDP and higher tax revenues
in nominal terms.
In the reverse direction moreover, assets held in a currency which has devalued suffer
losses on the part of those holding them. For example, by the end of 2011, following a
25 percent fall in the rate of exchange and 5 percent rise in inflation, euro-zone
investors in Pound Sterling, locked in to euro exchange rates, had suffered an
approximate 30 percent cut in the repayment value of this debt.

INTEREST ON LONG TERM SOVEREIGN DEBT

In June, 2012, following negotiation of the Spanish bailout line of credit interest on long-
term Spanish and Italian debt continued to rise rapidly, casting doubt on the efficacy of
bailout packages as anything more than a stopgap measure. The Spanish rate, over 6%
before the line of credit was approved, approached 7%, a rough rule of thumb indicator
of serious trouble.

POLICY REACTIONS and EU emergency measures

European Financial Stability Facility (EFSF)

On 9 May 2010, the 27 EU member states agreed to create the European Financial
Stability Facility, a legal instrument aiming at preserving financial stability in Europe by
providing financial assistance to euro-zone states in difficulty.
The EFSF can issue bonds or other debt instruments on the market with the support of
the German Debt Management Office to raise the funds needed to provide loans to
euro-zone countries in financial troubles, recapitalize banks or buy sovereign debt.
 Emissions of bonds are backed by guarantees given by the euro area member states in
proportion to their share in the paid-up capital of the European Central Bank.
The 440 billion lending capacity of the facility is jointly and severally guaranteed by the
euro-zone countries' governments and may be combined with loans up to 60 billion
from the European Financial Stabilisation Mechanism (reliant on funds raised by
the European Commission using the EU budget as collateral) and up to 250 billion from
the International Monetary Fund (IMF) to obtain a financial safety net up to 750 billion.
The EFSF issued 5 billion of five-year bonds in its inaugural benchmark issue 25 January
2011, attracting an order book of 44.5 billion.

RECEPTION BY FINANCIAL MARKETS

Stocks surged worldwide after the EU announced the EFSF's creation. The facility eased
fears that the Greek debt crisis would spread, and this led to some stocks rising to the
highest level in a year or more.
The euro made its biggest gain in 18 months, before falling to a new four-year low a
week later. Shortly after the euro rose again as hedge funds and other short-term
traders unwound short positions and carry trades in the currency. Commodity prices
also rose following the announcement.
The agreement is interpreted as allowing the ECB to start buying government debt from
the secondary market which is expected to reduce bond yields. As a result Greek bond
yields fell sharply from over 10% to just over 5%. Asian bonds yields also fell with the EU
bailout.

USAGE OF EFSF FUNDS

The EFSF only raises funds after an aid request is made by a country. As of the end of
July 2012, it has been activated various times. In November 2010, it financed 17.7
billion of the total 67.5 billion rescue package for Ireland (the rest was loaned from
individual European countries, the European Commission and the IMF).
In May 2011 it contributed one third of the 78 billion package for Portugal. As part of
the second bailout for Greece, the loan was shifted to the EFSF, amounting to 164
billion (130bn new package plus 34.4bn remaining from Greek Loan Facility) throughout
2014.
On 20 July 2012, European finance ministers sanctioned the first tranche of a partial
bail-out worth up to 100 billion for Spanish banks. This leaves the EFSF with 148
billion or an equivalent of 444 billion in leveraged firepower.

EUROPEAN FINANCIAL STABILISATION MECHANISM (EFSM)

On 5 January 2011, the European Union created the European Financial Stabilisation
Mechanism (EFSM), an emergency funding programme reliant upon funds raised on the
 financial markets and guaranteed by the European Commission using the budget of the
European Union as collateral.
It runs under the supervision of the Commission and aims at preserving financial
stability in Europe by providing financial assistance to EU member states in economic
difficulty. The Commission fund, backed by all 27 European Union members, has the
authority to raise up to 60 billion and is rated AAA by Fitch, Moody's and Standard &
Poor's.
Under the EFSM, the EU successfully placed in the capital markets a 5 billion issue of
bonds as part of the financial support package agreed for Ireland, at a borrowing cost
for the EFSM of 2.59%.

EUROPEAN CENTRAL BANK

The European Central Bank (ECB) has taken a series of measures aimed at reducing
volatility in the financial markets and at improving liquidity.[226]
It began open market operations buying government and private debt
securities, reaching 219.5 billion in February 2012, though it simultaneously absorbed
the same amount of liquidity to prevent a rise in inflation.
It changed its policy regarding the necessary credit rating for loan deposits, accepting as
collateral all outstanding and new debt instruments issued or guaranteed by the Greek
government, regardless of the nation's credit rating.
The move took some pressure off Greek government bonds, which had just been
downgraded to junk status, making it difficult for the government to raise money on
capital markets.

LONG TERM REFINANCING OPERATION (LTRO)

Though the ECB's main refinancing operations (MRO) are from repo auctions with a
(bi)weekly maturity and monthly maturation, the ECB now conducts Long Term
Refinancing Operations (LTROs), maturing after three months, six months, 12 months
and 36 months. In 2003, refinancing via LTROs amounted to 45 bln euro which is about
20% of overall liquidity provided by the ECB.
The ECB's first supplementary longer-term refinancing operation (LTRO) with a six-
month maturity was announced March 2008.
The first tender was settled 3 April, and was more than four times oversubscribed. The
25 billion auction drew bids amounting to 103.1 billion, from 177 banks. Another six-
month tender was allotted on 9 July, again to the amount of 25 billion.
On 22 December 2011, the EC started the biggest infusion of credit into the European
banking system in the euro's 13 year history.
Under its Long Term Refinancing Operations (LTROs) it loaned 489 billion to 523 banks
for an exceptionally long period of three years at a rate of just one percent. Previous
refinancing operations matured after three, six and twelve months. The by far biggest
amount of325 billion was tapped by banks in Greece, Ireland, Italy and Spain.
MONEY SUPPLY GROWTH

In April, 2012, statistics showed a growth trend in the M1 "core" money supply. Having
fallen from an over 9% growth rate in mid-2008 to negative 1% +/- for several months in
2011, M1 core has built to a 2-3% range in early 2012.

REORGANIZATION OF THE EUROPEAN BANKING SYSTEM

On June 16, 2012 the European Central Bank together with other European leaders
hammered out plans for the ECB to become a bank regulator and to form a deposit
insurance program to augment national programs. Other economic reforms promoting
European growth and employment were also proposed.

OUTRIGHT MONETARY TRANSACTIONS (OMTS)

On 6 September 2012, the ECB announced to offer additional financial support in the
form of some yield-lowering bond purchases (OMT), for all euro-zone countries involved
in a sovereign state bailout program from EFSF/ESM
A euro-zone country can benefit from the program if -and for as long as- it is found to
suffer from stressed bond yields at excessive levels; but only at the point of time where
the country posses/regain a complete market access -and only if the country still comply
with all terms in the signed Memorandum of Understanding (MoU) agreement.
Countries receiving a precautionary programme rather than a sovereign bailout, will per
definition have complete market access and thus qualify for OMT support if also
suffering from stressed interest rates on its government bonds.
In regards of countries receiving a sovereign bailout (Ireland, Portugal and Greece), they
will on the other hand not qualify for OMT support before they have regained complete
market access, which will normally only happen after having received the last scheduled
bailout disbursement.
If Spain signs a negotiated Memorandum of Understanding with the Troika
(EC, ECB and IMF) outlining ESM shall offer a precautionary programme with credit lines
for the Spanish government to potentially draw on if needed \this would qualify Spain
also to receive the OMT support from ECB, as the sovereign state would still continue to
operate with a complete market access with the precautionary conditioned credit line.
In regards of Ireland, Portugal and Greece, they on the other hand have not yet regained
complete market access, and thus do not yet qualify for OMT support. Provided these 3
countries continue to comply with the programme conditions outlined in their signed
Memorandum of Understanding, they will however qualify to receive OMT at the
moment they regain complete market access (until the point of time where they no
longer suffer from elevated/stressed interest rates).

EUROPEAN STABILITY MECHANISM (ESM)

 The European Stability Mechanism (ESM) is a permanent rescue funding programme to
succeed the temporary European Financial Stability Facility and European Financial
Stabilisation Mechanism in July 2012 but it had to be postponed until after the Federal
Constitutional Court of Germany had confirmed the legality of the measures on 12
September 2012.
On 16 December 2010 the European Council agreed a two line amendment to the
EU Lisbon Treaty to allow for a permanent bail-out mechanism to be
established including stronger sanctions.
In March 2011, the European Parliament approved the treaty amendment after
receiving assurances that the European Commission, rather than EU states, would play
'a central role' in running the ESM.
According to this treaty, the ESM will be an intergovernmental organization under public
international law and will be located in Luxembourg.
Such a mechanism serves as a "financial firewall."

PROPOSED LONG-TERM SOLUTIONS

European fiscal union

Increased European integration giving a central body increased control over the budgets
of member states was proposed on June 14, 2012 by Jens Weidmann President of
the Deutsche Bundesbank, expanding on ideas first proposed by Jean-Claude Trichet,
former president of the European Central Bank. Control, including requirements that
taxes be raised or budgets cut, would be exercised only when fiscal imbalances
developed.
This proposal is similar to contemporary calls by Angela Merkel for increased political
and fiscal union which would "allow Europe oversight possibilities."

EUROPEAN BANK RECOVERY AND RESOLUTION AUTHORITY

European banks are estimated to have incurred losses approaching 1 trillion between
the outbreak of the financial crisis in 2007 and 2010. The European Commission
approved some 4.5 trillion in state aid for banks between October 2008 and October
2011, a sum which includes the value of taxpayer-funded recapitalizations and public
guarantees on banking debts.
On 6 June 2012, the European Commission adopted a legislative proposal for a
harmonized bank recovery and resolution mechanism. The proposed framework sets
out the necessary steps and powers to ensure that bank failures across the EU are
managed in a way which avoids financial instability.

EUROBONDS
 A growing number of investors and economists say Eurobonds would be the best way of
solving a debt crisis, though their introduction matched by tight financial and budgetary
coordination may well require changes in EU treaties.
Using the term "stability bonds", Jose Manuel Barroso insisted that any such plan would
have to be matched by tight fiscal surveillance and economic policy coordination as an
essential counterpart so as to avoid moral hazard and ensure sustainable public
finances.
Germany remains largely opposed at least in the short term to a collective takeover of
the debt of states that have run excessive budget deficits and borrowed excessively over
the past years, saying this could substantially raise the country's liabilities.

EUROPEAN MONETARY FUND

On 20 October 2011, the Austrian Institute of Economic Research published an article

that suggests transforming the EFSF into a European Monetary Fund (EMF), which could
provide governments with fixed interest rate Eurobonds at a rate slightly below
medium-term economic growth (in nominal terms).
These bonds would not be tradable but could be held by investors with the EMF and
liquidated at any time. Given the backing of all euro-zone countries and the ECB
"the EMU would achieve a similarly strong position vis-a-vis financial investors as the US
where the Fed backs government bonds to an unlimited extent."
To ensure fiscal discipline despite lack of market pressure, the EMF would operate
according to strict rules, providing funds only to countries that meet fiscal and
macroeconomic criteria. Governments lacking sound financial policies would be forced
to rely on traditional (national) governmental bonds with less favorable market rates.

DRASTIC DEBT WRITE-OFF FINANCED BY WEALTH TAX

According to the Bank for International Settlements, the combined private and public
debt of 18 OECD countries nearly quadrupled between 1980 and 2010, and will likely
continue to grow, reaching between 250% (for Italy) and about 600% (for Japan) by
2040.
A BIS study found that increased financial burden imposed by aging populations and
lower growth makes it unlikely that indebted economies can grow out of their debt
problem if only one of the following three conditions is met:
1. Government debt is more than 80 to 100 percent of GDP.
2. Non-financial corporate debt is more than 90 percent.
3. Private household debt is more than 85 percent of GDP.
The Boston Consulting Group (BCG) adds that if the overall debt load continues to grow
faster than the economy, then large-scale debt restructuring becomes inevitable. To
prevent a vicious upward debt spiral from gaining momentum the authors urge policy
makers to "act quickly and decisively" and aim for an overall debt level well below 180
percent for the private and government sector. This number is based on the assumption
 that governments, nonfinancial corporations, and private households can each sustain a
debt load of 60 percent of GDP, at an interest rate of 5 percent and a nominal economic
growth rate of 3 percent per year.

CONTROVERSIES

The European bailouts are largely about shifting exposure from banks and others, who
otherwise are lined up for losses on the sovereign debt they have piled up, onto
European taxpayers.

EU treaty violations

The EU's Maastricht Treaty contains juridical language which appears to rule out intra-
EU bailouts. First, the no bail-out clause (Article 125 TFEU) ensures that the
responsibility for repaying public debt remains national and prevents risk premiums
caused by unsound fiscal policies from spilling over to partner countries. The clause thus
encourages prudent fiscal policies at the national level.
The European Central Bank's purchase of distressed country bonds can be viewed as
violating the prohibition of monetary financing of budget deficits (Article 123 TFEU). The
creation of further leverage in EFSF with access to ECB lending would also appear to
violate the terms of this article.

CONVERGENCE CRITERIA

The EU treaties contain so called convergence criteria, specified in the protocols of

the Treaties of the European Union. Concerning government finance the states have
agreed that the annual government budget deficit should not exceed 3% of the gross
domestic product (GDP) and that the gross government debt to GDP should not exceed
60% of the GDP (see protocol 12 and 13).
For euro-zone members there is the Stability and Growth Pact which contains the same
requirements for budget deficit and debt limitation but with a much stricter regime. In
the past, many European countries including Greece and Italy have substantially
exceeded these criteria over a long period of time.

Political impact
Handling of the ongoing crisis has led to the premature end of a number of European national
governments and impacted the outcome of many elections:

Republic of Ireland February 2011 After a high deficit in the governments budget in
2010 and the uncertainty surrounding the proposed bailout from the International
Monetary Fund, the 30th Dil(parliament) collapsed the following year, which led to a
 subsequent general election, which further led to a change of government and the
appointment of Enda Kenny as Taoiseach.
Portugal March 2011 Following the failure of parliament to adopt the government
austerity measures, PM Jos Scrates and his government resigned, bringing about early
elections in June 2011.
Finland April 2011 The approach to the Portuguese bailout and the EFSF dominated
the April 2011 election debate and formation of the subsequent government.
Spain July 2011 Following the failure of the Spanish government to handle the
economic situation, PM Jos Luis Rodrguez Zapatero announced early elections in
November. Following the elections, Mariano Rajoy became PM.
Greece November 2011 After intense criticism from within his own party, the
opposition and other EU governments, for his proposal to hold a referendum on the
austerity and bailout measures, PM George Papandreou of the PASOK party announced
his resignation in favour of a national unity government between three parties, of which
only two currently remain in the coalition. Following the vote in the Greek parliament
on the austerity and bailout measures, which both leading parties supported but many
MPs of these two parties voted against, Papandreou and Antonis Samaras expelled a
total of 44 MPs from their respective parliamentary groups, leading to PASOK losing its
parliamentary majority.
France - May 2012 - The French presidential election, 2012 became the first time since
1981 that an incumbent failed to gain a second term, when Nicolas Sarkozy lost
to Franois Hollande.

PROJECTIONS

In 2012 some hedge fund investors with reasonably good track records expect that the
crisis will run its course in 3 to 5 years, saying "The perceived risk is greater than the
actual risk". However, even they shy away from investments in Greece, Italy and Spain.