With fears that the Greek economy could default and spark a global financial disaster, Europe is facing its most severe economic challenge since 1945. The debt crisis in Europe’s 17-nation single-currency zone has entered a new and critical phase.
Greece has a sovereign debt pile of €340 billion ($481.5 billion), or more than €30,000 per capita. The €110 billion bailout it accepted last year from the European Union and International Monetary Fund has proved insufficient in stabilizing the Greek economy. A second package worth €109 billion is now under discussion. Because Greece’s debt is equivalent to 150 percent of its GDP, it holds two unwanted world records: it has the lowest credit rating for a sovereign state, and the most expensive debt to insure. Greece’s people have run out of patience with an ever-deepening austerity drive that has slashed public sector wages by a fifth and pensions by a tenth.
So, how did Greece get to this point?
Greece has been living beyond its economic means in recent years. The Greek government borrowed heavily and went on something similar to a spending spree after it adopted the euro. Public spending soared and public sector wages practically doubled over the past decade. Furthermore, as money flowed out of the government’s coffers, tax income was hit because of widespread tax evasion. More than 6 000 businesses were identified as owing $41 billion in taxes and penalties, and as added embarrassment the top debtor was the state owned railroad, owing an impressive $1.3 billion.
Why does Greece need another bailout?
In 2010, Greece was given €110 billion in bailout loans to help it deal with the repercussions of the 2008 global economic crisis. It is now due to receive another €109 billion. Greece required the bailout because, due to its poor credit rating, borrowing money from the private sector had become too expensive. Since it could not afford to borrow money from financial markets to pay its debts, Greece turned to the European Union and the International Monetary Fund. Their objective was to give Greece time to sort out its economic situation so that the cost of borrowing commercially would come down. Despite these efforts, the situation has not improved. In fact, the ratings agency Standard and Poors recently decided that Greece was the least credit-worthy country that it monitors. As a result, Greece cannot afford to borrow money from the private sector to pay off its massive debt, nor does it have enough money left over from the first bailout.
Why does this impact other countries?
The longer the crisis drags on, the greater the risk that this situation will spread to other troubled euro zone economies like Ireland and Portugal, which have also been bailed out before. The situation could also affect Spain, an economy much bigger and far more expensive to rescue.
A default by Greece would also hammer the banks that hold its debt, including the European Central Bank and big French and German lenders. Europe’s banks are big holders of Greek debt, with perhaps $50-60 billion outstanding. It could also prompt credit markets to freeze up, which happened in American markets after the collapse of financial services firm Lehman Brothers. After the collapse, banks virtually stopped lending to each other. If Greece cannot make its payments on time, an orderly default will ensue, meaning the payment of its debts will be pushed back by decades. A disorderly default could mean that much of this debt would not be repaid—ever. Either way, it will be extremely painful for banks and bondholders.
What’s more, Greek banks are subject to the sovereign debts of their own country, which means that new capital is hard to attain because of its high cost and associated credit risk ratings. A loss of confidence could also spark a run on the banks where people withdraw all their money, making the problem worse. That situation could also spread to overseas banks, which could stop lending until the full extent of a default is known. Greece owes $53 billion to banks in France and Germany alone, which means that these banks would also struggle to operate if the country is unable to pay off its loans.
What do companies have to do?
The best strategy for a European company is to have as little exposure to Europe as possible. Investors and banks are busy drawing up lists of the companies that have the highest proportion of sales to countries outside Europe. Companies with lower quantities of sales in Europe are in luck, but those with a vast majority of sales in Europe will suffer. The first priority for many firms is to reduce their exposure to the most troubled peripheral euro-zone countries.
The next goal for many European firms is to move even quicker into fast-growing emerging economies. For example, Klöckner & Company, which trades metals globally, bought a Brazilian trading company in May, and is preparing to open a China office. Big firms outside of Greece tend to favour further investment in indebted euro-zone countries. However, medium-sized, owner-managed companies bitterly oppose it because family business owners are personally liable for debts. They would rather endure a Greek default than burden their own country with more debt.
What is the current situation?
Greece’s membership in the single-currency euro club means it cannot use the solution of stimulating growth by devaluing its currency. It cannot cut interest rates either because these rates are decided by the European Central Bank in Frankfurt. Instead, the public sector cuts are almost certain to deepen the Greek recession, reducing tax revenues and making it even harder to pay off the debts in future. Protests are taking place in Greece and the population has lost faith in the government.
If the crisis continues, Greece will be driven to the brink of political and economic collapse and the rest of Europe will suffer.
