Explaining the EU debt crisis
The European Union (EU) debt crisis was spurred initially by concerns surrounding Greece’s debt level, however, other EU member countries, including Portugal, Italy, Ireland and Spain, are now also caught up in the financial troubles.
The background to the crisis
The Greek economy has had prominent periods of boom and bust over the last decade, and over this timeframe overall debt levels have risen markedly. Public debt was increased in an effort to support the Greek economy during periods of downturn. Private debt also became much easier to obtain in boom times, which led to a dramatic increase in the level of debt held by Greek citizens.
But why is a country as small as Greece the trigger for a broader regional economic emergency?
Complex financial interdependencies exist
Despite Greece’s economically small stature within the EU, Greek debt is primarily funded by French and German banks. As these banks are backed by their respective governments, Greek debt effectively becomes an issue not just for the Greek population but also for the citizens of France and Germany.
French, German and British banks also provide significant levels of funding to Spain, and in turn, Spain is owed significant amounts of money by its neighbour Portugal.
Spain remains one of the more fragile EU members with unemployment levels nearing 20% of the population. Given that they are exposed to one-third of Portugal’s total debt, the outlook for the Spanish economy looks set to remain weak for some time to come.
The largest debtor in the region is Italy, which owes US$1.4 trillion to its EU neighbours, a figure that is more than six times the level of Greece’s debt. France has provided a massive US$511 billion of debt financing to Italy, which, to put it in perspective, represents 20% of France’s overall economic output in 2009.
Containing the crisis is vital
In a worst case scenario, if one country were to default on their debt the situation could easily escalate. The debtor country would have its access to credit reduced in order to provide key services to its citizens. This is likely to result in severe government spending cutbacks and possible civil unrest as a consequence.
The countries providing the credit would shoulder the burden of the debt default, and as they would no longer be receiving any principal or interest repayments from the debtor country, would have less income to support their own economies. This would leave the credit-providing countries financially vulnerable and at possible risk of defaulting on their own debts. A ‘chain reaction’ outcome could theoretically destabilise not only the EU region but financial markets globally.
No easy solution
Resolving the EU debt crisis won’t be easy. Portugal, Italy, Ireland, Greece and Spain are facing EU-mandated financial austerity measures to reduce their levels of debt. Implementing these measures is an essential step to contain the crisis, but there are risks attached.
From an economic perspective, trying to reduce both private sector and government debt levels at the same time can easily result in a sudden and severe economic contraction, unless that country can manage to increase its exports. Most commonly this can be achieved by a country depreciating its currency, which makes exports cheaper and usually serves to stimulate demand. When such moves do not result in export growth, existing debt is even harder to pay off.
Outcomes for Australian investors
Sound investing opportunities are expected to remain in an area as geographically and culturally diverse as the EU, but it is important to be aware of the dark clouds that continue to lurk on the horizon.
Researching thoroughly before making any decision to invest is always a good idea, but is especially paramount in the present economic climate.
Sources:
www.nytimes.com Bill Marsh, Europe’s web of debt, The New York Times, 1 May 2010 (accessed 23 July 2010)
www.voxeu.org Paul De Grauwe, Greece: The start of a systemic crisis of the Eurozone? Vox EU, 11 May 2010 (accessed 23 July 2010)
