[Yooseon Jang (z3288417), Pansy Lau (z3251940), Michelle Tat (Z3289967), Catherine Wang (z3254653)]

Emerging Capital Markets Presentation Report

Who are the creditors of PIIGS? What issues/problems are exposed in the sovereign debt crisis? What are the implications of the crisis for policy makers? The unsustainable levels of national debt and risk of default experienced by the economies of Portugal, Italy, Ireland, Greece and Spain (PIIGS) have elevated these nations to the centre of the Eurozones current sovereign debt crisis. This report will firstly identify the creditors of the PIIGS nations, being the main recipients of sovereign bonds. Furthermore, an examination of the issues facing individual PIIGS nations reveals the presence of both structural and cyclical problems. Finally, the implications of the crisis on policymakers revolve around the implementation of austerity measures, the need for structural reform and expose the downfalls of a monetary union. PIIGS Creditors The economic integration of the Eurozone has led to the manifestation of a web of debt, whereby individual PIIGS governments rely upon each other, as well as the larger EU economies of France, UK and Germany, as primary recipients of their sovereign debt. 1 Furthermore, the European Central Bank, International Monetary Fund and EU hold large amounts of PIIGS sovereign debt following the implementation of bailout packages to Greece, Ireland and Portugal.

1 Schwartz, N. (2010) Ins and Outs of Each Others European Wallets, The New York Times (published 1 May 2010)

[Yooseon Jang (z3288417), Pansy Lau (z3251940), Michelle Tat (Z3289967), Catherine Wang (z3254653)]

With government debt ranging from 65% of GDP in Spain to 139% in Greece, the regions largest economies of Germany, France and the UK have moved to rescue PIIGS economies from financial turmoil by becoming their main creditors.2 Specifically, the largest recipients of total outstanding government debt across all PIIGS nations are non-resident creditors including the ECB.3 In this regard, Germany, France and UK have approximately $US8billion each in general Portuguese sovereign debt, while France and Germany respectively hold $US56billion and $US34billion of Greek central government debt.4 However, Spain and Italy have the benefit of having a large portion of its debt owed by domestic banks as opposed to external investors. In particular, $US73billion in Spanish government bonds (45% of total public debt), 5 and $US259billion of Italian government securities are held domestically. 6 Moreover, the ECB, IMF and EU have taken on significant portions of sovereign debt as part of bailout packages to PIIGS economies. The ECB and IMF/EU holds approximately $US26billion and $US30billion respectively in Irish government bonds,7 while the ECB owns an estimated $US58billion in Greek state bonds as at May 2011.8 Issues and Problems Exposed in Sovereign Debt Crisis

Political weakness corruption, social instability (strikes and protests e.g. Ireland)
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Political weakness includes issues such as corruption in the governments and the occurrence of strikes and protests. Essentially, the greater the political risk within a country, the greater the political weakness there will be. In recent report conducted by Transparency International Greece ,found that Greece is awash with bureaucratic corruption: that everyone from doctors to lawyers to civil servants to government officials are on the take, costing Greeks $1 billion a year to pay them.
http://www.telegraph.co.uk/finance/comment/8604437/Buy-into-Greece-Itscorrupt-bureaucratic-and-unreliable.html

2 Eurostat, September 2011 3 IMF, September 2011 4 BIS, June 2011 5 Bank of Spain, September 2011 6 Bank of Italy, May 2011 7 BIS, June 2011 8 BIS, June 2011

[Yooseon Jang (z3288417), Pansy Lau (z3251940), Michelle Tat (Z3289967), Catherine Wang (z3254653)]

Furthermore the political weakness in PIIGS and neighbouring economies are due to the market volatility in the Eurozone which has brought credit rating downgrades and deterioration in economic growth. Ireland:

o As Ireland officially entered into a recession in September 2008, the country was facing high unemployment rates with over 326,000 people claiming unemployment benefits in the country, the highest recorded level since 1967. Furthermore, the government was planning on imposing a pension levy which could cost 350,000 public sector works up to 2,800 euros each year. This led to protests in early 2009; over 100,000 took part in protests in Dublin to express their anger towards the Irish government and their handling of the recession.#
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Spain:

o The recession has had an especially negative impact on the youth with unemployment rates increase to over 40% for the 20-to-24 year old age bracket. This led to a protest movement in Madrid in May 2011, with over 28,000 protesters participating.
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Greece: o Greece s Financial Crisis as primarily due to the presence of corruption within their government which saw the deliberate misreporting of statistics. The country s lack of transparency about the scale of its debt burden has been a constant risk factor, with the government regularly revising its budget figures downwards.
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On 23 April 2010 the Greek government asked fellow euro-zone members and the International Monetary Fund for a bail out . In exchange for the bail out Greece had to introduce a series of austerity measure s including cuts to public spending and a rise in taxes. This triggered huge levels of strikes and violent protest. Including most recently a 24 hour strike initiated by Greek public transit workers and taxi drivers.#

2. Issues concerning Macroeconomic Policies (that is, fiscal issues and monetary policy) - Rising government deficits and debt levels, bond yield spread increase, inflation, decrease in demand of exports/investment/consumption , unemployment, slow growth rates, debt-to-gdp ratios high,
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Fiscal issues related to the government spending, taxation and interest rate change to help stabilise the economy. Monetary policy is an action by the Federal Reserve to influence the country s availability and cost of money.

[Yooseon Jang (z3288417), Pansy Lau (z3251940), Michelle Tat (Z3289967), Catherine Wang (z3254653)]

Increasing interest rates: As investors lose confidence in the countries ability to pay off their debts, the interest rates will increase. This increase on the bond yields is to compensate for the high risk in loaning further funds. This essentially equates to a high borrowing cost which will make it even hard for countries to raise money to repay its debts. (diagram PIIGS borrowing costs)# High levels of public, corporate and household indebtedness are reflected in growing external debt: economic agents (governments, businesses and households) in the PIIGS spend much more than they produce, leading to wide current account deficits; : Greece s current account deficit reached 11.2% of GDP in 2009, followed by Portugal (10.5%) and Spain (5.5%).This has lead to the accumulation of external debt and explains why the PIIGS countries have become significantly dependant on external financial support. The bail outs are making private investors less keen to hold a troubled country s bonds. As old debts are refinanced and new deficits funded by the richer European nations and the IMF, the share of such a country s debt held by official sources will rise. This will leave a shrinking pool of private investors to bear the loss when the debt is restructured, as a result the loss that each private investor will have to accept becomes greater. Concerns about export growth due to a lack of competitiveness within the PIIGS countries is a key policy issue. The fall in borrowing costs on entry into the euro area led to unsustainable booms in borrowing and domestic demand in these countries, fueling inflation and raising relative prices within the currency union. Restoring competitiveness through domestic cost compression within the euro area will be difficult given deflationary pressures from the recession, and will further exacerbate adverse debt dynamics by limiting nominal GDP growth over coming years.# In the classification of the Global Competitiveness Report 20102011, covering 133 countries, Greece was 83rd in economic competitiveness, Italy 48th, Portugal 46th, and Spain 42nd. Ireland retained a relatively high position number at 29 (see: The Global Competitiveness Report 20102011) Greece and Portugal s financial crisis was largely due to fiscal problems; Their fiscal management was inconsistent with the principles laid down in the Stability and Growth Pact and the Maastricht Treaty. As such, their economy has been buoyed by weak growth, high unemployment, high interest rates and increasing debt service costs. Italy#: o With market interest rates anticipated to increase, this will push the country s cost of servicing debt. o its debt-to-GDP ratio is currently around 120%, however its budget deficits are not considered to be substantially high, at only 4% of GDP. o Italy will have to refinance 26% of its outstanding debt within the next 12 months. o Budget deficit to GDP Ratio is -5.30% (May, 2010). o Average inflation rate since 2000 has been 2.33% o Unemployment rate of 8.30% (Q1, 2011)

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[Yooseon Jang (z3288417), Pansy Lau (z3251940), Michelle Tat (Z3289967), Catherine Wang (z3254653)]

Greece: o its debt-to-GDP ratio is around 160% o Budget deficit to GDP Ratio is -12.70% (May, 2010) o Average inflation rate since 2000 has been 3.39% o Unemployment rate of 14.10% (Q1, 2011) Spain: o its debt-to-GDP ratio is 60% o Budget deficit to GDP Ratio is -11.20% (May, 2010) o Average inflation rate since 2000 has been 2.97% o Unemployment rate of 20.70% (Q1, 2011) Portugal o its debt-to-GDP ratio is 93% o Budget deficit to GDP Ratio is -8.00% (May, 2010) o Average inflation rate since 2000 has been 2.60% o Unemployment rate of 11.10% (Q1, 2011) Ireland: o its debt-to-GDP ratio is 97%.# o Budget deficit to GDP Ratio is -12.50% (May, 2010)# o Average inflation rate since 2000 has been 2.95% o Unemployment rate of 14.70% (Q1, 2011)#

Debt-to GDP (2010)

Budget Deficit-toGDP (2010)

Average Inflation rate since 2000

Unemployment Rate (2011)

Portugal Ireland Italy Greece Spain

93% 97% 120% 160% 60%

-8.00% -12.50% -5.30% -12.70% -11.20%

2.60% 2.95% 2.33% 3.39% 2.97%

11.10% 14.70% 8.30% 14.10% 20.70%

3. Financial panic decrease in investor confidence, large withdrawal of foreign funds, exchange rate depreciation?, non-performing loans, decrease in credit rating
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Although the sovereign debt crisis have been centred on PIIGS, the Financial Crisis has yielded problems for many other European countries and other economies such as the US.This decrease in investor confidence has led to the widening of bond yield spreads in PIIGS and other EU Members. The spread of the European Financial Crisis has led to the downgrading of credit ratings for several countries, which evidences the financial panic in the economies: o In September 2011, S&P downgraded Italy to A from A+

[Yooseon Jang (z3288417), Pansy Lau (z3251940), Michelle Tat (Z3289967), Catherine Wang (z3254653)]

o o

In June 2011, S&P downgraded Greece to CCC from B, the world s lowest credit rating. In June 2011, Moody s downgraded Portugal to Ba2 from Baa1.# In July 2011, Moody s downgraded Ireland to Ba1 from Baa2, with further downgrades anticipated for the next 18 months.#

The evident financial panic across the global economy can be evidenced by the IMF s recent decision to cut its 2011-12 global growth forecast to 4%, a drop from the growth forecast of 4.3-4.5% three months ago.
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The financial panic is fuelled by investors speculations which can lead to capital flight.

4. Property bubble
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With the strong economic growth, economies such as Spain and Ireland experiences substantial growth in real estate prices from 1985 to 2008; there was a high demand to construct more homes and offices across the countries during this period. These development were encourage by the governments and the banks issues substantial mortgages and long-term loans to prospective buyers. This also led to an increase in foreign investment which eventually inflated the economy and was essentially unsustainable. The supply of homes heavily exceeded its demand which led to thousands of building projects being abandoned. Spain:

o Average property prices increased by 270% between 1997-2007, with house ownership reaching over 80%.# The substantial increase in real estate price meant that developments were unaffordable which soon led to a burst in the real estate bubble.# o Capitalization rates, which measures the annual return of income-producing
properties, is currently around 6.5%, which is 2.25 percentage points larger since the third quarter of 2007; this indicates an erosion in Spanish commercial-property prices.#

o Furthermore, analysts believe that the property market will continue to weaken over the coming years given the decline in the Spanish economy.
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Ireland:

o Ireland s sovereign debt crisis was primarily caused by the real estate bubble rather than government s overspending; the state guaranteed six Irish-based banks who had financed the real estate bubble.

[Yooseon Jang (z3288417), Pansy Lau (z3251940), Michelle Tat (Z3289967), Catherine Wang (z3254653)]

The Irish Property bubble began in 2000 and continued until 2006; After 2000, most of the Ireland s economic growth was driven by real estate bubble. In 2006, it was reported that construction accounted for 20% of the nation s Gross National Product (GNP); this meant that the banks had high exposures to commercial property and building loans. Furthermore, wages were driven to high uncompetitive levels. The collapse of the real estate bubble in 2006 led to a drop of the GNP by 25% and an increase in unemployment rate to over 15% by the end of the year.#

5. Moral hazard
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By having the European Central Bank act as the lender of last resort, it raises the issue of moral hazard as it gives the governments the incentives to issue too much debt. The large rescue plan increases the risk of moral hazard , whereby countries do not implement the necessary steps to reduce domestic imbalances on the assumption that the EU, ECB and IMF will bail them out. This could lead to a re-emergence of financing risks in the medium term. As politicians are unlikely to weaken their political position through raising taxes or reduce spending, there is strong incentive to seek out a bailout package or a loan guarantee to reduce its debts. Moreover, as one country is able to obtain a bailout package, it makes it even more difficult for the foreign government and financial institutions to refuse bailouts for out nations; this will lead to our next issue of financial contagion as more economies run the risk of not being able to receive their loan repayments.

6. Contagion (currency, issues for other countries not just PIIGS)

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Contagion, if the term is used accurately, occurs only in circumstances in which other countries are free of the problems of the country that first experienced trouble and yet suffered unwarranted investor disaffection. (Anna Schwartz, 1999)# As PIIGS continue to struggle to repay its debt, banks and other financial institution which have lent these countries money are at risk of contagion which will affect these banks home counties. (diagram European financial contagion)# As the debt crisis deepened in Greece, investors confidence decreased in the other European economies, with the worst impacts on Ireland, Spain and Portugal. Usually, the debt issues would be eased through monetary policies of increasing the money supply or lowering. However, being located in the

[Yooseon Jang (z3288417), Pansy Lau (z3251940), Michelle Tat (Z3289967), Catherine Wang (z3254653)]

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eurozone/having the Euro as the common currency, the individual countries cannot devalue their currency. There is a risk of spreading to the large debtor nations such as Japan and US With spread already widening in PIIGS, there are rising concerns for Belgium and France as their spreads are increasing. For France and Germany, their 10 year spread have widen out to its widest level since the mid 1990 s.# For the PIIGS countries adoption of the euro a decade ago meant they had to cede control over their monetary policy, and a sudden increase in the risk premiums that bond markets assigned to their sovereign debt

7. Liquidity/insolvency issues
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Insolvency is when a party can no longer meet its financial obligation to its lenders when the debts are due. Liquidity refers to the convertibility of ones assets into cash quickly. The liquidity problems in Europe are rooted in fears of insolvency. As investors fear collapse they pull their funds out of the countries leading to decrease in available funds and liquidity. Greece has been assumed to be insolvent. Greece is the only country to default so far, with a bailout package introduced to help reduce its repayments.# Moreover, one of the Central Banks primary roles is to provide liquidity into the financial system. In growing concerns regarding liquidity problems in the eurozone, the Central Banks often intervene and inject money into the banking system to ease the liquidity issue and ensure the money markets can continue to function. However, analysts believe that the European sovereign debt crisis is a not a liquidity problem, but a solvency issue. #

8. Other debt issues:

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In addition to government debts, PIIGs are also dealing with problems associated with bank-related debts, large national debts and pessimistic forecasts of economic growth and deficits in the coming years. Italy s economic growth is expected to increase at an annual rate of 0.7% from 2011-2014, which is lower than the original projection of 1.3%# Greece and Ireland s GDP is expect to decline by 3.6% and 0.9% respectively, with the PIIGS already being deemed as the slowest growers for 2012. (Diagram - GDP growth forecasts)#

[Yooseon Jang (z3288417), Pansy Lau (z3251940), Michelle Tat (Z3289967), Catherine Wang (z3254653)]

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For Portugal, its GDP growth has been negative for the past 6 months at 0.6% and the the growth is expected to remain stagnant for the rest of the year.# For Spain, the GDP growth rate is expected to be around 0.3% for the rest of the year.#

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The unfortunately named PIIGS have seen their bond yields rise sharply again in recent days. Greek, Irish and Portuguese bonds in particular have come under pressure on concerns of deepening economic contractions and possible defaults [1]

Spain: Vulnerable to rising interest rates and financial panic (due to speculators) Issue with interest rates: o As Spain is part of the Eurozone, the country cannot set their own interest rates. o The single monetary policy has meant that excessively loose conditions for our economy have been almost continuous. [3] Falling prices of bank shares, indicating the relationship between the banking and fiscal problems in the Eurozone. On May 9, Standard & Poor's downgraded Greece's credit rating to "B". On May 16, the
European Union (EU) and the International Monetary Fund (IMF) announced 78 billion euros to Portugal as emergency assistance. On June 13, Standard & Poor's further downgraded Greece's credit rating to "CCC", and would continue to maintain a negative outlook. This is the lowest sovereign credit rating Standard & Poor's gives.

Greece: Ireland: Debt crisis was catalysed their decision to guarantee substantial debts of their banking sector during the financial crisis in 2008. Irish property bubble burst slump in the residential and commercial property market with a collapse in sales levels and property values Emigration Unemployment[4] - the number of people demanding unemployment benefit increase to 11.4% in 2009. House prices, the ESRI said, will fall by a third from their peak during the housing boom of 2007. Irish government debt will rise from 41% of the republic's GDP to 58% in 2009, and 70% next year Henry McDonald, April 2009

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[Yooseon Jang (z3288417), Pansy Lau (z3251940), Michelle Tat (Z3289967), Catherine Wang (z3254653)]