Question:
Conduct an analysis on the following topic and prepare an Executive Summary-style report with supporting exhibits (Insightful Graphs, tables etc. from quality expert analyst references used to write the report).
"Does the economic bailout of Spain and Greece spell the beginning of the end for the European Monetary Union (EMU)?"
Answer:
European Monetary Union: The worsening Macroeconomic Picture
The Eurozone sovereign debt crisis, which started in April 2010 after the S&P credit rating downgrade of Greece, seems to head only in the wrong direction. With the bailout of Greece first and now the EU support of €100 billion, the EU is making the spiral of debt only worse. The role of European Central Bank (ECB) is stabilizing the region is being questioned more than ever before and ESM (European Stability Mechanism) and EFSF (European Financial Stability Fund) are debated to only fashionable acronyms than anything else. The current account balance of the region as a whole has worsened from -$23.27 billion in 2010 to -$32.72 billion in 2011. External debt has also increased from $13.72 trillion in 2010 to $16.08 trillion in 2011, a whopping increase of more than 17%. As a consequence, the average inflation rate of the region experienced a jump to 3% in 2011 from 1.8% in 2010. The GDP growth rate has also been hampered and was at a concerning level of 1.6% in 2011, compared to 2.1% in 2010 (more recent macroeconomic indicators can be found in the figure 2 of the Annexure). All these statistics present a gloomy picture of the Eurozone and it makes the disintegration of the region as a monetary block more and more eminent.
ECB and the Funding Mechanism: Inadequate to say the least
The biggest problem with the ECB lending has been the "no condition" lending to the troubled states' banks, which might as well go directly to the governments of the respective states, hence giving them no incentives to improve their debt position. In this light, the €100 billion loan to Spain complicates the matters rather than making them simple. This bailout approximates 10% of Spain's GDP and will lead to an expected 17% increase in the debt GDP ratio of the country. Further, this grant is expected to be absorbed by the failing loans in reality sector and thereby, not leading to any reforms in order to contain the fiscal deficit. What it also does is to worsen the position of the existing creditors as the credit rating of Spain will further go down and the chances of loan recovery follow the same pattern. This fact was reflected by the rising bond yields of the country, which is due to low demand and low price of the bonds, leading to an increase in the rising yield.If the easy way of getting these grants continues to exist, there are more demands of a bailout expected in the coming future, from Italy for an instance.
Another question which arises here is how the EU is funding these bailouts. EU has announced that the sole source of these bailout funds would be either ESM or EFSF. However, the position of these two funds is in a questionable condition, if not critical. The ESM has yet not been approved by the German parliament. The reason for this blockage is the view of Germany against the "no condition" bailout of countries in trouble, like the case of Spain. Further, the strong sentiments against this kind of bailout make it highly improbable for the mechanist to get ratified. The EFSF, on the other hand, is facing a problem of low funds. Spain already owed the EFSF its contribution share of €93 billion which is now highly unlikely to come. With a standing fund of €200 billion, out of which €93 billion not coming to the fund, and the bailout amount of €100 billion to Spain, the fund will be left with only €7 billion. This is too less an amount by any standards and clearly fails the claim of the EU to declare it the funding mechanism of the troubled EMU countries. Even at the full EFSF capacity of €100 billion after the Spain bailout and the €500 billion capacity of the ESM, if at all ratified by the German parliament, the funds will be too small to meet the bailout money requirement, which stands in the tune of €1500 billion according to figure 1 in the Appendix. This indicates the intrinsic issue with ESM and EFSF: they have been too small to contain the damage in the EU since their very inception. While the needs for bailouts have been rising over the period of time, with more and more countries joining the crisis ridden list, the funding has not been adequately increased. Thus, in order to meet the funds requirement, a cooperative step by all the members countries need to be taken, which does not seem to happen in the near future as most of the members are battling their own issues.
The case for EIB: not entirely "risk" free
With the ECB failing to meet the fund requirements through the proposed ESM and EFSF and also not able to impose any conditions on the debtor countries; the case for European Investment Bank (EIB) has gathered momentum. According to PeerSteinbrück of social democrat party of Germany, EIB should take over the role of the source of the funding. The reasons are compelling to do so. First, the EIB, unlike ECB, can impose conditions on the debtor nations in the form of risk adjusted interest rate, forcing the debtor nations to push for reform. Further, the EIB also has a banking license, so it can access the liquidity of the ECB if required. However, there is implicit reason of concern in the EIB funding mechanism as well. With a risk adjusted interest rate interest rate, which will be higher than the normal lending rate, the chances of repayment will decrease even further. The problem with this approach is that while it takes care of the risk factor involved in lending, it also increases the chances of a credit default. This, in turn, might lead to an all-round default on the EIB loans from the debtor nations, worsening the situation and making the German economy more dependent on these nations.
Conclusion
With the bailout of the Spain, coming after the bailout of Greece, the problems of the EUM seem to get aggravated. The "no conditions" ECB lending may spark a demand for grants from other troubled members, creating the problem of moral hazard and leading to the Domino Effect. The mechanism in place to handle the need for this kind of money, namely ESM and EFSF were always and are today incapable of meeting the requirements. Even the EIB takeover as the source of funding seems to be problematic due to the implicit higher rates of lending. This all points out to a stalemate in the EUM and the problems for Germany are increasing with every passing day. If it goes with the view of keeping the region intact, it might become dependent on the member nations due to the heavy loans it has granted them. So, the future of the EUM lies more or less in the hands of Germany, and of course, its affection to the integrity of the region.