- How does Government finance its operations?
- What is Sovereign Debt?
- What is Sovereign Debt Crisis?
- Why Greece has high Sovereign Debt?
- TimeLine of Events
- What’s the EU Exit Rumor?
- consequences IF Greece Exits Eurozone?
- Impact on India?
- Food for thought
How does a Government finance its operations?
- Obviously by putting direct and indirect taxes on your and me. But even after taxing us, there is not enough money to run any bogus Government schemes, then what can they do? That’ll give the answer for…
- Sovereign debt is the money a government borrows from its own citizens or from investors around the world.
Then what is Sovereign Debt Crisis?
- When Government doesn’t have capacity to pay back the Sovereign Debt, it called “Sovereign Debt Crisis”.
- Governments borrow money by selling bonds to investors.
- In return for the investor’s cash, the government promises to pay a fixed rate of interest over a specific period – say 4% every year for 10 years.
- At the end of the period, the investor is repaid the cash they originally paid, cancelling that particular bit of government debt.
- Government bonds have traditionally been seen as ultra-safe long-term investments (aka “Gilt Edged Securities”) and are held by insurance companies and banks, as well as private investors. They are a vital way for countries to raise funds.
What is a bond market?
- Once a bond has been issued – and the government has the cash – the investor can hold the bond and collect the interest every year until it is repaid. But investors can also buy and sell bonds that have already been issued on the financial markets – just like buying and selling shares on the stock market.
- The price of the bond will rise and fall according to speculation and analysis by experts.
For example, you bought a Government of India bond. It says Rs.100 / 4% / 2014.
That is, you paid the “MRP” Rs.100 to Indian Government, and every year they’ll pay you 4% of the Rs.100 until 2014. And on 2014, they’ll also repay you the entire Principal of Rs.100
Suppose things go nice and smooth until 2012. But Then
- There is heavy inflation, you can’t buy even peppermint for Rs.4 and or
- There is a rumor that Government will default and its payment and won’t repay you any money.
In either case, you want to “Exit” from game before its too late. You want to sell the bond to another person and recover whatever money possible and reinvest that money in something even safer and more profitable, for example starting your own Saas-bahu serial. It doesn’t require lot of brain or money (*if you ask the actresses to bring their own makeup, expensive sarees and jewellary), and still you get to earn plenty of ad-revenue from anti-aging and skin whitening creams.
So, you come to sell this bond to me. But I also read the newspapers (except The Hindu), so I know things are not good with Indian Government or economy, so I won’t pay you Rs.100 but only Rs.90 for your bond. You’re not in a position to negotiate, you’re panicked, you just want to exit from this game and you fear that if you continue to hold this bond, 15 days from now, people won’t even pay you Rs.50 for it.
Thus I buy the Bond worth Oringally “MRP” of Rs.100, for Rs.90 from you.
Question: why would I do that? Why would I buy a “not so good-looking” bond from you?
- My profit is more than yours! How? Because, You invested Rs.100 and get Rs.4 every year, so your profit (technically known as Bond-yield) is (4/100) x 100 = 4%.
- While I invested Rs.90 and get Rs.4 every year, so my profit (Yield) is (4/90) x 100 =4.44…% which is better than your 4% yield.
- I may be speculating that after a month or two, the situation with Indian economy / Inflation / Government will improve and then I would be able to buy a peppermint for Rs.4
Why do bond markets matter?
- Because they determine what it costs a government to borrow.
- When a government wants to raise new money, it issues new bonds, and has to pay an interest rate on those bonds that is acceptable to the market.
- The yield (profit) at which the market is buying and selling a government’s existing bonds gives a good indication of how much interest the government would have to pay if it wanted to issue new bonds.
- So, for example, Spanish 10-year bond yields have risen above 6% in recent years. That means that if the Spanish government wants to borrow new money from the bond market for 10 years, it would have to pay an interest rate on the new bond of more than 6% to seduce the buyers.
Borrowing beyond capacity
Governments can just go on print “Bonds” on their HP printers and sell it to junta, because money doesn’t fall from sky. Someone someday will have to pay for it. If they don’t, then the Bond Yield will increase and a point will come when you (Government) have to offer 36% interest rate on fresh bonds to seduce new investors. Therefore, Governments, put limit on their own borrowing. In India we’ve a thing called FRBM (Fiscal responsibility and budget Management).
For Europen Union, back in 1997 when they were forming the gang, they had decided that each gang-member (country) will not borrow beyond 3% of its GDP per year.
But Government of Greece manipulated** its account-books to appear as if they were staying within the 3% limit, but actually they had been borrowing much above their “Aukaat” – almost 13% of their GDP.
**(might have taken coaching from Ramalinga Raju!)
Why is Greece such a messed up Economy?
I’ll copy paste the answer from Amol Agrawal’s article.
- around 1,2 million people are employed by the Greece Government —this includes clerks, teachers, doctors, and priests—which amounts to almost 27 percent of the total working population of the country (France24 2010). Thus one out of four working Greeks is employed wholly or partly in the public sector. More than 80 percent of public expenditure goes to the wages, salaries and pensions of the civil servants.
- Getting a civil service job in Greece is widely perceived as being granted a sinecure and not as a contractual obligation to work. The resulting inefficiency of the civil service reinforced a system of promotions based on seniority and not on merit or talent. One can only move up the ladder more quickly if one has good connections with politicians and trade unionists.
- This huge bureaucracy just keeps making laws. From 1974 onwards, 100,000 laws were passed around 2857 per year!
- Then there are rules limiting competition. You pay a fees to lawyers for everything. You need a degree licence for doing anything in Greece
- In Greece one can find a whole set of laws mandating opening and closing hours of various enterprises, or defining the geographical proximity where two similar establishments can operate, setting minimal prices for various professional services, issuing licenses and preventing or limiting competition.
- Similar restrictions apply to the operation of drugstores. You are only allowed to own and operate a drugstore in Greece if you hold a degree in pharmacology. The same applies to opticians. You can only own a shop selling spectacles if you hold a degree in optics!
- If you have a business and you want to advertise your brand or product you have to pay an amount equal to 20 percent of the advertising expenses to the pension funds of the journalists.
- Each time you buy a ticket on a boat, 10 percent goes to the pension fund of the harbor workers. A part of the ticket price that covers the insurance of passengers goes to the sailors’ social security fund.
- If you sell supplies to the Army, you will have to pay 4 percent of the money to the pension funds of the military officers. When you buy a ticket at a soccer game, 25 percent of the amount goes to the pension funds of the police.
- It is estimated that there are more than 1,000 such levies whose total cost amounts, according to some calculations, to over 30 percent of the country’s GDP
- Greece is a society dominated by rent seeking rather than wealth producing activities. The fact that two thirds of the electorate is living partly or wholly on government hand-outs significantly affects the ideological narratives that are popular in the country.
–end of copy paste–
In short, Greece is not a country but Air India running MNREGA. And adding insult to the injury, due to the recession in USA, the tourism and export industry of Greece had took a huge setback.
TimeLine of Events
- An EU report starts talking about the irregularities in Greek accounting procedures.
- Concern starts to build about all the heavily indebted countries in Europe – Portugal, Ireland, Greece and Spain (PIGS).
A.Raja could give the loans to save these countries but stupid Indian media gets him arrested, while Mohan continues to loop his repeated tape on every 15th August speech that Naxalites are the biggest thread to India, while Pranab continues to loop his tape that everything bad with Indian economy is because of “Global Situation”.Anyways Fast forward to
February 2012: The Austerity Bill
EU To Greece: Ok we’ll give you the money to pay off your debts, and we call this money “Bailout money” but you’ll have to shut down your Air Indias and MNREGAs and we call it “Austerity Measures”.
PM of Greece: “Whaat an idea sir-ji.”
Greece Government introduces the austerity bill in parliament which included following measures
- 15,000 public-sector job cuts
- liberalisation of labour laws (businessmen can easily hire and fire employees)
- Lowering the minimum wage by 20% from 751 euros per month to 600 euros.
Junta of Greece: “Not a good idea sir-ji”
and they start rioting on the street. But since Government kept the promise of introducing reforms, EU gives them billions of Euro as loan.
May 2012: Elections in Greece
- But no party gets clear majority and no coalition Government is formed.
- So they plan to hold election again on June 2012, and a judge has been appointed to head an interim government in the mean time.
What’s the EU Exit Rumor?
There are two major parties in Greece.
- The right wing party: they say we continue in Eurozone, agree to their demand, cut more jobs and public spending for receiving more bailout money.
- The Left Wing Party: they want to renegotiate the loan-terms with EU and IMF and donot want to implement any austerity measures. They’d take a hostile stand against EU, although in media they say “We want to continue in Eurozone” but their agenda and gesture speaks otherwise.
See this same like Paki PM comes to India and speaks in one tone but when he’s back in an election rally in Lahore he’d be speaking an a totally different tone about Kashmir. And there he’ll say India is not cooperating with us and India is the bad guy.
Experts feared that public of Greece will elect anti-bailout parties that reject the spending cuts (austerity measures) suggested by EU and IMF. So this newly elected party will try to renegotiate the bailout terms with EU / IMF to such a ridiculous level, that negotiations will break off and then Greece will exit from EU.
Thankfully for the time being, crisis has been averted as the right wing pro-EU / bailout party has gained the majority.
consequences IF Greece Exits Eurozone?
I’m taking following diagram and points from BBC article
Lines at the Banks
- Ordinary Greeks may queue up to empty their bank accounts before they get frozen and converted into drachmas that lose half or more of their value. Depositors in other eurozone countries seen as being at risk of leaving the euro – Spain, Italy – may also move their money to the safety of a German bank account, sparking a banking crisis in southern Europe.
Loan Default by Greece
- Unable to borrow from anyone (not even other European governments), the Greek government simply runs out of euros. It has to pay social benefits and civil servants’ wages until the new drachma currency can be introduced.
- The government stops all repayments on its debts, which include 240bn euros of bailout loans it has already received from the IMF and EU.
- The Greek banks – who are big lenders to the government – would go bust.
- Meanwhile, the Greek central bank may be unable to repay the 100bn euros or more it has borrowed from the European Central Bank to help prop up the Greek banks.
- Greece’s banks would be facing collapse. People’s savings would be frozen. Many businesses would go bankrupt. The cost of imports – which in Greece includes a lot of its food and medicine – could double, triple or even quadruple as the new drachma currency is introduced.
- With their banks bust, Greeks would find it impossible to borrow, making it impossible for a while to finance the import of some goods at all.
- One of Greece’s biggest industries, tourism, could be disrupted by political and social turmoil (and rioting).
- In the longer run, Greece’s economy should benefit from having a much more competitive exchange rate. But its underlying problems, including the government’s chronic overspending, may not go away.
Businesshouses go Bankrupt
- Greek companies who still owe big debts in euros to foreign lenders, but whose main sources of income are converted to devalued drachmas, will be unable to repay their debts. Many businesses will be left insolvent – their debts worth more than the value of everything they own – and will be facing bankruptcy. Foreign lenders and business partners of Greek companies will be looking at big losses.
- Some contracts governed by Greek law are converted into drachmas (=old currency of Greece before Euro), while other foreign law contracts remain in euros. Many contracts could end up in litigation over whether they should be converted or not.
Sovereign Debt Crisis for Weak Eurozone Nations
- If Greece leaves the eurozone, that will send negative impression among the investors all over the world, that Eurozone countries are not trustworthy, hence they’ll not lend to other countries such as Spain or Italy and if they lend, they’ll charge heavy interest rate.
- This could leave the governments of Spain and Italy short of money and in need of a bailout. These two huge countries together account for 28% of the eurozone’s total economy, but the EU’s bailout fund currently doesn’t have enough money to help them out.
- And as explained earlier, they (Spain and Italy) will have to offer more interest rate on new bonds, because of the Bond Yield problem.
Good for US and Japan
- Nervous investors and lenders around the world may start selling off risky investments (i.e. Bonds and Equities coming from Greece and similar nations) and move their money into safe havens. They’ll instead prefer to park their money in the gilt-edged securities (i.e. the Government treasury bonds of US, Japan, Germany etc.)
- Thus on one hand, the Greece, Spain and Italy will have to pay high interest rate to borrow from market, while US, Japan and Germany can borrow more cheaply.
- Problem for India: Creding Rating agencies are not very happy with India’s performance, they’re unlikely to increase our rating. Meaning, if Mr.X pulls out his money from Greece or other EU nation, he’ll most likely put it in US, Japan and Germany but not in India. Because India is getting negative rantings from Standard and Poors, Moody’s etc.
Political Turmoil in Europe
- As eurozone governments and the European Central Bank (ECB) face enormous losses on the loans they gave to Greece, public opinion in Germany may turn against providing the even larger bailouts probably now needed by big countries like Italy and Spain.
- The ECB’s role of quietly providing rescue loans to these countries in recent months would be exposed and could become politically explosive, making it harder for the ECB to continue to help these troubled nations.
- However, the threat of a meltdown might push Europe’s or the eurozone’s governments to agree a comprehensive solution – either dissolution of the single currency, or more integration, perhaps through a democratically-elected European presidency tasked with overseeing a massive round of bank rescues, government guarantees and growth.
Recession in Europe
- Businesses, afraid for the euro’s future, may cut investment.
- Faced bad news in the press, ordinary people may cut back their own spending. = less demand= could push the eurozone into a deep recession.
- The euro would lose value in the currency markets, providing some relief for the eurozone by making its exports more competitive in international trade. But the flipside is that the rest of the world will become less competitive – especially the US, UK and Japan – undermining their own weak economies.
- Even China, whose economy is already slowing sharply, could be pushed into a recession. (Because people in Europe will cut down their spending = less demand for Chinese goods)
—-End of BBC copy paste—
Why Greece Exit =Trouble for India?
- When investors take out their money from Greece, they’ll most likely convert it into Dollars and invest it US. Means less “supply” Dollar in the international forex market = dollar becomes more expensive, you’ve to offer more rupees to buy same amount of dollar. 1$ might become 57Rs. = crude oil expensive = everything becomes more expensive.
- Some of above investors may also invest in gold, (After loosing faith in bond market). Again same supply-demand situation. Gold becomes more expensive.
- Investors will become more and more cautious about credit-ratings, they won’t dare to invest in places with negative ratings. In a way, right now India is no better than Greece when it comes to inefficient bureaucracy, PSU and policy paralysis. Thus Indian Companies and PSUs will have to offer more interest rates under bond yield problem (why? Because RBI is not cutting down the Repo rate) = so profit margins falls= less production = fall in IIP Index = job cuts= demand falls = fall in GDP. Finally, when GDP growth is negative for two consecutive quarters or more = the Recession.
- Seeing the situation of Greece people (Pension and job cuts), the citizens of other European nations will try to save more and more money for the possible bad times ahead = less spending on luxery items = less demand for indian textiles, polished dimanonds and automobiles.
- Indian businessmen who exported goods and services to Greece earlier, will have trouble collecting their money. Because Greek businessman might simply give up saying “either you accept my Drachma or file a court case on me. I don’t care. I don’t have money”. When Indian businessman cannot collect the payment = job cuts, reduced production= low IIP. (Impact of low IIP already explained in an old article)
Food for thought
- You might wonder- why is Greece against the austerity measures, when the whole world wants them to do it?
- Their logic: if we stop welfare programs and reduce salaries and pensions, then people will have less money to spend = demand supressed = slowdown.
- So instead of cutting the Government expenditure, we should do the reverse, just like what Lord Keynes suggested, “To combat recession, Government should start spending on public works, thus creating jobs and demand in the market.”
Who do you think is right? Greece or the EU?
Fantastic article feel like reading novel..
really only this site has cleared my doubts
thanx a lot
pool of knowldge
….every doubts has cleared…
grt job sir,,
so much thank you
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hi i really enjoyed your wonderful explain about the crisis recently happened in (poor-Greece presently)..having fun during the reading that is unforgettable one in my special life of “reading”!!
Plz share d file
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It have very comprehensive and well articulated explanation which will never ever bore you..
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i am very greatful to you for your contribution. i am an ardent follower of your bolgs and articles.
will you please write something on the following topics with your funny touch obviously…… :-)
1. effect on indian economy because of the inclusion of yuan as an international currency in IMF……
2. effect on economy for simplified GST..
3. climate summit – india’s gains and losses
4. outcome of the WTO nairobi meet…
Really things never seems to be so easy b4 getting in touch of this site….no words for the work you doing :)……u really a gr8 teacher.
Thank you Mrunal Sir,
I never found this topic so easy. :)
Article not only was informative but also fun . Thanks for sharing !