The Bailout for Greece and Implications for EU and Pakistan

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Context

300_AthensLeaders of the sixteen EU member states have finally given the go ahead to an 110bn euro loan to Greece with the intention of preventing its debt crisis from spreading any further. This three-year loan comes with a condition that Greece should cut back on its public spending. The EU leaders have also put forward recommendations for a European Stabilization Mechanism to promote financial stability.

Furthermore, the EU leaders affirmed their commitment to speed up deficit reduction. They also decided to tighten EU’s budget policies, supervise deficits and competitiveness and use all the available means to bring stability to the region.

The package consists of strong measures to reduce public spending and raise the government’s revenue. Greece will be required to reduce wages and pensions, increase Value Added Tax (VAT) by 2% from the current 21% and raise taxes on tobacco, alcohol and fuel by at least 10%. The IMF had imposed a similar VAT requirement on Pakistan when it approved an emergency package worth $7.6bn dollars in November 2008 to prevent a balance of payments crisis.

Analysis

350_GreeceThis financial assistance comes at a time when fears of Greece debt crisis threatening the continuance of the Euro as the combined currency of the EU are widespread. It is being hoped that the bail out will help mitigate fears of the crisis spreading from one indebted country of the EU to another.

The efforts for political union between the European countries gained momentum at the closing stages of the Cold War. The French were afraid of the prospect of a reunited Germany dominating Europe once more. In response, France engaged Germany in the process of the European building through the formation of a single currency for the region. The government of Germany accepted this wholeheartedly in exchange for the promise of more serious attempts towards political union between the European countries.

The introduction of the Euro and the establishment of the Eurozone was a major milestone in the history of Europe. The debt crisis in Greece is threatening to be a crucial setback or even a reversal of Europe’s unification process. This crisis is the consequence of a EU country spending extensively and mounting up its deficits, and therefore facing the likelihood of not being able to pay back its debts. It was then forced to plead to the EU member states to provide assistance with the repayment.

Europe’s PIGS (Portugal, Italy, Greece and Spain) had been extraordinarily extravagant in their spending and consumption levels, and hence have accumulated massive debts. Germany, on the other hand, has the highest rate of savings in Europe. Being the strongest economy in the EU, Germany is considered the most significant rescuer for Greece and other countries. However, the majority of the German public was strongly opposed to the German government and EU providing assistance to Greece to help steer itself out of crisis.

The main reason why this bail out was approved was the fear that if the Greek government can’t pay back its debt, it will definitely pave the way for a new wave of global financial meltdown, and will result in the remaining three PIGS countries to follow Greece’s trend. As the debt crisis in Greece intensifies, it has become commonplace to argue that the subsequent chain reactions will ultimately lead to the end of EU and reversal back to nationalism and protectionism.

IMF and Greece

The IMF has approved a 30bn euro three-year loan for Greece as part of a joint EU-IMF 110bn euro bail out package. The package consists of strong measures to reduce public spending and raise the government’s revenue. Greece will be required to reduce wages and pensions, increase Value Added Tax (VAT) by 2% from the current 21% and raise taxes on tobacco, alcohol and fuel by at least 10%. The package is designed to help the government reduce its deficit to below 3% by 2010 (from 13.6% in 2009) and put debt-to-GDP ratio on a downhill trajectory.

The IMF had imposed a similar VAT requirement on Pakistan when it approved an emergency package worth $7.6bn dollars in November 2008 to prevent a balance of payments crisis. The loan was subsequently increased to $11.3bn in July 2009. Pakistan received a third installment of $1.2bn in August last year, bringing the total payment to $5.148bn.

The Federal Board Of Revenue of Pakistan, which is in charge of tax collection, has proposed a VAT of 15%. Critics were quick to point out that the proposed VAT will add to inflation, reduce people’s spending power and slow down demand in a country that is already gripped with 13% annual rate of inflation and severe power shortages.

Likely impact of the EU crisis on Pakistan

The EU accounts for about 20% of Pakistan’s external trade. The Pakistani exports to the EU (mostly textile and clothing) amounted to 3.3 billion euros in 2008 and the EU exports to Pakistan (mostly machinery, and pharmaceutical and chemical products) amounted to 4.3 billion euros in the same year. The composition of Pakistani exports (and imports) to EU countries is shown in the linked graph.

As we can see from the linked table, Pakistan has been running trade imbalances with the EU for the last few years. This recent financial crisis is likely to further widen the country’s trade deficit. Pakistan is heavily relying on textile and clothing, which account for most of the country’s exports. In periods of crisis, people are less likely to spend on these products as much as they spend on necessities, particularly at a time when the customer confidence is at an all time low. The value of the Euro has fallen due to the fear that countries like Spain and Portugal could face similar crisis, which is likely to make imported products to Europe more expensive.

Pakistan has to change its over-reliance on textile and clothing if it is to improve its trade imbalances. High costs of production also get in the way of efforts to increase exports, making Pakistani products less competitive in international markets. To mention just one example, electricity tariffs in Pakistan are the highest in the world, which has a wide-ranging effect on the cost of production.

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