The Impact of Small Economies on Financial Markets: The European Crisis of 2010 - Assignment Example

?Critically analyze how the government debt problems initially faced by a few relatively small economies could trigger such a wide impact in financial markets during 2010-2012 (euro crisis) Introduction The European crisis is an ongoing financial crisis experienced by a significant part of the European zone, primarily affecting Greece, Spain, Ireland, Cyprus, and to a certain extent, the rest of Europe. It is a crisis which has been largely credited to the sovereign government crisis as well as issues in the financial market affecting various countries in the European zone. This paper seeks to present the issues experienced under the financial market, mostly those which relate to the stock market, the bond market, and the equity market. The issues referring to the economies affected by the crisis shall also be discussed in this paper in order to establish the impact of sovereign debt to the euro financial crisis. This paper is being carried out in order to establish an academic and analytical discussion of the European crisis, linking its causes with its eventual impact on a larger economic region. Body The European crisis significantly impacted on the European financial market. Various elements colluded in order to cause the European crisis, with the crisis more or less unfolding in smaller economies, including Greece, Portugal, and Ireland. The money market was significantly affected by the deterioration in market conditions which started in 2007 (European Central Bank, 2012). The interbank markets are usually subjected to counterparty risk. The collapse of Lehman Brothers in 2008 led to lower confidence in the market, which then caused issues in financial integration (European Central Bank, 2012). Such event triggered the increase in cross-country dispersion in overnight rates, as well as lower interbank market activity. Although measures to address market tension were implemented by the European Central Bank, the tension re-emerged in 2010 due to pressures in euro government bond markets (European Central Bank, 2012). More remedies were implemented by the ECB which helped improve the money market in the euro area. However, in 2011, more pressures on the euro sovereign bonds caused issues in market integration. Such deterioration also became apparent in the secured financial market. In 2011, the ECB once again introduced remedies to ensure liquidity support for financial institutions (European Central Bank, 2012). Price-based remedies implied deterioration in the integration of the money market, specifically for short maturities. Integration gains which were expected after the bailouts were reversed by the crisis. With longer maturities, the measures of integration seemed to be stable; however in 2011, these measures actually indicated deterioration (Dadush, et.al., 2010). The sovereign bond markets went through significant tension in 2011. During the onset of the financial crisis in 2010, only three smaller countries were severely affected; however, in 2011, the larger countries were soon affected, especially in terms of their bond yields (European Central Bank, 2012). Moreover, market declines in sovereign yields could not be reached with the implementation of fiscal adjustments, as in the case of Ireland. Improvements in the sovereign bond market were evaluated based on simultaneous movements in yields. Europe for the past 2-3 years has been faced with a very serious crisis (European Commission, 2010). The bond market has already been closing to the euro-area countries, and for those who are still open, they are charging high rates of interest for any loans or investments. The increase in bond yields is based on the fact that where investors view more significant risks associated with their investments in a country’s bonds, they would also likely need higher returns in compensation for such risks (European Commission, 2009). An unfavourable cycle often ensues from this situation as the demand for higher yields would lead to higher costs in borrowing for the country. This causes financial issues and strains, often leading investors to demand higher yields; and then the cycle starts again (World Bank, 2010). Loss of confidence among investors causes sales to impact on the country as well as other countries having similar issues. This phenomenon is referred to as contagion. The contagion has caused the European debt crisis to be a major focus for the global financial markets from 2010 to 2012. Due to the market crisis from 2008 to 2009, investors have been quick to react to any form of negative news from Europe (Constancio, 2012). Their reactions included the sale of anything risky and the purchase of government bonds from the largest and most financially secure countries. The European bank stocks did not do well as compared to their global counterparts, especially during times of crisis (Constancio, 2012). Bond markets for affected countries also did not do well with rising yields causing prices to fall. Moreover, yields from US Treasuries declined to record low levels, reflecting investors seeking safety. Contagion is a form of systemic instability, one which was very much apparent during the European crisis. Just as a health contagion refers to the spread of a disease, economic contagion refers to the spread of the economic turmoil or crisis. This crisis causes widespread economic imbalances, shocks and concurrent failures (Constancio, 2012). As imbalances weaken the system, the different transmission channels would interact and even strengthen the contagion. This would likely be seen in the current euro crisis context with the financial markets knee deep in problems, fiscal deficits, and high debt levels (Amisano and Tristani, 2011). Moreover, the fact that many countries which used to be competitive, like Greece and Portugal, have lost their competitiveness seems to have exacerbated the contagion. The smaller economies of Greece, Portugal, Ireland, and Cyprus experienced significant issues with their sovereign debts which triggered and further pushed the contagion forward. Greece experienced its economic peak during the mid-2000s when it was considered one of the fastest growing economies in the European zone (Competition Master, 2012). Amidst this economic peak however, it also had a large structural deficit. As a result, when the global economic recession unfolded in the late 2000s, Greece suffered significantly because its primary businesses – shipping and tourism – were very much vulnerable to the changes in the normal business cycle (Competition Master, 2012). The government allocated funds significantly in order to ensure their functionality; as a result, their debts also rose significantly. Due to its rising debt and economic issues, Greece was prompted to ask for a €45 billion loan from the European Union and the International Monetary Fund (Competition Master, 2012). As a result, their sovereign debt rating was dropped to BB+ due to possible issues of default. As a result of the downgrade, the global stock markets as well as the euro currency suffered a decline (Pratley, 2012). Another smaller economy, Ireland, has also impacted on the European economic crisis. The Irish sovereign crisis was credited to the state serving as guarantor to six Irish banks that supported a property bubble (McConnell, 2011). This crisis started first with a real estate boom for Ireland. During the boom, various Irish banks were loaning money to many citizens who were jumping into the real estate bandwagon. However, the world economy suffered an economic downturn during the late 2000s and caused the collapse of the real estate business (McConnell, 2011). Many people were unable to pay back their loans. This crisis eventually led to the collapse of the Irish economy, mostly manifested by high unemployment rates and significant budget deficits in their GDP (McConnell, 2011). Their credit rating fell rapidly due to their banking losses, especially as many depositors and bondholders cashed in. In the case of Portugal, another smaller economy, the inflation of the bonuses of top management and head officer bonuses as well as wages from 1974 to 2010 was the primary cause of their increase in national debts. This increase also caused much slippage in their government-controlled public works (Haidar, 2012). With unchanged recruitment policies, the crisis also caused the rise in the number of their public employees. Mismanagement in their credit, public debt creation, and structural cohesion allocations for over forty years also created an economic disaster waiting to unfold (Haidar, 2012). The unavoidable eventually unfolded with the advent of the global economic crisis which was exacerbated by the US credit problems. Due to its existing issues, Portugal was significantly affected by the crisis. This led to a downgrade of its sovereign bond rating which then caused much pressure on their government bonds (Haidar, 2012). In the case of Spain, this country did not suffer from considerable debts when compared with other countries affected by the crisis. Debt was avoided with the ballooning of their tax revenues from the real estate bubble which then helped support government spending (Murado, 2010). Its debts are also controlled internally; however, their debts, when analysed based on their GDP is expected to reach about 90% of their GDP by the year 2013 (Hidalgo, 2012). In the case of Cyprus, the yields on the long-term bonds increased in late 2011 due to the fact that the country’s major credit ratings were downgraded following the explosion of one of their major power plants (Hadjipapas and Hope, 2011). This explosion slowed down their financial and structural activities and reforms. The financial crisis became even more severe with Portugal being downgraded in mid-2011 and with Greece’s economic issue not being resolved, the contagion became a very much apparent issue (European Central Bank, 2012). The downgrade also indicated that Portugal would likely need another round of refinancing. Moody established that another round of refinancing would cause the participation of the private sector in Portugal. This did not however present a favourable solution to the issue. The downgrade of Portugal as well as issues in Greece triggered a sell-off in Spanish and Italian government bonds (European Central Bank, 2012). There were no negative reports on the economy of Spain and Italy at that time. But then, in July of 2011, Italy bond yields increased by 100 basis points, and Spain yields increased by about 80 points. These market changes were triggered by the contagion (European Central Bank, 2012). The initial increase in bond yields can be understood by issues raised due to the scope and extent of the private sector association in Greece, a condition for another bailout programme during the euro area convention in July of 2011. Various investors considered it rational to decrease their sovereign debt and for others to decrease their exposure to various countries in the euro area as market issues concerning sovereign debt sustainability would likely become a bigger problem for them. Other investors also withdrew due to the highly volatile financial market. Falling demands caused the decrease in prices and then also caused the value attributed to bonds being held by other investors (Alter and Schuler, 2011). Investors wanted to decrease exposures when their positions were under unfavourable conditions. They also wanted to handle and accept losses at the earliest time in order to avoid exposure to potentially significant losses. Reduced prices in bonds also caused higher yields which then increased the sustainability of debt prospects for governments which had major funding issues, thereby confirming the expectations of investors (Alter and Schuler, 2011). Due to the integrated currency for the euro area, the contagion spread fast and easily to the different parts of Europe. Unravelling this crisis will likely take a long time because of the complications which have been added to the problem, as well as the persistent issues being encountered by the smaller economies of Greece, Portugal and Ireland. Conclusion The study above implies that the euro crisis had a significant impact on the equity markets, bond markets and money markets in Europe. One of the main impacts is that the crisis caused a major imbalance in the economic system and the prices and exchange currencies for bonds and equities. Investors became significantly careful about their investments in the euro area and were quick to withdraw and shift their investments at the first sign of trouble. This further caused instability to the euro economies, most especially the smaller economies. 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