Financial and Sovereign Debt Crisis in Europe - Essay Example

? New Policies Proposed To Solve The Financial And Sovereign Debt Crisis In Europe. number Word count-2,492 Words Table of Contents Table of Contents 2 Executive Summary 3 Introduction 4 Establishment of a Crisis Management Fund for the Euro Zone 6 Establishment of an Orderly Default Framework 6 Imposition of a ‘Haircuts’ on the Face Value Debt 7 Two tire European Crisis Resolution Mechanism (ECRM) 7 Sovereign-debt Restructuring 8 Closer Economic Integration and Fiscal Union 9 Increasing the Rescue Firepower Funds 10 Conclusion 11 Works Cited 12 New Policies Proposed To Solve The Financial And Sovereign Debt Crisis In Europe. Executive Summary Europe has experienced two interrelated crises over the past few years namely the banking crisis emanating from capital market security losses, as well as homegrown boom-bust problems and the sovereign-debt crisis that was caused by recession experienced in the region. However, the sovereign debt crisis particularly worsened in 2010 raising many concerns over the effectiveness of the fiscal policy adopted by the European Monetary Union, which appeared to have failed totally in abating the crisis. Greece and Ireland were among the worst hit countries while Spain and Portugal experienced its impact to a lesser extent. Nevertheless, other European countries have raised concerns that the crisis needs to be controlled amicably lest it spreads to other European countries a scenario, which may become difficult to solve. As a result, the European Union has proposed a raft of measures, which it aims to use in solving such crises in Europe. This paper will analyze some of the new policy initiatives that the European member states has proposed for tackling the financial and sovereign-debt crisis in the region. Introduction The financial and sovereign debt crisis witnessed in the Euro zone in the recent past has revealed so many shortcomings in the monetary and fiscal policy framework that the European Monetary Union (EMU) has to adopt itself as a way of solving its financial and sovereign debt crisis. This is evident from the fact that the rule-based frameworks for the Euro zone’s fiscal policy developed by the Stability and Growth Pact and Excessive Deficit Procedure has always failed to prevent the debt crisis (Blundell-Wignall and Slovik 5). This is in spite of the fact that the policy has put a lot of emphasis on keeping the debts of the public sectors low, as well as strengthening a forward-looking budgetary planning. Furthermore, even after the occurrence of the crisis of 2010 that resulted in the agitation of the financial markets, it became apparent that the EMU did not have what it takes to manage and solve the crisis as noted by Cottarelli et al. (Par.4). Such a failure has prompted the European Union to respond to the crisis in more appropriate manner that will prevent any financial and foreign debt crisis in the future. The first proposed policy for solving Europe’s financial and sovereign-debt crisis in the region was the stabilization of Greece followed by the establishment of the European Financial Stability Facility (EFSF) that has proved effective in stabilizing markets (Honohan par.2). Nevertheless, Swartz reveals that these crisis responses were established in an ad-hoc manner and on a provisional basis and fails to provide an adequate basis for dealing with any probable future debts and financial crisis (6). There are also several other policies which have been proposed as a means of tackling the financial and sovereign debt crisis in the Euro zone. The paper will examine the new policies that have been proposed to solve the financial and sovereign debt crisis in Europe. Becker argues that Europe is one of the regions that suffered most from the effects of financial and sovereign debt crisis that affected several countries in this region following the debt and financial crisis of the 2010 spring (Par.1). This crisis is said to have affected many financial markets in the region including banking institutions, which suffered most due to default from customers, the impact of which saw some banks and countries seek for help from others countries in order to contain the crisis. Greece is one of the countries that was worse hit by the financial and debt crisis in the region (Blundell-Wignall and Patrick 3). This was despite the measures that had been put in place in an attempt to solve the crises following the financial meltdown of 2007/2008, which affected many countries in Europe. For instance, Blundell-Wignall and Atkinson report that the earlier proposed measures such as rule-based frameworks for the Euro zone’s fiscal policy developed by the Stability and Growth Pact and Excessive Deficit Procedure failed terribly in preventing debt and financial crisis from hitting Europe (6). As a result, a raft of new policies have been proposed by the European Union members as the best way of solving the financial and sovereign debt crises that have been common in the region over the past few years. Findings show that most of these new proposals are aimed at strengthening the Stability of Growth Pact and the Excessive Deficit Procedure (Blundell-Wignall and Atkinson 6). In addition, the new proposal aims at making the present rule of the policies more effective while also strengthening their enforcement through the introduction of stiffer and automatic penalties on any financial institution or country that violates the rule. Some of the new proposed policy measures are described hereunder: Establishment of a Crisis Management Fund for the Euro Zone One of the new financial and sovereign debt crisis management proposals according to Blundell-Wignall and Atkinson was that made by the European Central Bank (ECB), which calls for the establishment of a crisis management fund for the euro zone (7). Honohan argues that this new proposal is intended to come into effect in case the strengthening of the rule-based frameworks fails in preventing future financial and debt crisis in the euro zone (Par. 3). This new proposal according to the ECB will only be used as a last-resort financing at a penalty rate to institutions and governments experiencing challenges in accessing private credit markets. For instance, these new proposals have been used in an attempt to bail out Greece after it experienced one of the worst debt crises recently. In this regard, the ECB was required to release part of the funds kept in the crisis management fund to bail out Greece, a move that at least helped Greece recover from the debt crisis according to Honohan (par.3). Establishment of an Orderly Default Framework Another new debt and financial crisis management proposal was that proposed by Germany a member of the European Union seeking the establishment of an orderly default framework for euro-are member states in a move aimed at making EFSF permanent. Gianviti et el. notes that the proposal were made following a French-German agreement on October 18 2010 that resolves that a permanent and robust mechanism need to be created to safeguard the euro-area member states from future crisis (3). In fact, a report by the European Council of October 28 2010 stated that all heads of states and governments from the euro zone resolved that all member states would create a permanent crisis management apparatus to protect the region’s financial stability in entirety. At the same time, Blundell-Wignall and Slovik indicated that the President of the European Council is committed to consulting with all member states of the European Council in a bid to ensure that the new proposal comes into effect soonest possible (9). Imposition of a ‘Haircuts’ on the Face Value Debt There has also been another proposal by some member states for the imposition of ‘haircuts’ on the debt’s face values in countries worse hit by the financial crisis in Euro zone such as Greece (Sturzenegger, and Jeromin Par.5). In this regard, Gianviti et el. reveals that the German finance ministry is already at its final stages in trying to coordinate the bondholders demands in foreign-debt crisis while at the same time levying ‘haircuts’ on the debt’s face value particularly on governments facing financial distress (3). Gianviti et el note that there have also been some proposals outside the fiscal circles such as that proposed by Gros and Mayer which seek the establishment of the European Monetary Fund, which is geared towards improving crisis prevention, as well as financing a mechanism for overseas debt resolution (par.3). Two tire European Crisis Resolution Mechanism (ECRM) After long deliberation between European member countries, it came out that the problems of the 2010 crisis were as a result of failure of the policy makers that had no clear crisis resolution mechanism to deal with the crisis. The 2007/2008 financial crisis had also been widely blamed on lack of clear policy guidelines to prevent a debt and financial crisis in the euro-area as reported by Sturzenegger and Jeromin (Par.6). In fact, report indicate that the region had been lacking proper rules guiding the market expectations regarding how the Commission and Governments can respond to a crisis attributed to the financial markets volatility when a crisis strike, which did prompt policymakers to act with urgency. In this regard, the European member states have proposed the creation of a two tire European Crisis Resolution Mechanism (ECRM) (Sturzenegger and Jeromin Par.7). The first pillar seeks the creation of a procedure, which will see negotiation being conducted between a foreign debtor and unsustainable debts and the creditors resulting in, as well as enforcing consent on ways of reducing the present value of the future obligation of debtors in a bid to re-establish the sustainability of public fund. Gianviti et al. notes that this will need the establishment of a special court to handle such cases (3). However, as this stands now, the onus rest at the hands of the European Union Court of Justice, which has the jurisdictions to handle cases of this nature. The second pillar of ECRM is that which seeks the creation of rules for financial assistance provision to the euro countries as a means of solving the crisis (Nelson, Belkin, and Mix 5). This proposal states that, in the event that a euro country becomes insolvent, the provision of financial assistance would be based strictly on arrival at an agreement between creditors and debtors thereby reestablishing solvency. In this regard, Gianviti et al. reveals that the provision of financial aid could be vested on EFSF on condition that it is transformed into a permanent and European Union (3). Sovereign-debt Restructuring Following the debt crisis of 2010, the European Union has proposed the establishment of a sovereign-debt restructuring mechanism as a mean of solving sovereign debt crisis in the euro zone. This follows the fact that this mechanism proved effective in helping Greece solve its debt crisis in 2010. Gianviti et al. reveals that the European crisis policymakers did propose the principle of solidarity in 2010 as a mean of helping Greece and other countries in the region solve their debt problems (3). In this regard, report indicates that in the absence of proper rules and procedures other than the ‘no bail out’ coupled with lack of a clear vision as to what constituted a sovereign default and its effects of the euro, it became difficult for policymakers to find the best solution to the Greece and other distressed governments. This led to a proposal that Greece and other distressed countries be saved through sovereign-debt restructuring mechanism that proved very effective in dealing with all uncertainties in the financial market that tend to trigger a debt or financial crisis according to Cottarelli et al. (Par.6). Sovereign-debt resolution according to Cottarelli et al. has the effect of reducing the amount of outstanding debt thereby extending the maturity of the remaining debts while at the same time reducing the interest paid on it (par.6). This is because sovereign-debt restructuring has the effect of returning the debtor-country back to a sustainable public financial state according to Gianviti et al. (3). In addition, sovereign-debt resolution aims at ensuring that the cost of restructuring between the creditors and debtors is fairly distributed. Closer Economic Integration and Fiscal Union The Leaders of the euro zone have also proposed the conceptualization of a more centralized European Union authority over the national economies (Becker par.6). This proposal was highlighted by Herman Van Rompuy, the President of the European Council at the October 2011 summit. However, the recent debate has focused mainly on whether the new round of treaty changes will be desirable for the implementation of the new reforms. However, opinion have been divided with some countries like the U.K. being skeptical of the proposed measures arguing that the treaties can possibly lead to hostilities within each member state, a scenario which could destabilize the Union, notes Becker (par.6). The economic integration also aims at ensuring that all Euro zone countries adopt a single currency to promote ease of solving debt and financial crisis according to Honohan (Par.5). This is because adopting a single currency will grant the ECB absolute powers to adopt effective monetary control across the entire region thereby preventing financial crisis and debt crisis from affecting the Euro zone. Report indicates that several countries have already agreed to adopt the euro currency as their medium of exchange (Honohan par.5). However, some countries have remained skeptical fearing that the adoption of the euro as a single currency will interfere with their monetary policy. This kind of resistance is said to have hindered the implementation of this plan, which has been lauded as the best move of controlling financial and foreign debt in the euro zone. Increasing the Rescue Firepower Funds Sturzenegger noted that the EFSF failed to perform its duties effectively due to insufficient funds (Par.6). As a result, he reports that in order for the EFSF to perform its duties as expected, the leaders of the euro zone has recognized that the current funds allocated for the EFSF is not sufficient to enable it fulfill its mandate. In this regard, Sturzenegger and Jeromin argue that the bailouts to Greece, Ireland, and Portugal did reduce the usable guarantees of EFSF to about €250 billion, which is equal to about $336 billion (9). However, many countries are no longer willing to contribute these funds mainly due to political reasons. As a result, the euro zone leaders have been debating on five sets of proposals aimed at increasing funding to EFSF so as to make it more efficient in solving the problem of financial and foreign debt crisis in the euro zone. One such proposal has been to leverage the available cash. In this regard, some leaders have proposed that EFSF should be allowed to guarantee losses up to the tune of 20% of sovereign bonds particularly in countries that were worst hit by the debt crisis such as Portugal and Spain instead of just purchasing bonds outright (Sturzenegger par.8). It is thought that such insurance will help in increasing the EFSF support value by more than five times, which will have the effect of evading upfront payments Conclusion Europe was indeed one of the regions experienced the worst impacts of the recent financial and sovereign-debt crisis. The worst impact was particularly felt in countries such as Greece, Portugal, Spain, and Ireland following the 2010 spring crisis that hit the region. Most of these countries are still struggling to come out of the crisis. What has surprised many is the fact that the crisis hit the region despite the fact that the European Union had already imitated some measures aimed at preventing such a crisis from hitting the region. Nevertheless, it came out that the European Monetary Union failed to prevent the crisis based on the fact that it has been based on the flawed hypothesis that sovereign-debt crisis is impossible. Therefore, it became important that a crisis resolution mechanism aimed at solving the financial and sovereign debt crisis in the region be established by the European Union member states. In this regard, a raft of proposals has been made with some already being implemented following the passage of a resolution by all member states. Among the new proposals of solving the financial and sovereign-debt crisis in the region included the establishment of a crisis management fund as proposed by the European Central bank (ECB), the establishment of an orderly default framework proposed by Germany and imposition of ‘haircuts’ on the debt’s face values in countries worse hit by the financial crisis. Others include two tires European Crisis Resolution Mechanism (ECRM), sovereign-debt restructuring mechanism, Closer Economic integration and fiscal union, as well as increasing the rescue the firepower funds. Certainly full implementation of these new proposals might help a great deal in shielding Europe from financial and sovereign debt crisis that appear to be common in the region. However, the full implementation will depend hugely on the goodwill of all member states as regards the new proposed policies. Works Cited Becker, Sebastian. “EMU Sovereign Spread Widening, Reasonable Market Reaction or Blundell-Wignall, Adrian, and Patrick Slovik. “The EU Stress Test and Sovereign Debt Exposures,” OECD Working Papers on Finance, Insurance and Private Pensions, No. 4, August 2010, Web. www.oecd.org/dataoecd/17/57/45820698.pdf. Blundell-Wignall, Adrian and Atkinson, Paul E. What Will Basel III Achieve? paper prepared for the German Marshall Fund of the United States (GMFUS), Web. http://gem.sciences-po.fr/content/publications/pdf/Blundell_Atkinson_Basel_III_achievements112010.pdf. Blundell-Wignall, Adrian & Slovik, Patrick. A Market Perspective on the European Sovereign Debt and Banking Crisis. OECD Journal: Financial Market Trends. Volume 2010 – Issue 2. Pp.1-28. Cottarelli, Carlo, Lorenzo Forni, Jan Gottschalk, and Paulo Mauro. “Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely”, IMF Staff Position Note, SPN/10/12, September 2010. Gianviti, Francois, Krueger, Anne O., Pisani-Ferry, Jean, Sapir, Andre & von Hagen, Jurgen. A European mechanism for sovereign debt crisis resolution: a proposal. BRUEGEL BLUEPRINT SERIES Volume X. Bruegel 2010. Pp. iv-37. Gros, Daniel & Mayer, Thomas. “How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund.” Vox 15 March 2010. Web. http://www.voxeu.org/article/towards-european-monetary-fund. Honohan, Patrick. “Financial Regulation: Risk and Reward, speech to Financial Services Summit “10 November 2010. Sturzenegger, Federico. Toolkit for the Analysis of Debt Problems, Working Paper 12/2002. Universidad Torcuato Di Tella. Sturzenegger, Federico & Jeromin, Zettelmeyer. “Haircuts: Estimating Investor Losses in Sovereign Debt Restructurings, 1998–2005”, IMF Working Paper 05/137. 2005. Swartz, Paul. “Greek Debt Crisis—Apocoplypse Later”, Centre for Geoeconomic Studies, Council of Foreign Relations. 2010. Nelson, Rebecca M., Belkin, Paul., & Mix, Derek E. Greece’s Debt Crisis: Overview, Policy Responses, and Implications. Congressional Research Service. August 18, 2011. Pp. 1-19. Exaggeration,” Deutsche Bank Research, June 29, 2009. Read More