The European Sovereign Debt Crisis - Essay Example

?On the European sovereign debt crisis I. Introduction A popular definition of the European sovereign debt crisis is that it is a situation in which several European countries face a risk of a breakdown in their financial institutions, deterioration of the problem of their large government debts, and condition of bond yields rapidly shooting up (Investopedia 2012). However, Wallison (2012, p. 71) expressed the view that “in a true sovereign debt crisis, a country cannot meet its debt obligations, largely because it does not have enough of the currency in which its debt is denominated.” The European sovereign debt crisis began in 2008 with the banking crisis in Ireland with the contagion of the crisis spreading out to Greece, Ireland and Portugal in 2009 (Investopedia 2012). According to Investopedia (2012) the crisis led to the reduction of the confidence of the market for European businesses and economies. In contrast, according to the version of Constancio (2012), the European sovereign debt crisis emerged only in spring 2010. The European sovereign debt crisis is the climax of the banking crisis resulting from the demise of the Lehman Brothers and the resulting bailout extended by governments to their banking system (Constancio 2012). In other words, it is held that the European debt crisis started out as a financial crisis from the Lehman Brothers. In the climax of the crisis, government was forced to support the financial system, creating large debts for government leading to the sovereign debt crisis. II. Impact on bond and other markets (equity, derivatives, commodities, forex, gold, etc.) Constancio (2012) has a good discussion on the emergence of European sovereign debt crisis and its impact on the financial markets. We use his interpretation. After the failure of the Lehman Brothers, the ECB or the European Central Bank implemented a policy of strong credit support and measures to boost liquidity way above than what could be achieved by a mere interest rate policy. The European government implemented measures to increase the maturities for debts, more access to foreign currencies and a program of bond purchases. The European sovereign debt crisis became severe with Moody’s downgrade of Portugal on 5 July 2011 (Constancio 2012). The situation plus the risk of a Greek default triggered a sell-off of Italian and Spanish assets. The initial effects of a sovereign debt crisis are for bond yields to go up. However, investors find it appropriate to reduce their exposures to government bonds in view of risks that governments may not be able to pay for their debts. Simultaneously, markets can expect that the foreign exchange markets can be affected substantially as demand for currencies affected by the crisis can significantly go down, proportional to the perception of the extent that the would be affected by the sovereign debt crisis. The effect on the foreign exchange market is important as the effects reverberate on the equities, commodities and derivatives markets. Expected depreciation of currencies affected by the sovereign debt crisis can lead to falling equities, commodity prices and derivative prices. However, as markets are interrelated, or as companies in one country may have investments in companies directly affected by the sovereign debt crisis, all of the financial markets are affected. The more correlated the companies in a region, for example, the more the rest of the markets are affected by the sovereign debt crisis in one country and soon, especially as governments respond to the crisis with bailouts and enhanced liquidity, the correlated governments and economies are affected by the sovereign debt crisis and not only the countries that were initially affected by the sovereign debt crisis. In contrast, to the extent that gold is seen as a store value of value, gold prices can pick up and enjoy a better market. When the financial markets are in doldrums and gold is seen as the better store of value than the bonds, equities, commodity markets, and derivatives, the gold market can be on a winning streak. However, softening of demand is one key feature in a sovereign debt crisis (Blommestein 2010). III. Sovereign default and lessons for the Eurozone from other defaulted countries According to Weist et al. (2010, p. 413), “history has shown that public borrowing accelerates markedly and systematically ahead of a sovereign debt crisis.” Thus, a key insight from Weist et al. (2010) is that excessive public borrowings have constituted as a major culprit in sovereign debt crises. Buccheit (2011) identified six lessons from other defaulted countries of Mexico, Latin America and Ruritania. However, it is his first recommendation that is most useful: do not make allow the transformation of the sovereign debt crisis into a banking crisis. Unfortunately, the current sovereign debt crisis in Europe has its roots in the banking crisis of countries such as Iceland. Thus, one possible interpretation of Buccheit’s recommendation is that when a sovereign debt crisis in a specific country did not originate from a banking crisis, it is wise not to allow the sovereign debt crisis to spread into the banking sector and precipitate a banking crisis. If, on the other hand, the sovereign debt crisis originated from a banking crisis, perhaps a good interpretation of Buccheit’s recommendation is for economic authorities to see to it that the handling of the sovereign debt crisis is not done in a manner that the banking crisis deteriorates. In other words, government authorities must see to it that the handling of the sovereign crisis is one in a manner that the banking system is kept healthy. Citing the experience of early post-World War II Germany, Mexico and many Latin American during the 80s, Radice (2011) pointed out that savage government expenditure cuts will only worsen a public sector deficits consistent with the prediction of Keynes. Similarly, Radice (2011) prescribed against forcing a complete repayment schedule from the countries affected by the sovereign debt crisis. Radice (2011) noted that “it was the imposition of austerity upon Germans that provided the economic and social conditions underlying the rise of Hitler.” Instead of savagely cutting spending in the face of a sovereign debt crisis, the opposite was done in Germany: a Marshall Plan Aid Programme ensured that demand was boosted up while reconstructing both Europe and Germany (Radice 2011). In the Argentinian sovereign debt crisis, international support and the International Monetary Fund endorsements were also seen as crucial for moderating the crisis (International Monetary Fund 2003). De Paoli et al. (2006) made a similar point for the Russian sovereign default: banks must continue lending to country, perhaps through loan rescheduling, for countries affected by sovereign debt crises. Meanwhile, drawing on the experience of the ongoing European zone sovereign debt crisis, Coeure (2012, p. 3) argued that “financial markets are prone to exaggeration, which amplify further the pro-cyclicality inherent in asset valuations.” The exaggeration tends to worsen the effects of a crisis or of a difficulty. Exaggerations can lead to assets being unsold, exchange rate depreciation or volatility, depreciated asset prices, shrinkage in demand, and lower government revenue earnings. While there may be real basis for some problems in the financial markets, a crisis can emerge because of exaggerations even if the variable values do not still warrant the transformation of a problem into a crisis. In other words, a knee-jerk reaction can exacerbate a problem into a crisis grade. IV. Effect on the financial landscape, lessons and trends and emerging Let us look at the financial landscape through the charts. Constancio (2012, p. 122) depicted how sovereign debt crisis from Greece, Ireland and Portugal affected Italy and Spain in Figure 1. Figure 1. Spread of sovereign debt crisis from Greece, Ireland, and Portugal to Italy and Spain Source: Constancio 2012 In other words, it is clear that the Eurozone sovereign debt crisis has depressed bond prices. The country figures are in yellow green (Italy and Spain) and Constancio (2012) basically argued that the effects of the European sovereign debt crisis in Italy and Spain have been transmitted from Greece, Ireland and Portugal. Meanwhile, the Bloomberg tables and chart below reveal other things. Table 1. Government budget imbalance of select European countries Country % Last % Year Ago Ireland -13.4% -30.9% Greece -9.4% -10.7% Spain -9.4% -9.7% UK -7.8% -10.2% France -5.2% -7.1% Netherlands -4.5% -5.1% Portugal -4.4% -9.8% Italy -3.9% -4.5% Belgium -3.7% -3.8% Germany -0.8% -4.1% Source: Bloomberg 2012 Table 1 indicate the country budget imbalances. Based on Table 1, the countries that continue to be seriously affected by the ongoing European sovereign debt crisis are Ireland, Greece, and Spain. The UK, France, Portugal are also seriously affected although negative imbalances are also experienced by Italy, Belgium and Germany. Table 2 shows the employment levels in select countries of Europe. Table 2. Unemployment level in select countries of Europe Country % Last As Of Spain 25.8% Sep 30 Greece 25.4% Aug 31 Portugal 15.7% Sep 30 Ireland 15.1% Sep 30 France 10.8% Sep 30 Italy 10.8% Sep 30 UK 7.8% Aug 31 Belgium 7.4% Sep 30 Netherlands 5.5% Oct 31 Germany 5.4% Sep 30 Source: Bloomberg 2012 Based on Table 2, the countries severely affected through its unemployment rate are Spain, Greece, Portugal, Ireland, France, and Italy. Of course, the UK, Belgium and Germany have also uncomfortable unemployment figures. As asset prices and demand are lower with a sovereign debt crisis, output is also affected leading to lower employment and higher unemployment rate. Table 2 indicates the effects of the European sovereign debt crisis on the gross domestic product of select countries. Table 3. Latest real GDP impact of the European debt crisis Country % YoY Greece -7.2% Portugal -3.4% Italy -2.4% Spain -1.6% Netherlands -1.6% Ireland -1.1% Belgium -0.3% UK 0.0% France 0.1% Germany 0.9% Source: Bloomberg 2012 Experience shows that the sovereign debt crisis is best address not through savage budget cuts but through budget cuts that can allow moderate economic growth or arrest the continuous downward spiral of output. As shown by the experience of post-World War II Germany, a promising approach to end the crisis is via international cooperation and development support to countries directly affected by a sovereign debt crisis. Weist et al. (2010) emphasised that an important key to handling a sovereign debt crisis is to strengthen not weaken institutions like government. References Blommestein, H., 2010. Public debt management and sovereign risk during the worst financial crisis on record: Experiences and lessons from the OECD area. In: P. Braga, A. Carlos & G. Vincellete, ed. Sovereign debt and the financial crisis. Washington: The World Bank, 449-465. Bloomberg, 2012. European debt crisis. Available from: http://www.bloomberg.com/markets/european-debt-crisis/ [Accessed 18 November 2012]. Buchheit, L., 2011. Six lessons from prior sovereign debt restructuring. Paper prepared for Resolving the European Debt Crisis, a conference hosted by the Peterson Institute for International Economics and Bruegel, Chantilly, France, September 13-14. Available from: http://www.iie.com/publications/papers/buchheit20110913.pdf [Accessed 15 November 2012]. Coeure, B., 2012. The euro area sovereign debt market: lessons from the crisis. Available from: http://www.bis.org/review/r120629a.pdf?frames=0 [Accessed 18 November 2011]. Constancio, V., 2012. Contagion and the European debt crisis. Banque de France Financial Stability Review, 16 (April), 109-121. De Paoli, B., Hoggarth, G. & Saporta, V., 2006. Costs of sovereign default. Financial Stability Paper No. 1. London: Bank of England. Investopedia, 2012. European sovereign debt crisis. Available from: http://www.investopedia.com/terms/e/european-sovereign-debt-crisis.asp#axzz2ChgN6kVw [Accessed 18 November 2012]. IMF, 2003. Lessons from the crisis in Argentina. International Monetary Fund: Policy Development and Review Department. Radice, H., 2011. Germany and the eurozone sovereign crisis: The lessons of history. Available from: http://www.social-europe.eu/2011/05/germany-and-the-eurozone-sovereign-debt-crisis-the-lessons-of-history/ [Accessed 18 November 2012]. Wallison, P., 2012. How and why a U.S. sovereign debt crisis could occur. Economic Journal Watch, 9 (1), January, 71-77. Weist, D., Togo, E., Prasad, A. and O’Boyle, W., 2010. Crisis preparedness and debt management in low-income countries: Strengthening institutions and policy frameworks. In: P. Braga, A. Carlos & G. Vincellete, ed. Sovereign debt and the financial crisis. Washington: The World Bank, 413-447. Read More