The European Sovereign Debt Crisis - Essay Example

European sovereign debt crisis Introduction The European sovereign debt crisis was a culmination of a financial debt crisis that was being experienced by a few countries within the Euro zone, which eventually spread to affect all the 17 Euro zone countries, while causing a financial crisis scare globally. The failure by the governments of the few countries, notably Greece, Ireland and Portugal to address the financial debt crisis dating back to the year 2000 eventually became the major cause of the European sovereign debt crisis (Beirne and Fratzscher, 77). However, the major question that lingers in the minds of many is how the financial debt crisis of the few countries could have caused such a global debt scare, yet those countries are not even the major economies of the Euro Zone. Thus, this discussion seeks to analyze how the financial debt crisis that started with the few countries eventually affected the whole of the Euro zone. The analysis will focus on two major areas of the financial markets; the bond markets and the foreign exchange, as the notable areas affected by the debt crisis. In this respect, the contagion process of the debt crisis from the few countries to the whole of the Euro zone will be analyzed. Discussion Three Major originators of the European sovereign debt crisis Greece is the major player as far as the European sovereign debt crisis is concerned, considering the fact that it is only when the sovereign debt crisis of Greece came to the fore that the real financial crisis facing the Euro zone started being considered. By the turn on the 20th century, Greece was one of the first growing economies in Europe (Fouskas, 27). However, the financial crisis of 2007/08 affected Greece notably, because its economy was dependent on tourism and exports, which slowed down as a result of the financial crisis, thus slowing down the economic growth in the country. To address this slow-down, the Greece government increased its spending in the economy, which in turn increased its sovereign debts (Fouskas, 132). The increased sovereign debt of Greece meant that the country’s budget deficit was increasingly becoming higher, compared to the country’s GDP. This effectively increased the borrowing rates of the country, which rose to a point where it became clear that the country would no longer be able to borrow from the internal markets, while at the same time indicating a high possibility of sovereign debt default (Armingeon and Kai, 424). In reaction to the high sovereign default risk by Greece, the credit rating of Greece was downgraded to junk status, also known as the BB+, which effectively meant that the investors in the economy were liable to lose between 30% and 50% of their investment (Hembruff, 712). Contrary to Greece, the Portugal sovereign debt crisis was prompted by the payment of unsustainably high wages to the public sector for a prolonged period of time between 1974 and 2010, which meant that the government was spending more than the revenues it was generating to cater for the high wage expenditure (Magone, 347). This in turn increased the budget deficit/GDP ratio to levels where the Portuguese government could no longer be able to borrow internally, and thus it had to seek for international intervention, through borrowing €78 billion from an IMF and European Union bailout package in 2011 (Magone, 347). The consequence of this was the lowering of Portuguese credit rating by the rating agencies to unfavorable status. On the other hand, Ireland’s nature of sovereign debt crisis took the form of the state government socializing losses made by the commercial banks through a property bubble that left the banks in the country lose a cumulative amount of €100 billion between 2007 and 2008 (Ullah, n.p.). The effect of this socialized loss was the overspending of the state government, thus raising its debt deficit beyond the levels it could be able to borrow domestically, and thus it had to seek international intervention through turning to the European Union and the IMF for €67.5 billion bailout (Young and Willi, 7). This situation caused the decline in the credit ratings of Ireland, such that it could no longer borrow favorably. The contagion of the sovereign debt crisis from the originators to the European Union The first major pattern of contagion of the sovereign debt crisis from the originators to the European Union was through the slowed domestic economies performance and consequent low trade capacities for the three countries, which eventually spread to the whole of the Euro zone, and eventually to the wider European Union and then globally (Steinbock, 112). Contagion is a concept that cannot be curtailed in the globalized world, where the economies of different countries within a region and even globally are intertwined. This is because, the other sovereign states forms the trading partners, creditors or debtors of a given sovereign nation (Laffan, 272). Thus, an economic situation that has an adverse effect on sovereign nation A, will also adversely affect sovereign state B (if it is a trade partner, creditor or debtor), which will in turn be transmitted to sovereign state C. eventually, the whole strand of countries infecting each other adversely will eventually form a complete conglomerate of countries that have been adversely affected. Therefore, once the sovereign debts of Greece, Portugal and Ireland skyrocketed beyond the abilities of these nations to finance more debts or even service the existing debts, then the trading partners, creditors and borrowers of these nations were adversely affected (Kuhn and Stoeckel, 633). The high budget debt/GDP ratio for the three countries meant that some of the domestic lenders to the government had to go bankrupt since the government could not service their debts. This meant a high rate of unemployment and consequent diminished standards of living and poverty for the three affected countries. For example, the unemployment rate in Ireland increased from an initial 4% in 2007 to an alarming 14% in 2010, while Greece which was worst hit had its unemployment rates increase from 7.5% in 2007 to 27.9% in 2013 (Fouskas, 136). The citizens of the three countries therefore lost their purchasing power, while the investors lost confidence in investing both in the government bonds or the stock market. Thus, the contagion process of the sovereign debt crisis of the three countries took the form of a spreading pattern of slowed economic performance for the three countries, which eventually spread to its trading partners, creditors and investors. This is because; considering the fact that such countries were no longer able to finance their additional debt deficits, while at the same time they were not able to service the existing debts, their trade partners lost the profits they obtain from undertaking trade with these countries (Constancio, n.p.). On the other hand, the creditors and investors would lose both on the interests and the premiums payable by these countries since they are unable to service their debts. This cycle of missing profits, interest and premiums will be spread across the entire spectrum of the region involved, especially where the creditors, investors and the trading partners are foreign countries (Forbes and Rigobon, 12). This way, the individual debt crisis of Greece, Portugal and Ireland impaired their ability to either export or import effectively. This in turn caused reduced trade for the trade partners in the Euro zone, which in turn meant the decline in economic performance, reduced currency values and the need for the state governments of the other Euro Zone countries to increase their spending to their economies in order to revive the economic performance. The end product of this pattern was the increased budget deficit for most of the Euro Zone member countries, which in turn reduced the currency value of the Euro (Rosen, 2). Consequently, the sovereign debt crisis that had started with Greece had caused contagion to France and eventually to the other Euro Zone countries, making the sovereign debt crisis to be felt by all the Euro Zone countries, since they had to increase their budget deficit/GDP ratios to sustain the momentum of their economies, thus putting the whole Euro Zone in a debt crisis situation, and at the same time causing a debt scare to the other creditors and trade partners beyond the Euro Zone. Effects on the foreign exchange The fact that the three countries were neither able to trade with their trade partners effectively nor to meet their debt obligations by servicing the debts owed to domestic and foreign creditors, meant that the credit ratings of the three countries was revised downwards (Stokes, 11). Furthermore, the failure of these countries to service their foreign debts meant that the foreign governments had to increase their sovereign deficits; through spending more in their respective economies than the incomes they generated, to avoid an economic downturn (Chaban and Ana-Maria, 197). This simply means that the currency of both the three countries as well as those of the other Euro Zone declined in value, causing the Euro to lose its currency value altogether. This caused the exports from the Euro Zone to be cheaper, while the imports into the Euro Zone where the Euro is the main currency became more expensive (Beirne and Fratzscher, 81). Consequently, the foreign exchange markets both in the Euro Zone and globally was adversely affected, through causing a widespread instability of currencies that were exchanging against the Euro. The second pattern through which contagion was spread from the three originators of the sovereign debt crisis to the Euro Zone was through speculation. According to the theory of speculation, speculation in economics is the process by which investors will either buy or refrain from buying certain stocks, in anticipation of either a favorable or unfavorable outcome in the future, respectively (Koch and Baumler, 201). Thus, the public debate by the politicians on the likelihood of debt defaults by some of the affected countries and the policy makers debate over the right policy measures that should be undertaken to improve the debt crisis situation are the two notable factors that increased the volatility of the Euro due to triggering unwanted market reactions, which in turn affected the rate of foreign exchange of the Euro against other currencies such as the British Pound, the US dollar and the Japanese Yen (Beirne and Fratzscher, 65). The statements that were being by politicians from the different countries, especially the countries that were hit by the debt crisis had a negative impact on the stability of the foreign exchange in the Euro Zone. Following such comments, the volatility of the currency increased on the basis of daily changes at the exchange rates, depending on whether the political statements were optimistic or pessimistic (Hembruff, 715). Therefore, the public disagreements on the policy measures that the ECB and EU should undertake in order to contain the negative effects of the debt crisis had an overall negative foreign exchange market repercussions, by causing the investors to adapt the wait-and-see approach, which in turn caused the shortage of financial exchange activities in the foreign exchange markets, resulting in volatility in the currency exchange rates (Koch and Baumler, 212). Effects on the bond market According to the investment theory, the economic changes in a certain aspect of the economy influence the business decision making of the different stakeholders (Ullah, n.p.). The reduced investment in these economies meant two things: First, the currencies of these countries would decline in value, owing to the slow economic performance. Secondly, the other trading partners to these nations started taking caution due to the fear of loss of the inability of the countries to meet their trade obligations (Stokes, 9). This prompted investors to take precautionary measures against more sovereign bond trading, not only for the Greece sovereign bonds, but also for the other countries in the Euro Zone which were likely to be affected by the sovereign debt default. Consequently, the bond markets in the whole of the Euro Zone and by extension globally declined (Rosen, 7). This is because, the investors who held the sovereign bonds for countries with a high budget deficit/GDP ratio rushed to sell their sovereign bonds, so that they could not incur losses, on the event that such nations eventually defaulted on their sovereign debts. This means that neither the three originators of the sovereign debt crisis nor the other European countries with a high sovereign level were able to access debt funding through the sovereign bonds (Young and Willi, 22). Additionally, the fact that most of the investors who held such bonds rushed to sell them off, means that here was an influx of sovereign bonds on sale in the bond market, which in turn lowered the prices of the sovereign bonds for such countries significantly. Works Cited Armingeon, Klaus, and Kai Guthmann. "Democracy In Crisis? The Declining Support For National Democracy In European Countries, 2007-2011." European Journal Of Political Research 53.3 (2014): 423-442. Beirne, John and Fratzscher, Marcel. “The pricing of sovereign risk and contagion during the European sovereign debt crisis”. Journal of International Money and Finance 3, 2013. 60-82. Print. Chaban, Natalia, and Ana-Maria Magdalina. 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