How Government Debt Problems Could Impact Financial Market - Essay Example

Critical analysis of how government debt problems could have a wide impact in financial market Contents Introduction 3 Discussion 3 Foreign exchangemarket 5 Impact on equity market 8 Conclusion 10 References 11 Introduction European sovereign debt crisis started with Greece in 2009. But the crisis soon spread to other countries and soon the crisis turned into global financial crisis. The crisis had a severe impact on different sectors of the financial market. The sectors that were impacted by the financial crisis were equity, bond, money market, foreign exchange market, derivative market. All the different countries and their financial markets are linked to each other in the current global scenario. The exposure of the financial markets of different countries to each other causes an impact on the financial markets globally. Though the amount of exposure of each country and each financial market to the financial market of another country varies but the fact remains that no country can be considered as isolated in respect of interconnectedness. This particular essay discusses the effect of financial crisis on two particular markets that is derivative market and foreign exchange market. The essay tries to find the possible reasons due which financial crisis started from a particular country with a small economy gradually effects the financial markets globally. In this respect of this analysis both fundamental and identifiable factors are tried to be identified. Discussion Throughout centuries there have been several financial crises that have had large scale impact on the overall financial system. Different crisis in different timers have been triggered by different factors. However although there have been various triggering factors for different crisis the impact levels of the crisis have also varied depending on their reach and spread. A few examples of such crisis in the past are Asian crisis, Japan Crisis, Crisis of the Nordic countries. However the financial crisis of the dimensions of European financial crisis is unprecedented. The massive scale of the crisis was caused by two related factors the banking crisis and the crisis of the bond market (Ullah and Ahmed, 2014). The crisis first broke in 2007 when the banks felt uncertain about their investments in certain complex financial instruments. They increased interbank lending rates and virtually stopped lending to other banks. This led to serious liquidity problems for the banks in the short run. At that time it was felt that the problem was more specific particular institution and those particular institutions may face default risk. However after default of major banks like Lehman Brothers, and risks concerning AIG which in turn took more financial institution with them in their downward journey panic stroke in the minds of investors. The investors rushed to sell their securities, valuation of companies were severely affected and the investors ran with their money to purchase sovereign debt instruments (Rengasamy, 2012). The crisis began to feed on itself as different financial instruments being linked to each other started going down with the other and the economy entered a phase of downward spiral. The companies saw their sales going down and inventories pile up. Figure 1: Change in interbank spreads (Source: European Commission, 2009) The crisis of the banks caused the governments to rush in and offer help to lead the banks to revival and out of the recession. However in doing so, the governments put a lot of pressure on the sorry state of internal finances and mismanagement over the years. This led to sovereign debt crisis. This dual crisis consisting of the sovereign debt crisis and banking crisis led the affected countries and ultimately the whole world into a deeper recession (Singala, 2012). Although the crisis first started with debt crisis of Greece it soon spread to other countries in no time. Figure 2: Bond spreads of different countries in the Euro zone (Source: Wignall and Slovik, 2011) The major concern of people in the Euro zone is the presence of high levels of public debt for many countries and presence of government deficits. Countries initially affected were Greece Ireland and Portugal. All these three countries have borrowed money to recover from the debt crisis. Another country which is likely to have a major impact is Italy. The debt levels of Italy are higher than the debt of Greece, Ireland, Portugal and Spain. Investors have become more nervous about the debts of Italy and Spain and they have subsequently demanded higher interest rate for the added risk (Nelson, Belkin, Mix and Weiss, 2012). In the following pages crisis of financial markets is analyzed with respect to foreign exchange market and derivative market. Foreign exchange market The daily foreign exchange trading volume is the largest and most liquid financial market with daily transactions of $5.3 trillion per day. The volume of transactions has increased from $4.0 trillion in 2010. The increase was about 35% as compared to the 2010 level. The daily foreign exchange transaction volume has increased by 20% from 2007 level. Figure 3: Volume of FX transactions over the years (Source: Rime and Shrimp, 2012) The foreign exchange market transactions were at a very low level in the financial crisis period. The volume of foreign exchange trade and activity in foreign exchange market continued to grow in the first year of the financial crisis (Allen and Moessner, 2013). However the daily volume of a foreign exchange trade plummeted after the Lehman brother bankruptcy case. The financial stability map of 2008 shows the impact of crisis. Figure 4: Figure Financial Stability Map (Source: International Monetary fund, 2008) By comparing it with the financial stability map of 2014 we can find the effective difference. Figure 5: Financial stability map (Source: International monetary fund, 2014) By analyzing the financial market stability map for 2008 and 2014 we find that in 2008, foreign exchange market was under a lot of stress due to the continuing crisis being faced by the European market under the twine effect of banking and debt crisis. The financial stability map shows that financial market, more particularly foreign ex market has continued to remain weaker in the period of financial crisis and was characterised by high levels of volatility (Morgan Stanley, 2011). The risk of the map is specified by movement of variables away from the centre. The foreign exchange continued to remain further away from the centre which shows greater volatility and risk in the particular sector. However risks made up of other three components have shown that they have remained stable compared to foreign exchange scenario during the financial crisis period. The effect on the foreign exchange was in a large way influenced by the rating of several credit rating agencies. Studies have shown the decisions taken in the foreign exchange market have been strongly impacted and affected by the credit rating of different countries by the credit rating agencies in the wake of foreign exchange rates (Stracca, 2013). During a survey conducted in various countries around the world it was found out those rating agencies signals do affect the exchange rate of a country and have an impact on the foreign exchange rates of other countries around the world (Browne, 2008). The changes in the exchange rates are more pronounced during issuance of outlook and watch signals given by the rating agencies than any actual rating changes done by them. The impacts of the watch signals given by the rating agencies have a stronger impact on the foreign exchange during periods of financial turmoil. Whereas market reacts very much spontaneously to the rating given out by any of the major rating agencies the reaction to the rating issued by certain particular rating agencies are more profound (Deutsche Bundes Bank Euro System, 2013). Any positive rating issued by Moody’s is found to have the strongest impact on the financial markets, whereas negative indications by Fitch tend to have the strongest impact. The crisis was triggered by several factors affecting different sectors simultaneously (Melvin and Taylor, 2009). The cause behind the fact is that financial crisis affects foreign exchange market is the fact that when faced with a financial crisis the investors in all markets want to move to safer heaven and diversify their exposure from the currency of the affected country (Alsakka and Gwilym, 2013). Impact on equity market During a financial crisis it is most common for the investors to move from risky ventures to those that they consider as safe heaven. This phenomenon was profoundly witnessed during the financial crisis that gripped the world during the 2008. The financial crisis was triggered by twine factors of bank failure and sovereign debt crisis which led to a global crisis on unprecedented scale since the great depression (Guraziu and Zeqo, 2012). As the banks defaulted on their debts investors started pulling their money out of the stock exchanges, currency markets, derivatives market and other markets that they considered as risky and putting their money in relatively safer forms of deposits like the sovereign debt instruments. The effect on the stock market due to this was that they became extremely volatile during this phase of financial crisis. However the returns of the stocks during this period, had remained fairly constant (Karunanayake, Valadkhani and O’brien, 2010). From the period ranging from 2004 to 2007, the financial markets were characterized by calmness. The measure for market volatility was below the long term average. However the financial crisis of 2008 changed the scenario with markets experiencing great volatility. This was the case most of the financial asset classes which suffered pullbacks during the period. Figure 6: S&P and VIX INDEX VALUES (Source: Manda, 2010) The crisis of 2007-09 periods was the first major global crisis that affected the whole world since the global depression. Although the crisis first started in the financial market of the US due to the effect on lending market, it quickly spread its wings to other countries and other countries soon came under the grasp of the crisis with many countries experiencing stronger market crashes than US economy itself (Mehl, Fratzscher, Ehrmann, and Bekaert, 2011). In case of banks share prices they were also affected by the ratings issued by credit rating agencies to the various governments. Although there is no strong evidence in this respect but the fall in share prices of the banks during financial crisis gives an indication towards this effect (Williams, Alsakka and Gwilym, 2013). The effects of the financial crisis were not only limited to the stock markets of developed countries but stock market of developing countries were also impacted. After applying Egarch model to the stock market data from India and Pakistan the researchers could state that negative shocks have more profound impact on the stock market prices than positive shocks (Ali and Afzal, 2012). Another study on the effect of stock prices finds out that as a result of the financial crisis unconditional mean daily returns were negative, volatility of the stocks increased by about 200%, correlation between stocks weakened, β of the financial stocks increased significantly (Chaudhury, 2011). The effect of the financial crisis on equity market is very profound. As the investors move to the safer investment markets such as sovereign debt instruments stock markets falls (Stewart, Elliott and Tremlett, 2012). In fact there is spiralling downward effect on all market factors as a whole (Taylor, 2011). As the investors move to safer heavens the share prices fall. Also the investor in this time tries to cut their retail spending so the company’s sales falls. As sales fall inventories pile up and the chain goes on. Conclusion The financial crisis in general has a tremendous impact on all elements of the financial markets. Since in this era of globalization different economies in different countries are linked to each other so a crisis started in one country soon has its impact felt on the global scale. Albeit the effect of the crisis on the financial markets of different countries is different and varies depending on the degree to which it is correlated to the original market of the crisis. As the financial crisis affects different financial sectors and financial markets the investors move to the safer instruments such as sovereign debt instruments. But the particular financial crisis that affected the global economy in 2008 was also affected by a debt crisis. In this situation the normal trend of the customers is to curtail their spending. This causes the sales figure of the companies to fall and inventory piling up. As this happens the companies become sick. As the banks and financial institutions default government steps in to help but this causes a strain of government’s financials and it leads to debt crisis. So the crisis in effect feeds on itself and the problem gradually worsens. References Ali, R. and Afzal, M., 2012. Impact of global financial crisis on stock markets: Evidence from Pakistan and India. Journal of Business Management and Economics. 3(7). pp. 275-282. Allen, W.A.  and  Moessner. R., 2013. The liquidity consequences of the euro area sovereign debt crisis. Bank for international Settlements. [Pdf] Available at:  http://www.bis.org/publ/work390.pdf [Accessed 5 December 2014]. Alsakka, R. and Gwilym, O. A., 2013. 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The impact of sovereign credit signals on bank share prices during the European sovereign debt crisis. [Pdf] Available at: http://www.bangor.ac.uk/business/research/documents/BBSWP13007.pdf [Accessed 5 December 2014]. Read More