The European Sovereign Debt Crisis During 2010-2012 - Essay Example

EU Sovereign Debt Crisis The European Union has been compelled to undergo two related crises, ly a sovereign debt crisis and a banking crisis. The sovereign debt crisis was aggravated by recession, a certain amount of fiscal mismanagement, and transfers to assist banks. Towards the latter half of the year 2010, the difficulty of budget consolidation had the unwelcome outcome of worsening the sovereign debt crisis (Blundell – Wignall & Slovik, 2010, p. 10). The sovereign debt crisis was of sufficient importance to cause the resources of the European Stability Mechanism to be extended to provide financial assistance to the Member States undergoing this crisis. Previously, this mechanism’s resources had been restricted to provide balance of payments foreign currency support to the Member States that had not adopted the euro (Lane, 2012, p. 58). Another measure adopted was that of the European Central Bank, which acquired sovereign bonds, in order to mitigate the risk posed by the loss of equilibrium (Nelson, Belkin, Mix, & Weiss, 2012). In the six months from May 2010 to October 2010, bonds worth approximately €65 billion were bought by the European Central Bank. Moreover, during the market turmoil that was experienced during the months of August and November of 2011, an additional amount of €125 billion was earmarked. As a result, the total bond holdings were in excess of €200 billion, which is of the order of 2% of the GDP of the euro region (Lane, 2012, p. 60). However, the compensating sterilisation operations have negated the liquidity created, and this in turn has ensured that debt is not monetised. A substantial amount of pressure has been exerted on the basic divisions of power between the EU government the Member States, due to the sovereign debt crisis. A solution has been provided for this crisis, and one part of this solution recommends the implementation of obligatory collective action clauses. In addition, it has been recommended that there should be extended maturities for sovereign bonds (Gott, 2011, p. 201). As such, the sovereign debt crisis of the euro zone necessitates the issuance of euro bonds or jointly issued debt. This was the considered opinion of Soros, a financier of considerable acclaim and accomplishment; as the affected Member States cannot resolve these issues, by solely relying on the structural reforms (Smith, 2012). The structural drawbacks and their consequences are the same, although the immediate causes may be different, with regard to the sovereign debt problem. This problem results from internal and external influences. Crucial national debt situations emerge from the inadequate growth of the domestic productive sector. A major consequence would be the resolution of the low liquidity issue in the secondary sovereign market (Fouskas, 2011, p. 188). A major consequence would be the resolution of the low liquidity issue in the secondary sovereign market. Subsequently, a weak economic recovery commenced in the EU. However, this recovery has been continually subjected to destruction, by sovereign debt, and the decisions of the fiscal and monetary authorities of the EU. The lost trust can be regained by the EU, only if versatile and strong willed decisions are taken (Junevicius & Liutkus, 2011, p. 128). A proposal for establishing a European Debt Agency was put forward by Tremonti, the finance minister of Italy. It was his firm conviction that this agency should replace the existing European Financial Stability Facility, after its tenure ends in the year 2013 (Marshall, 2012). As such, the attraction of this proposal lies in the fact that every Member State can issue European bonds to the extent of 40% of their GDP, which is significantly lower the 60% limit prescribed by the Maastricht Treaty. This would gradually generate a sovereign bond market of a size that could be compared favourably with the bond market of the US treasury market. Initially, the European Debt Agency would finance half of the debt issues of the Member States, and this could be increased to even 100%, during times of crisis (Junevicius & Liutkus, 2011, p. 128). Moreover, this intervention enables a sovereign debtor to provide creditors with the choice of accepting the new bonds as a substitute for the existing securities. Although the new bonds would be of lesser value, they would prove to be more attractive, as they would be accorded priority during repayment. On the other hand if a default is coerced by the creditors, they would lose much more than by accepting the new bonds. Moreover, the sovereign debtor benefits as it can continue to access the international capital markets at reasonable rates. Furthermore, no international guarantee, as is the case with Eurobonds, is necessary (Junevicius & Liutkus, 2011, p. 128). However, such conversion from old into new debt instruments has to be performed prior to default. Another major feature of European bonds is the process by which they can be converted into national bonds. This change would be via a discount option, and with regard to bonds that under market stress, there would be a higher discount. Prior awareness regarding these discounts would strongly induce Member States to reduce their deficits. Thus, European bonds have the capacity to terminate the disruption of sovereign bond markets and prevent negative outcomes in the national markets (Junevicius & Liutkus, 2011, p. 128). A major consequence would be the resolution of the low liquidity issue in the secondary sovereign market. Some of the important objectives that the European bonds are believed to accomplish are the creation of a bond market that would be comparable to the US Treasury Bill market, in terms of size and liquidity. Another aim is to enable a switch to be made, by means of a discount option (Frankel, 2012). In addition, there would be a preclusion of speculative attacks against sovereign debts in the Euro zone. Moreover, excessive interest rates would be circumvented. Finally, Member States would be accorded access to adequate resources (Junevicius & Liutkus, 2011, p. 129). However, the disadvantages associated with these new bonds are that these would weaken market incentives for fiscal discipline, as spendthrift Member States would be able to borrow at lower rates. Furthermore, the disciplined Member States would be penalised. In addition, the European bonds necessitate a fiscal union, wherein fiscal sovereignty would be compromised for nations with high debt (Junevicius & Liutkus, 2011, p. 129). In May 2010, Greece was excluded from the bond market. Thereafter, Ireland and Portugal met with the same fate. Moreover, Spain and Cyprus requested official funding. In order to address the needs of these nations, a joint programme involving the EU and the International Monetary Fund (IMF) was formed (Lane, 2012, p. 57). Moreover, these programmes insisted upon the recipients of the bailouts to implement fiscal austerity measures in combination with structural reforms. These initiatives were aimed at enhancing economic growth. Moreover, the overextended banking systems of these countries were required to reduce the amount of borrowed investment funds and their capital structure was changed (Lane, 2012, p. 57). In addition, the scale of funding for these programmes was far in excess of the International Monetary Fund’s normal lending pattern. Consequently, the major portion of the funding had to emanate from the EU. At that juncture, it was decided to constitute a European Financial Stability Facility on a temporary basis. The objective behind this move was to issue bonds that were buttressed by guarantees from the Member States, so as to provide official funding for future crises (Lane, 2012, p. 58). Additionally, the demand for higher interest rates by private investors, made it very difficult for the Greek government to sell its bonds (Arellano, Conesa, & Kehoe, 2012, p. 4). As a measure of assistance, the EU and the IMF, in the year 2010, sanctioned a € 110 billion loan to Greece (International Monetary Fund, 2010). However, the sovereign debt crises continue to plague several nations of the Eurozone. Moreover, Bonds are subject to contagion risk and this involves the influence of several factors; such as, the invocation of cross default clauses in other bonds issued by a company, when there is a failure to make payments in a particular series of that company’s bonds. This usually leads to restructuring, in order to safeguard bonds that have not yet been defaulted (Blundell – Wignall & Slovik, 2010, p. 12). Furthermore, investors in the European Union (EU) have to envisage similar issues. This is due to the fact that if a particular Member State restructures its debt, the other Member States could find the necessary inducement to follow suit, if they were to encounter similar debt and fiscal issues. In addition, the market would attach a risk premium till such time as growth improves or the fiscal problems are solved (Blundell – Wignall & Slovik, 2010, p. 13). Consequently, the total outstanding debt of Greece, Portugal and Spain, as of the third quarter of 2009, was $ 1.3trillion. European and UK banks were at the greatest danger from this enormous debt, as this debt constituted 92% of their total foreign bank exposure to public and private borrowers. The government debt was $ 265 billion. Government debt was around 8% of the asset base of the European banking sector. This had increased dramatically in some Member States, such as Spain and Greece. Bond markets will fail to stabilise, sovereigns will face increased difficulty in carrying out their adjustment programmes, and harm their chances to renew their access to private capital markets (Risk, 2011). These outcomes will be the result of absence of clarity on the extent of participation necessary with regard to the creditors of the private sector. In addition, the burden of future bailouts would be shared only by the bonds to be issued after the year 2013. This information from the finance ministers assuaged the misgivings of the present bond holders. As a result, the borrowing costs of Ireland were significantly lowered, from the unprecedented high of 9% (Treanor, et al., 2010). Despite the bailout of € 640 billion, promised by the EU and the IMF, the interest rates on the Greek, Irish and Portuguese benchmark bonds continued to be very high (public debt management network, 2011). The unyielding market pressures compelled the leaders of the EU to come up with a new structure. This initiative was aimed at providing assistance from the European Financial Stability Facility and purchase bonds in the government auctions. In addition, interest rates were reduced and repayment terms were extended, in order to mitigate the conditions of the rescue loans made available to Greece (Landon, 2011, p. 10). However, there are some difficulties associated with these plans. First, the European Financial Stability Facility cannot purchase bonds in the secondary market, and has to restrict itself to government auctions. This would exert even greater pressure on the European Central Bank, which is the buyer of last resort. Second, this plan stipulates that the fund can purchase bonds only from the nations that had been provided with the bailout money. This condition, effectively excludes Portugal, which requires such support to the maximum extent (Landon, 2011, p. 10). In addition, the improper functioning of the secondary markets has proved irksome to investors. These investors are compelled to retain bonds till their maturity, and this has caused them to demand higher prices at the time of underwriting primary issuances (Junevicius & Liutkus, 2011, p. 128). The EU has not come up with a comprehensive solution to this problem. Despite the visible benefits of participating in the global economy, there are several dangers inherent in this. For instance, economic disasters in some other nation or region can have an adverse and severe impact on the situation in the home country. Thus, the sovereign debt crisis and recession in Europe have substantially impacted US exports and the stock market (Steiner, 2012). This crisis has consequences for global trade, and the protracted recession in Europe has brought about a slow down in the global economy. Thus, it can be surmised that the sovereign debt crises has affected the global economy. References Arellano, C., Conesa, J. C., & Kehoe, T. J. (2012). Chronic Sovereign Debt Crises in the Eurozone, 2010-2012. Region, 26(2), 4 – 11. Blundell – Wignall, A., & Slovik, P. (2010). A Market Perspective on the European Sovereign Debt and Banking Crisis. OECD Journal: Financial Market Trends, 2010(2), 9 – 36. Fouskas, V. K. (2011). Sovereign Debt Crisis and Peripheral Capitalisms. Politička misao, 48(5), 175 –192. Frankel, J. (2012, June 27). Could Eurobonds be the answer to the Eurozone crisis? . Retrieved October 31, 2012, from VOX: http://www.voxeu.org/article/could-eurobonds-be-answer-eurozone-crisis Gott, J. B. (2011). Addressing the Debt Crisis in the European Union: The Validity of Mandatory Collective Action Clauses and Extended Maturities. Chicago Journal of International Law, 12(1), 201 – 228. International Monetary Fund. (2010, May 9). IMF Approves €30 Bln Loan for Greece on Fast Track . Retrieved November 1, 2012, from IMF Survey online: http://www.imf.org/external/pubs/ft/survey/so/2010/new050910a.htm Junevicius, A., & Liutkus, E. (2011). The EU Sovereign Debt Crisis and “European Bonds” Option. European Integration Studies(5), 125 – 131. Landon, T. (2011, March 15). What Is Missing in Deal On Europes Debt Crisis. New York Times, p. 10. Lane, P. R. (2012). The European Sovereign Debt Crisis. Journal of Economic Perspectives, 26(3), 49 – 68. Marshall, A. G. (2012, July 2). Italy in Crisis: The Decline of the Roman Democracy and Rise of the ‘Super Mario’ Technocracy. Retrieved October 31, 2012, from http://www.infowars.com/italy-in-crisis-the-decline-of-the-roman-democracy-and-rise-of-the-super-mario-technocracy/ Nelson, R. M., Belkin, P., Mix, D. E., & Weiss, M. A. (2012, September 26). The Eurozone Crisis: Overview and Issues for Congress. Retrieved October 31, 2012, from Congressional Research Service: http://www.fas.org/sgp/crs/row/R42377.pdf public debt management network. (2011, March 15). News. Retrieved November 1, 2012, from http://www.publicdebtnet.org/public/News/newsDetail.jsp?id=4007 Risk, H. (2011, February 14). EU sovereign debt: Bondholders should bite restructuring bullet. Retrieved October 17, 2012, from http://www.euromoney.com/Article/2745350/EU-sovereign-debt-Bondholders-should-bite-restructuring-bullet.html Smith, G. T. (2012, January 25). Soros: EU Needs Euro Bonds. Retrieved October 17, 2012, from The Wall Street Journal: http://online.wsj.com/article/SB10001424052970203806504577182680217363936.html Steiner, S. (2012, October 29). European debt crisis: Impact on the US. Retrieved November 1, 2012, from Bankrate.com: http://www.bankrate.com/finance/economics/european-debt-crisis-impact-on-us-1.aspx Treanor, J., Inman, P., & Wintour, P. (2010, November 13). Ireland denies reports of EU bailout talks: G20 soothes bondholders over sovereign debt crisis News pushes borrowing costs down from 9% high. The Guardian, p. 44. Read More