European Sovereign Debt Crisis - Essay Example

Table of Contents Introduction 2 2. Determinants of the crisis 2 3. Impact on bond market and implications for other markets 3 4. Lessons from other defaulted countries 8 5. Policies and Measures 8 6. Perspectives 10 7. Conclusion 11 Reference List 12 1. Introduction Recent years have proved to be challenging for Europe’s economy, which was affected by two major crises: a banking crisis and a sovereign debt crisis. It is important to analyze this topic in order to draw lessons from the past events, and to consider measures appropriate to be taken. This paper is organized as follows: Section 2 provides an overview of the causes which determined the recent crisis, Section 3 discusses implications for other markets, Section 4 overlooks lessons from other defaulted countries, Section 5 underlines policies and measures taken to counteract the crisis, and the paper ends with Sections 6 and 7 which provide perspectives and conclusion. 2. Determinants of the crisis The systemic causes of the sovereign debt crisis are the imbalances in the European Monetary Union, and the global political economics. Related to the first cause, three important aspects must be mentioned. One of them is lack of flexibility for the labor market, which is necessary when considering a monetary union (Heinz, & Ward-Warmedinge, 2006). Secondly, the necessity of international fiscal transfers for asymmetric imbalances was not accomplished. Another reason was the lack of flexibility of the capital and product markets, which did not respond to competitive market forces (Grahl, 2011). In what concerns the second cause of the sovereign debt crisis i.e. global political economics, it is well argued that Germany’s politics have affected the EMU and increased the severity of this crisis. More specifically, Germany’s act as an export country with mercantilist origins created significant losses for the other countries in the EMU, and can be responsible for the current crisis (Conquest, R., & Bruges Group, 2011). 3. Impact on bond market and implications for other markets From the start of the sovereign debt crisis, the long-term government bond yields of some countries from the euro zone (Greece, Italy, Spain, Portugal, and Ireland) have intensively increased compared to the German Bunds. In the next figure is provided an overview of the downward trend of the price of the Italian 10 years’ government bonds (the relationship between yield and price is inverse proportional). Figure no. 1 Evolution of the price of Italian 10 years’ government bonds Source: Bloomberg. An explanation for the spreads in bond yields are: an aggregate risk factor, the country credit risk and the chain effect from the situation in Greece (Santis, 2012). If the last factor is straightforward, the first two factors need to be explained. The first factor i.e. aggregate risk is an indicator of changes in monetary policy, as well as global situation and investors risk aversion (Wall, Minocha & Rees, 2010). On the other hand, the country risk factor is an indicator of the country’s ability to repay its sovereign debt, and it is as well connected to raising funds and liquidity (Howells & Bain, 2007) In what concerns the impact on other markets, spillovers from the bond market affected financial intermediaries (for instance: bank lending) and stock and commodities markets, and also determined shifts in investor market sentiment and changes in investors’ risk aversion (Massa, Keane, and Kennan, 2012). In the following figures, can be seen the effects of the crisis on the Euro Stoxx 50 Index and FTSE 100 Index. Figure no. 2 Evolution of Euro Stoxx 50 Index Source: Bloomberg. Figure no. 3 Evolution of FTSE 100 Index Source: Bloomberg. Other effects are related to the announcements of credit rating agencies, which have many considerations before downgrading or upgrading a country’s rating. Credit ratings agencies are considered to have an important economic role for the financial market (Bogaertz, Cremers & Goetzmann, 2012) due to their goal of assigning opinions about the creditworthiness of debt instruments and issuers. A study made on a market based economy – U.K., by Barron et al. (1997), identified significant abnormal stock returns as a cause of bond rating downgrades and positive credit watch announcements. For the case of euro zone, the announcement of future downgrading of the Greek sovereign bond on February 24th, 2010 determined a decrease of 2% in most of the European stock markets. Also, as it was mentioned previously, the commodities market was also affected, and this lead to a decline in the derivatives market which have as underlying assets the respective commodities. The following figure depicts the decrease in commodity futures prices. Figure no. 4 Evolution of Futures Commodities Prices Source: Bloomberg. There are implications of this crisis also for the exchange rates. As will be seen next when considering the history of other defaulted countries, a currency crisis is interrelated to the banking and sovereign debt crisis. The next figures show the evolution of the euro currency with respect to American dollar, and sterling pound as the sovereign debt crisis has deepened. Figure no. 5 Evolution of EUR/USD Source: Bloomberg. Figure no. 6 Evolution of EUR/GBP Source: Bloomberg. 4. Lessons from other defaulted countries The crisis which hit Argentina several years ago, can offer some lessons for what is happening nowadays in the euro zone. One important issue in this matter is related to the fiscal deficit. Measures such as decreases in nominal expenditures and/or increases in taxes are not appropriate in the case of recessions. Secondly, considering that the public sector is large, it is inappropriate to use deflation to correct the overvaluation of the currency (Cavallo, 2011). Furthermore, devaluation in a dollarised economy (euro-ised in the case of Greece) can be problematic as it can lead to significant balance-sheet problems that need some form of government intervention (Geithner, 2003). Another defaulted country which experienced a similar crisis to that of the euro zone is Russia. Russian experienced a crisis in 1998 due to the default of sovereign debt, but also due to its banking system. The default of Russia lead to a systemic failure of other markets, and determined an increase in the credit spreads of sovereign debts (Mortikov and Volonkin, 1999). A major lesson which can be learned from Russian experience is that government intervention through fiscal system is not appropriate in times of crisis. 5. Policies and Measures The European Union policies have as main objective the maintenance of price stability, but this crisis proved that this condition is not a sufficient one. The systemic risk and financial instability determined the present crisis and put pressure on medium-term price stability, which needed to be counteracted by central banks decisions. At the start of the financial crisis, the banking system decreased the interbank lending due to counterparty and liquidity risks. So, the short-term interest rates in the interbank market were disconnected from the ECB’s main policy rate, and became impossible for the ECB to have an influence to the general economic activity through this instrument – interest rates (Candelon & Palm, 2010). Trying to solve this issue and also because of the collapse of Lehman Brothers in 2008, ECB focused on the liquidity in the interbank market through expansion of the list of eligible collateral for refinancing operations. Moreover, refinancing operations for longer maturities, including six month and one year maturities were introduced in order to help the banks to manage the problems with the liquidity. One of the non-standard measures applied by ECB in 2009 in order to counteract the crisis was the Covered Bond Purchase Programme (CBPP1), which underlined a purchase of €60 billion worth of covered bonds between July 2009 and July 2010. The main objectives of this programme were: a decrease in short - term rates, a ease in financing requirements for credit institutions, a stimulation for these to lend more, and an improvement of liquidity (Ismailescu & Kazemi, 2010). Another measure taken by ECB was the Securities Markets Programme (SMP), launched in May 2010, which had the objective to protect the monetary policy transmission mechanism. This programme was supposed to correct issues related to key government and private bond market segments. 6. Perspectives From the sovereign debt crisis which affected the euro zone, can be drawn important lessons. One of them is related to the monetary policy of the central bank, which should have the same main objective i.e. price stability. It is the duty of central banks to ensure financial stability and liquidity to the market. A second lesson is concerning the need for the euro area governments to make structural reforms and sustain healthy fiscal policies, within the euro area governance framework. In this matter, maybe fiscal policies should follow the same strict framework, as well as monetary policies. Although some measures were taken in this matter, there is still room for improvement. Moreover, the financial sector should suffer reforms in matter of supervision and regulation. In time of crisis, credit institutions have been rescued and benefited from the help of central banks, but they should asses better the risks to which they are exposed in order to avoid similar situations in the future. In what concerns regulations, Basel III is an important regulation in matters of considering a higher minimum capital ratio and a more sane risk management from the financial institutions (Madura, 2010). Although, the European Union has a Growth and Stability Pact, which main goal is to protect against fiscal deficits and excessive government debt, the crisis proved that this measure is not sufficient. Future considerations should be made regarding this pact, as well as promoting a sane fiscal policy by adequate governance of these principles. Compliance of the principles stated in the pact, as well as penalties for the countries which do not succeed to comply with them is an area which needs to be revised in order to prevent other recessions. 7. Conclusion Throughout this paper, important aspects related to the sovereign debt crisis were discussed. It should be remembered the role of key institutions in providing an efficient adjustment mechanism to economic shocks because in a monetary union, the countries do not have the instrument to change the nominal exchange rate in order to counteract internal and external imbalances. It can be sustained that the measures taken to counteract the sovereign debt crisis had a role in providing financial intermediation in the euro area. These measures ensured the financing requirements of the banking system, and as well restore some of the confidence of the investors, participants in the financial markets. Furthermore, the considerations of ECB ensured the expansion of lending, and finally contributed to the main objective of maintaining the price stability. Reference List Barron, M.J., Clare, A.D. and Thomas, S.H., 1997. 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Occasional Paper Series ODI, 52. Howells, P. and Bain, K., 2007. Financial Markets and Institutions. Harllow: Pearson Education Limited. Ismailescu, I. and Kazemi, H., 2010. The Reaction of Emerging Market Credit Default Swap Spreads to Sovereign Credit Rating Changes. Journal of Banking & Finance, 34, pp. 2861-2873. Madura, J., 2010. Financial Institutions and Markets. 9th ed. Connecticut: South-Western Cengage Learning. Massa, I., Keane, J., and Kennan, J., 2012. The euro zone crisis and developing countries. Working Papers ECB, 345. Mortikov, V. and Volonkin, V., 1999. The debt crisis in Russia. Russian & East European Finance & Trade, 35(2), pp. 31-42. Santis, R., 2012. The euro area sovereign debt crisis: Safe heaven, credit rating agencies, and the spread of the fever from Greece, Ireland and Portugal. Working Paper Series ECB, 1419. Wall, S., Minocha, S. and Rees, B., 2010. International Business. 3rd ed. Harlow: Prentice Hall. Read More