The European Sovereign Debt Crisis - Essay Example

THE EUROPEAN SOVEREIGN DEBT CRISIS The European Sovereign Debt Crisis The European region has experienced interrelated sovereign debt and banking crisis. Bonds spread by countries such as Ireland, Greece, Spain as well as Portugal increased during the crisis. The debt crisis made headlines globally because of its destabilizing effects. Renewed challenges in global financial markets are closely associated with the debt crisis. It is vital to study the effects of the crisis on the financial markets using an event study approach that focuses on theoretical perspectives. Consequently, the euro debt crisis is crucial as one intends to study its spillover effects. This is because the crisis was characterized by decisions and events at a political level (Acharya and Steffen, 2012, p. 12). In this case, the Euro debt crisis will be viewed as a financial phenomenon that affected the European region. Historical events associated with the Euro sovereign debt crisis will investigate the negative watches and downgrades on European governments, financial markets, stock, and bond markets. The Euro sovereign debt crisis reached its peak in March 2012 after Greece conducted the largest sovereign debt restructuring. Countries such as Spain, Ireland, Italy and Portugal were also facing serious financial crisis. It is essential to note that all member states of the European Monetary Union provided loan guarantees. As a result, the creditworthiness of the region was at stake (Ahearne, Griever and Warnock, 2004, p. 316). The effect of this event was that all member states of the Euro, even states that had sound public finances, were subjected to downgrades or placed on negative watches by global rating agencies. Some of the countries lost their investment grade statuses. This is an alarming signal for international investors. Before, the first country was downgraded, speculation against the EURO was attracted and the stock markets turned down. As a result, some countries began losing their access to capital markets. European Union politicians devised a plan to accuse credit rating agencies, which worsened the crisis (Andrade and Chhaochharia, 2010, p. 2431). Changes in funding conditions used by banks are important in the assessment of financial intermediaries. These intermediaries supply credit to the economy. Since 2009, the remuneration on deposits in core European Union countries remained unchanged. However, there were large dispersions compared to the period prior to the crisis. The costs of the deposits increased significantly in several peripheral countries (Angeloni and Wolff, 2012, p. 19). This reflected the difficulties that banks were experiencing as they tried to obtain funds through market sources. In 2012, these rates decreased owing to the improvements in market confidence that triggered the cut in ECD interest rates. Funding difficulties experienced by peripheral countries adversely affected the financial conditions, non-financial corporations and households. For instance, the charge of short-term loans to a non-financial corporation augmented unexpectedly in peripheral countries, in 2011. In countries such as Portugal and Greece, the interest rates neared the levels of 2008 (Arezki, Candelon and Sy, 2011, p. 9). Reactions of the European Money Markets The sovereign debt crisis sent ripples all over the international banking systems. This prompted interventions by central banks and governments on a scale that is comparable to the programs instituted during the 2008 financial crisis. European authorities pledged financial support to the tune of 1 trillion EURO. This support was meant for the recapitalization of the challenged Euro area countries (Arteta and Hale, 2008, p. 59). The European Central Bank injected an exceptional amount of liquidity in order to mitigate the effects of the banking system balance sheet disclosure especially the deteriorating sovereign debt. European banks hold huge amounts of debt securities in government. They hold these debts as securities because the Capital Requirements Directives allows a zero percent risk weight for the government bonds that are issued in domestic currencies. Additionally, Requirements Directive excuse government debts availed using domesticated or localized currencies from the 25 percent limit on a large exposure. This applies to all asset holdings. Banks hold considerable amounts of debts that are issued by foreign sovereigns (Bank of International Settlements, 2011, p. 11). According to data provided by BIS, the exposure of banks to the public sectors in overseas countries or entities range from 75 percent to 200 percent for Tier 1 capital German and Italian banks, and Belgian banks respectively. The debt crisis offers an ideal opportunity to examine the effects of exposure to the sovereign debt crisis on bank lending. Theoretically, it is possible to distinguish the channels that increase the risk of foreign sovereign debts in banks. Banks that hold these portfolios can have reduced supply of bank credits. Losses of bank capital have direct unconstructive repercussions on the assets of a bank eventually reducing the profitability of the bank. There are advanced consequences for the availability and cost of funding. Probable losses on sovereign bonds can increase concerns for counterparty risks. For instance, during the debt crisis, market counterparties, especially the U.S became concerned because of increased risks of loaning to banks that have been significantly exposed to sovereigns that face growth and fiscal pressures (Bofondi, Carpinelli and Sette, 2012, p. 22). As a result, the markets faced a sharp withdrawal of mutual funds. Financial institutions usually use sovereign debts as collateral. Collateral is sought when people want to secure wholesale funding. Elevated sovereign risks lessen the chances of collateral and bank’s funding capacity. Empirical analysis shows a correlation between lending by banks and diminishing creditworthiness of distant sovereign debts. Banks that hold these debts face challenges during lending. Preferred econometric requirement shows that affected banks increased their lending by 23.5 percent as evident in the third quarter of 2010 (Bord and Santos, 2012, p. 6). This figure is lower than the figure for non-affected banks. This suggests that GIIPS debts mooted a post economic crisis recovery for syndicated lending. Assessing how banks that are exposed to faulty sovereign debts re-adjust portfolios show European bias. Banks affected by the debt crisis reduce their lending to all markets. However, this did not affect their lending to non-GIIPS European markets. Furthermore, affected banks adjust their lending to the rates and trends in the U.S (Brown and Dinc, 2011, p. 1379). It is vital to note that throughout the preliminary stages of the event, carry trade-type behavior mitigated the slowdown and effects of overall lending. During the latter stages of the crisis, the assets purchase program may have permitted banks to lessen their exposure once the default risks on sovereign debt became relatively high. There exists an international transmission of financial shocks through the balance sheets of international banks. This supports the notions that banks have the potential to transmit negative shocks to their capitals, internationally and domestically. As a result, government debts on the overall bank-lending trend become impaired. This shows a link between the foreign debt problems and the supply of credit to companies (Cetorelli and Goldberg, 2011, p. 65). There also exists a link between banks and sovereigns with respect to the propagation of the sovereign debt crisis. European bank stock markets states are usually impacted by exposure to sovereign debts. This is compounded by news on sovereign ratings, which affect the stock prices for banks. Rating downgrades during speculative grades has significant spillover effects across European countries. Sovereign rating changes influenced the stock returns of banks, particularly with an impending downgrade. Whenever banks are hit by a shock to their assets and wealth, they are forced to rebalance their loan portfolios. As a result of the rebalancing, these banks usually abandon their foreign customers because they had weaker lending relationships. This happens because of biases caused by information advantages that influence domestic investors. Empirical evidence shows that banks usually transmit their negative shocks to their domestic capitals. Banks sharply reduce their lending trends to their international customers (Correa, Sapriza and Zlate, 2012, p. 49). The effect is a rebalancing of the portfolio in order to favor domestic customers. In as much as syndicated loan, may exhibit home bias; the feature is a sign of good times. The home bias rose by 20 percent during the banking crisis. Banks exposed to deteriorating sovereign debts increase their lending. However, their increase percentage is below the percentage for banks that are not exposed to the debts. Reaction of the Bond Market Government bonds negatively react to poor sovereign ratings. Credit rating events such as negative watch list and downgrade announcements can provide insightful information regarding the trends of the bond market. Credit ratings reduce the complexities of bulk information. Additionally, they provide private information. Institutional investors may restructure their portfolios because of the investment policies that may restrict assets that have a certain rating (Correa, Sapriza, Lee and Suarez, 2012, p. 22). As a result, the rating agencies may fail to provide information about the creditworthiness of the investor. Reoccurring negative ratings usually reveal a downward trend in the future creditworthiness of a country. This also reveals a downwards trends for the whole region with possible significant economic changes. It is possible to note that mid-term bonds that mature between 1-10 years show significant reactions using all event windows and models. Long-term bonds show delayed negative reactions to the debt crisis. While government bonds of ranging maturities react badly to negative watch listings and downgrades, the mid and long-term bonds react negatively to the debt crisis. Investors view the debt crisis as a long-term event (De Haas and Van Horen, 2012, p. 236). The reaction of investors is based on the notion that the structure of the European Union does not have a stable monetary and economic function. The evidence of bond market reactions indicates that sovereign ratings are affected by national stock markets. It is important to consider the effects of the crisis on the local currency. In case, the domestic currency is constantly losing and under pressure from the market, the international investors may become discouraged to invest in stocks that are denoted with a EURO. Secondly, European banks are major bondholders of government bonds from the European region. In case the bonds depreciate, the bank’s stock price faces pressures (De Haas and Van Horen, 2013, p. 248). These effects are highly accelerated because European banks engage in each other’s debts. This effect has the potential of spilling over to the entire stock market. These arguments show that negative ratings on a sovereign affect the stocks and bonds through several channels. The Markets, Sovereign Debt and Fiscal Policy Options In case the current membership of the European Union is maintained, these fiscal problems must be resolved quickly. The Union can target four critical areas in order to resolve the debt crisis. These are growth and inflation, primary deficit, interest rates and restructuring. In the case of growth and inflation, the Union needs to formulate policies against quantitative easing. This policy aims at weakening the Euro and increasing inflation. The Union should collectively cut the primary deficit further (De Marco, 2013, p. 18). In case all countries cut their budgets together in a synchronized manner, the impact on growth will be greater than with most fiscal multiplier calculations for each country. The Union should also reduce interest rates on the debts. The financing of budgets using EU bonds, which have low interest rates, can reduce the debt-service burdens. This will solve issues of liquidity and increase investor confidence. It is vital to restructure interest and principle rates. Conclusion This study employs an event study approach that relies on theoretical perspectives. The Euro debt crisis is useful as an individual endeavors to understand spillover effects and contagion. This is because the crisis was enhanced by decisions and events at the political level. The Euro debt crisis is a financial phenomenon that affected the European region. Therefore, this case investigates the impact of negative watches and downgrades on European governments, financial markets, and stock and bond markets. The debt crisis prompted interventions by central banks as well as governments. The effects of the debt crisis on financial markets motivated these interventions. Empirical analysis shows a correlation between lending by banks and failing creditworthiness of foreign debts. Banks that hold these debts face challenges in lending. Econometric specification shows that affected banks augmented their lending by 23.5 percent during the third quarter of 2010. This figure is lower than the figure for non-affected banks. In the event that banks are hit by a shock to their assets and wealth, they are forced to rebalance their loan portfolios. Rebalancing makes, these banks abandon their foreign customers because they had weaker lending relationships. Empirical evidence shows that banks usually transmit their negative shocks to their domestic capitals. Banks sharply reduce their lending trends to their international customers. The effect is a rebalancing of the portfolio in order to favor domestic customers. List of References Acharya, V and Steffen, S 2012, The Greatest Carry Trade Ever? Understanding Eurozone Bank Risks, NYU working paper. Ahearne, A., Griever, W., and F. Warnock 2004, Information Costs and Home Bias: An Analysis of US Holdings of Foreign Equities, Journal of International Economics 62, 313-336. 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