European Sovereign Debt Crisis - Essay Example

THE EUROPEAN SOVEREIGN DEBT CRISIS Month, Year The European Sovereign Debt Crisis of demonstrates features of financial collapse such as the increased asset prices, strong leveraging, and a long period of credit growth among European financial institutions. The sovereign Crisis began because of the dysfunction of the monetary union of the states within the Eurozone in addition to the politicizing of the economic control in Europe. The Impact of the European Sovereign Debt Crisis includes the reduction of the bond yield in the United Kingdom.

In addition, the crisis led to a downtown in the equity market and increased demand for gold because of loss of confidence in the Euro by investors. The states within the European market should learn from the consequences of sovereign default so that their economic condition is kept at check. To prevent debt crises, various financial institutions and policy makers in countries have used policies and strategies of stabilizing the economy, which include regulation of financial credit and national balance sheet management.

Introduction The world economy is controlled by various financial and political forces, which should be regulated to avoid sovereign debt crises and defaults. The European Sovereign Debt Crisis illustrates the failure of financial institutions, which stretched across the world. Governments, which face such crises, may announce sovereign default leading to economic consequences. This paper gives a critical discussion of the European Foreign Debt Crisis of 2010/2011, its impact in the bond market and the lessons, which the Eurozone states would learn, from sovereign defaulters such as Russia and Argentina.

A critical analysis of the effectiveness of economic policies and the impact of sovereign debt crises on the financial landscape is also provided in this paper. Part A: European Sovereign Debt Crisis The recent European Sovereign Debt Crisis of 2010/2011 has many features in common with the financial stresses experienced in the early 1990s in the world economy. The features of the sovereign debt crises such as low risk on premiums, long duration of credit growth, abundant liquidity, high asset prices, strong leveraging, and real estate bubbles are experienced in the European Sovereign Debt Crisis which began in 2008 with the collapse of the banking system of Iceland.

As a result, there is a lot of uncertainty of banks on the creditworthiness of the institutions in which they had heavily invested. As a result, there is reduced investments by banks in various institutions in the United Kingdom as demonstrated by Brearley (2010, p. 36). Moreover the recent European Sovereign Debt Crisis has caused a big liquidity problem among the European banks. Because of the liquidity problem, the European banks are failing to rollover their debts. The European Sovereign Debt Crisis may be viewed as a mere liquidity problem by policy makers and financial institutions like the previous crises which would cause eventual collapse of the financial institutions.

Estenssoro (2010, p. 4), explains the beginning of the recent European Foreign Debt Crisis by showing that the emergency concerned with the solvency of various financial institutions in Europe demonstrated a serious economic problem policy makers thought that it was unlikely for the financial systems in Europe to fail. From the point of view of Blundell-Wignall and Slovik (2010, p. 12), the European economy was believed to be immune to the financial turbulences because it was considered to be thriving through the good financial positions of businesses and households in addition to the growth in export.

In September 2008 when the recent crisis began, these perceptions changed drastically with evaporation of valuations of the financial firms, which caused panic within the stock markets. At this point, the collapse of the financial institutions became a real threat to the stakeholders of the financial and manufacturing sectors. The sovereign debt crises, which led to the recent European Sovereign Debt Crisis, were worsened when banks were forced to hold back credit, which led to the plummeting of the economic activities in Europe.

The collapse of the credit market started to spread to other parts of the world with trade credit becoming expensive and scarce. As a result, there was a drop in sales and piling up of inventories, which made businesses loose the consumer confidence. These economic situations contributed to the European sovereign Debt Crisis. This crisis is affecting many economies within Europe and in the international arena. Cushnie (2010, p. 17) emphasizes that the recent European sovereign Debt Crisis was caused by the exposure of the European Union countries to the deteriorating world economies.

The foreign economic environment affects Europe because the Exchange rate of the Euro in comparison to other world currencies was turbulent when the crisis began. Therefore the import and export trade between Europe and other countries was poor as compared to the time when the region was free of any crisis. Additionally, the failing world economy contributed to the downtown of several European banks because investors become suspicious of the portfolios of the banks hence it was difficult for them to obtain capital from shares and deposits.

This caused financial institutions to further limit their lending with banks, which would not finance themselves anymore being forced to sell their assets at low prices. The recent European Sovereign Debt Crisis has its rots in the dysfunctional regulation of the Euro as the common currency in Europe. Roche (2010) asserts that the dysfunction in the European monetary union contributed to the Sovereign Debt Crisis because there was no political unity to support the economic policies of the union.

The arrangement, which led to the standardization of the Euro as the legal tender in the Eurozone, was not well planned. As explained by Neumann (2010, p. 32), the European Central Bank was given the responsibility of the Euro’s monetary policy and since there was no formal representation of member states in the bank, financial crises would not be contained in accordance to the interests of the states. Additionally, a formal policy was not laid to ensure that all states in the union recognized the Euro as the common currency.

Furthermore, the governance of the central bank did not involve all member states which led to divergent financial interests within the region as explained by Brearley, (2010, p. 37). The contribution of the dysfunctional monetary union to the European Sovereign Debt Crisis is illustrated by the fact that member states were deprived the choice of solving the crisis because of the limited authority over the Euro. Therefore, the European states would not lower interest rates as a monetary measure of solving the crisis.

In addition, the states did not have the authority of devaluing the common currency so that the crisis would be solved. As demonstrated by Blundell-Wignall & Slovik (2010, p. 18), the European Sovereign Debt Crisis was caused by the political crisis in Europe which presented itself in a financial dimension. The countries had political disagreements on employment of individual of economic measures by individual states in solving the crisis. Neumann (2010, p. 28) adds that the public finance and economic challenges of the member states within the European Union are not economically congruent.

As a result of these differences, there were divergent political incentives within the region. Rich economies wanted their political dimensions to dominate over those of the poorer European economies. This resulted to divided approaches on the measures of solving the sovereign financial crisis. PART C: Sovereign Default According to Fildes (1999), foreign default refers to the refusal or failure of sovereign country to fully pay its financial debts. Foreign default is usually in form of a formal announcement by a government of a sovereign state saying that it will not pay its debt.

This announcement by a sovereign state is referred to as repudiation. Cessation and partial payment of debts by a government are also forms of foreign default. Shlyzhius (1999) explains that because sovereignty of states makes them to be in control of all of their affairs, it means that it is not mandatory for a country to pay its debts. However, it should be noted that severe pressure might result from non-compliance to settlement of debts by a country, which may lead to the lending state declaring war on the defaulting country.

The foreign default of Argentina leaves many lessons to be learned by states in the European Union. According to Porzecanski (2005, p. 311), there was hyperinflation in Argentina between 1989 and 1990 due to its failure to pay debts. Because the Argentine currency was fixed to the US dollar at very high levels, the reserves of the USD needed by Argentina to ensure convertibility was so high that a financial disaster resulted. Therefore, the inflation in Argentina could not be contained and prices of goods and services in the country were unstable.

Because of the huge foreign debts of Argentina which it would not pay, and the fixed exchange rate, Hatchondo and Martinez (2010, p. 291) explain that its imports became cheap leading to reduced competitiveness because there was external flow of dollars from the country. The result of this was increased levels of unemployment in Argentina. The financial crisis in Argentina also led to the increasing of its debts through IMF lending which was aggravated by increased government expenditure, tax evasion, and corruption.

According to Porzecanski (2005, p. 329), the sovereign default of Argentina led to reduced foreign investment because the confidence of the investors on the country’s economy was lost. The consequences of Russia’s 1998 sovereign default and financial crises also serve as a lesson to be learned by defaulting nations. Shlyzhius (1999, p. 3) asserts that the Russian sovereign default led to wakening of the Russian Rubble with the country’s Central Bank refusing to offer support the falling currency in September 1998 due to the sovereign default of the government.

As a result, there was increased inflation, which led to a food crisis in Russia, which also resulted to the appeal of the country for humanitarian aid from international community. The consequence of the Russian sovereign default is also demonstrated by the drastic fall of the Russian stock exchange soon after the default. Conclusion The recent European sovereign Debt Crisis of 2010/2011 is rooted to the initial political and economic disharmony within the European Union. As a result the financial institutions began to fail as credit became scarce and investments in the economy reduced.

The results of the recent sovereign debt crisis include the reduction of the European bond yield and a downtown in the equity market. Because of the political and financial implications of the sovereign default, the financial institutions and policy makers within the European States should apply various strategies such as regulation of credit and the national balance sheet as a way of ensuring economic stability of the region. References Blundell-Wignall, A and Slovik, P 2010, "A Market Perspective on the European Sovereign Debt and Banking Crisis,” OECD Journal.

Financial Market Trends, no. 99, pp. 9-36. Brearley, B 2010, "Top managers steer clear of sovereign debt crisis", Investment Week, pp. 36-37 Cushnie, L 2010, "Hak Salih: UK facing sovereign debt crisis", Investment Week, pp. 17. Estenssoro, A 2010, "European Sovereign Debt Remains Largely a European Problem,” Regional Economist, pp. 4-5. Fildes, T 1999, "Russias default focuses lenders minds,” Euroweek, no. 598, pp. S18-S20 Hatchondo, J. & Martinez, L 2010, "The Politics of Sovereign Defaults", Economic Quarterly - Federal Reserve Bank of Richmond, vol. 96, no. 3, pp. 291-317. Neumann, M 2010, "Managing the Sovereign Debt Crisis,” CESifo Forum, Vol. 11, no. 3, pp. 27-32. Porzecanski, A 2005, "From Rogue Creditors to Rogue Debtors: Implications of Argentinas Default", Chicago Journal of International Law, Vol. 6, no. 1, pp. 311-332. Roche, D 2010, "Against the tide: Sovereign debt crisis Beyond the death zone", Euromoney, no.

00142433, p 1. Shlyzhius, G 1999, "Russias external debt: Economic implications", Euromoney, no. 00142433, pp. 2-3.