The European Sovereign Debt Crisis - Case Study Example

Running head: INTERMEDIATE MACROECONOMICS The European sovereign debt crisis Name Course Information Professor Information Date Due Introduction This paper intends to discuss the European Sovereign Debt Crisis. The first section is a detailed assessment of sovereign debt crisis covering on the impact of a default on a state. The second section offers an overview of how global financial crisis paved way for the European Sovereign Debt crisis. Factors leading to European Sovereign Debt will be given necessary attention. As indicators of possibility of default, CDS spread and sovereign bond rating will surface in the essay. Finally, a number of recommendations will be drawn at the end. Sovereign Debt Crisis Before exploring the European sovereign debt crisis, it is important to understand the terms sovereign default. Duthel (2012) found that sovereign debt arises when a sovereign state fails to repay fully its debt. Under such a situation, an environment of scepticism among potential lenders or those who have purchased government bonds is created. In reaction to the suspicion that the government might not be able to settle its debt, lenders, and bondholders raises interest rates consequently giving rise to sovereign debt crisis. Duthel goes ahead to state that government is exposed to sovereign debt crisis when it depends on short-term bonds as a means of financing its activities. Blanchard and Fischer (1989) reiterate that short-term bonds lead to a mismatch in maturity between the bonds and the value of long-term asset. Besides, sovereign debt crisis occurs due to mismatch in currencies under a situation where a government is unable to issue bonds in own currency following a deterioration in value of domestic currency. In effect, a government is obliged to pay back in foreign currency, which is expensive. Bearing in mind that a sovereign state may not be forced to settle its debt, they may not qualify for any other credit. Additionally, defaulting state risks the possibility of its overseas assets being seized. Domestically, the government will experience pressure from internal bondholders who will require the government to pay the outstanding debt. As opposed to defaulting on the entire debt, governments often resort to debt restructuring where a government negotiates with bondholders on reducing or delaying debts (Krueger, 2002). Financial crisis to sovereign debt In a study by Lapavitsas (2012), the 2007-09 global financial turmoil triggered Eurozone crisis. The researcher highlights the role played by speculative mortgage lending and trading of derivative securities in creating immense bubbles between 2001-07 consequently leading to 2007 crisis and recession. Banks were nonetheless rescued by state by availing liquidity and capital in the year 2008-09. Notwithstanding the fact that government expenditure contained recession, Eurozone was exposed to sovereign debt crisis, 126.8 percent of GDP, a situation aggravated by feeble structure of monetary union. It can therefore be construed that the crisis of the public debt was the second stage of global financial crisis that started in 2007, a situation that Lapavitsas classified it as a crisis of financialisation. Figure 1 is a comparison of debt to GDP ratio of Japan, Euro Area, and USA. After the financial crisis of 2008-2009, debt ratio in United States rose from 85 to 99 percent, a figure that was way below Japanese ratings of 220 percent. The diagram further illustrates that euro exchange rate has been stable across the entire Euro area. Figure 1: Debt to GDP Ratio Source: Collignon (2012, p.12) Collignon (2012) reports that even though debt to GDP ratio was low for Euro Area compared with Japan, the problem rests with individual state whose debt ratio is way above the requisite 3%, as shown by table 1. Greece for example recorded 4.2 percent of total debt in Eurozone. Table 1: Public Debt and Deficits of States in Eurozone Source: Collignon (2012, p.12) Leads to European Sovereign Debt Crisis Grahl (2011) notes that weak integration of countries in the Eurozone region was a major precursor to the sovereign debt crisis. Maastricht Treaty, the Stability and Growth Pact and Lisbon Strategy are some of the treaties and agreements that reinforced the European Monetary Union. The European Central Bank had a mandate to manage monetary policy across the euro region. While formulating monetary policy, European Central Bank emphasised on conditions in core states instead of looking at various economic conditions in all euro states. The result of this action was a low interest rate across the region. In the same vein, European Central Bank has demonstrated inefficiency in its operation bearing in mind that it has not been allowed to manage state debt. The introduction of Euro into the Eurozone made it possible for nations to borrow cheaply. Member states assumed that by virtue of being a member of Eurozone, risk had reduced because of guiding rules imposed by integration. The rules outlined that member states were to operate a government debt that was under 60 percent. It was also stipulated that budget deficits should be within 3% of GDP. Outright violation of economic rules for Eurozone damaged the credit profiles of many countries in the region. A new phase of the European sovereign debt came to life in the late 2009 when some countries reported huge deficit to GDP ratio. As an example, Ireland and Spain reported fast falling fiscal revenue as compared with GDP due to sensitivity of tax revenues to deteriorating economic activities and asset prices (Sargent, 2012). A prominent scenario of misreported deficits occurred in Greece after the 2009 October general elections. The new government headed by George Papandreou discovered that budget deficit was 12.7 percent of GDP, a figure higher than previously estimated 6.0 percent (Armitstead, 2012). Upon conducting further investigation, it emerged that Greek fiscal accounts had been understated for several years. This observation not only demonstrated flouting euro’s fiscal rules but also showed extensive indiscipline nature of Greece, which was then replicated in weak nations. As an indicator of violated Stability and Growth Pact, Greece had maintained its fiscal deficit above 3% for approximately ten years. Looking at the Stability and Growth Pact agreement, members of the European Union were supposed to maintain their budget deficits at 3 percent of GDP (Siegert, 2004). The agreement however lacked sufficient mechanism to ensure that countries followed the rules to the latter. International loans and EU funds made available by formation of a union propagated the aspect of borrowing subsequently culminating into deficits and debts. The other precursor to the crisis was government inefficiency in managing the debt by increasing taxes or reducing spending. This killed investor confidence in Greece. Notwithstanding the fact that some fiscal reforms were installed to stimulate growth and slash debt, minimum positive outcomes were registered. Bearing in mind that Greece was not willing to raise taxes for purposes of financial programs; the government remained with a single option of borrowing funds. To contain deficits Greece issued government short-term maturity bonds. When payment for the bonds became due, the government was obliged to pay at a high rate simply because of poor revenue emanating from low economic performance. Inability of the government to settle debts raised scepticism amongst investors who in response required high interest rates in order to purchase Greek issued bonds. These factors made borrowing to be very expensive and risky on the part of an investor. At this stage, bailout was indispensible. The spread of sovereign debt crisis The spread of sovereign debt crisis was mainly supported by investor perception that countries in Eurozone were characterized by shared policy. This contagion effect saw the spread of the crisis from Greece to Ireland, Portugal, Spain, and Italy. Briefly, contagion effect arises when an investor believes that countries under crisis presents a risk of losing their finances hence are prompted to act in a certain manner (Kolb, 2011). Even though Greece was the only country with high debts, investors became insecure about the situation of other countries in Eurozone. To counteract the insecurity, investors demanded high interest rates regardless of whether the perceived debt situation was realistic. Data Analysis CDS spreads are critical elements indicating the risk of defaulting (Lane, 2012). When CDS rating is high, the possibility of default is high. This is a good indicator of risk of default on corporate and sovereign debt. Before the crisis, CDS spreads for many countries in euro region were low, which indicated that investors held low level of probability that countries would default on their debts. CDS spread subsequently rose following the 2008 crisis. Figure 2 of CDS spread in weak marginal EU shows a deterioration of investor confidence on the ability of the nations to surface loans. Figure 2: CDS of some EU Members Source: (Akdoğu, 2012, p.131) Sovereign bond spread ratings assess the possibility of default. Interest rate levels, growth prospects, debt levels, budget deficits are taken into account when developing a sovereign rate. S&P, Moodys, and Fitch conduct the process of rating. Greece’s sovereign bond spread became worse from mid-2007 to 2011. Creditworthiness often changes during crisis period and is reflected in bond spread. Ireland, Portugal, and Spain followed suit as its credits were downgraded as shown in figure 3 of Sovereign Bond Spreads in Selected EU States Figure 3: Sovereign Bond Spreads Source: (Akdoğu, 2012, p.132) Recommendations to deal with the crisis In order to address Eurozone crisis, it is prudent to learn from crisis faced in the past by other regions i.e. the Russian crisis of 1998. Russia reduced expenditures including military allocations while also improving efficiency of tax collection. In a similar manner Greece and Spain reduced expenditures on salaries for civil servants. It is however important to take into consideration the nature of demand to realise positive results. The European Central Bank is barred from directly financing countries in the Euro region. To enhance moral wellbeing of EU nations, the EU treaty provides for a no bailout clause. This provision ought to be reinforced by developing an institution that will address cases of sovereign debts. Member states of the EU have already taken an initiative by bringing into being the European Financial Stability Facility for nations that are facing problems with their debts (Kolb, 2011, p. 380). Thirdly, exchange rate stabilization measure is paramount. Rigidity in a monetary union is visible in Euro area because of the inability of a member state to manipulate exchange rate to solve its problems and subsequently regain competitiveness. Usually, exchange rate policy under the scenario of EU reflects economic situation of the entire region. There is a necessity to break down monetary union to allow weak currencies to face floating exchange rates. When debt situation of a country is beyond repair, resolution can be made to restructure the debt. Kolb notes that Russia restructured its public debt in 1998 after a three-month freeze. The approach nevertheless lacks credibility for external investors. Conclusion Sovereign debt crisis was the second stage of a financial crisis that stated in United States following massive failure of financial institutions. Generally, the crisis came to be termed as a crisis of financialisation. After conducting extensive research on diverse areas of European Sovereign Debt, it became clear that structural inefficiency of Eurozone was majorly to blame for underperformance of member states. Greece for example failed to reveal true deficits, which ultimately affected on investor confidence and by extension the interest rating. By contagion, crisis in Greece overflowed to other Eurozone member states. Reference List Akdoğu, S. K. (2012). CDS, bond spread, and sovereign debt crisis in peripheral EU. Published in: Crisis Aftermath: Economic policy changes in the EU and its Member States, Conference Proceedings, Szeged, University of Szeged , Vol. ISBN 9 (2012): pp. 126-133. Armitstead, Louise (2012). “What's the Greek debt crisis all about?” The telegraph 23 Feb 2012. Web. Blanchard, O., and Fischer, S. (1989). Lectures on Macroeconomics. Cambridge, US: MIT Press. Collignon, S. (2012). Europe’s Debt Crisis, Coordination Failure, and International Effects. ADBI Working Paper 370. Tokyo: Asian Development Bank Institute. Duthel, H. (2012). European Debt Crisis 2011. India: IAC Society. Grahl, J. (2011). Crisis in the Eurozone’. Soundings, 47(47): p. 143 – 158. Kolb R. W. (2011). Sovereign Debt: From Safety to Default. Hoboken, NJ: John Wiley & Sons. Krueger, A. O. (2002). A New Approach to Sovereign Debt Restructuring. Washington, DC: International Monetary Fund. Lane, P. (2012). The European Sovereign Debt Crisis. Journal of Economic Perspectives, 26(3): 49-68. Lapavitsas, C., et al. (2012). Crisis in the Eurozone. London: Verso Books. Sargent, T. J. (2012). United States Then, Europe Now. Journal of Political Economy, 120(1): 1–40. Siegert, C. (2004). The Stability and Growth Pact. Munich: GRIN Verlag. Read More