The European Sovereign Debt Crisis - Essay Example

? The European Sovereign Debt Crisis Introduction The crisis that has been persisting in the European economy since the year 2009 had been substantially caused due to the Sovereign Debt Crisis. Sovereign Debt is the debt incurred by the government of a nation. Many European countries under the Maastricht have clubbed together their monetary authorities under the rules and regulations of the European Central Bank (ECB). All these nations were combined together and were known as the European Monetary Union (EMU). It was found that from 2009 onwards, some countries in the EMU like Spain, Portugal and other countries in the similar zone, were not able to refinance the debts incurred by the government. This crisis in some of the countries in the EMU had a spill-over effect and had generated an economic scarcity in most of the contemporary economies in the world. The essay in this context desires to throw light on how the crises in some of the economies in the EMU were responsible for the massive and deadly financial crisis in the financial markets of the whole European Union (Ross, 1979). Crisis in a Small Economies Triggered a Large Impact The economies in the contemporary world have become highly integrated in nature after the emergence of globalization and liberalization. The debt crisis that was initially faced by the public authorities in a few small economies in the Euro zone like Spain, Greece etc were responsible for the occurrence of the Sovereign Debt Crisis for the whole European Continent. The Property Bubble that occurred in Spain long back in 2007 was largely responsible for the occurrence for the recession in the European economy at the latter stage. It was found that after a long term sustainable growth, the Spanish economy had become highly unproductive in nature. The entrepreneurs started to invest more in the real estate sector. However, it was found that the prices of the properties constantly increased in the economy because real estate trading was used for speculative purposes in the Spanish economy. Ultimately, this caused a fall in the disposable income of the individuals who had to purchase houses at very high prices. The number of the failed projects in the economy started to increase. All the other economic indicators like the government debt, exchange rates, velocity of money circulation, derivative trading etc became worse in the economy at this point of time. As the countries used to follow the regime of fixed policies, the recession in one particular economy had largely triggered the same in other economies in the Euro zone. Greece was one of the poorest nations that had remained in the Euro Area. The government of the country took large amount of loans from the ECB for mitigating the requirements if the expansionary fiscal policies. However it was a matter of concern that the government of the country could not pay back the loans to the ECB. This was the reason for the huge fiscal deficit in the country. Fiscal deficit in the nation contagiously affected the supply of money in the economy. Thus during 2005 and 2009, some countries which were indeed small economies like Spain, Italy, Greece, Portugal etc. had to face severe financial crisis for reasons like property bubble, high fiscal debt or lack of productivity. Since all the nations in the Euro zone were integrated together in terms of the monetary policies taken for them, the crisis in some of the economies soon triggered the same in other economies in the European Continent and generated the severe Sovereign Debt Crisis in the country (Klann, 2007). Impact in the financial Market The financial market in the Euro zone was distressed after the occurrence of the Sovereign Debt Crisis. The severity of the recession caused in the economy has not been completely recovered from even at this juncture of time. Derivatives Market During the Sovereign Debt Crisis, the European economy faced severe financial crisis. The number of failed out financial projects were excessive. The overall productivity of the economy had fallen to a large extent. This made the investors in the economy highly suspicious of their investment returns. Figure 1: Risk Return Preferences of the Investors (Source: PPT) As stated above, investors can be averse to risk taking and may demand for high compensations on the investments made as shown in the black curves in the above diagram. On the other hand, the investors can also be risk lovers and thereby demand for low amount of compensations, as shown by the red curves. It was found that during the Sovereign Debt Crisis, the investors became more risk averse in the European economy. As a result, the derivative trading in the economy fell to a large extent. Moreover, the government faced huge fiscal debts, it was almost impossible for the government to extract money from the economy through simple open market operations in the European economy. As a result the bond as well as the derivative trading in the European economy declined drastically during the Sovereign Debt Crisis. The impact was first felt in the economies such as Spain, Ireland etc and later gradually had spread and transformed to the rest of the EMU (Laeven and Majnoni, 2003). Figure 2: Depressed Capital Market during Sovereign Debt Crisis (Source: Mistal, 2012) The above graph shows the fall in derivative trading in the European economy during the Sovereign Debt Crisis. Money Market The impact of the Sovereign Debt Crisis was instantaneous in the money market of the European Economy. Figure 3: Credit and Deposits in the Spanish Economy (Source: Kennedy and McQuinn, 2011) As shown in the above graph, the rate of deposits in the economy of Europe was less that the rate of credit operations. It is felt by some analysts that one of the primary causes for the crisis in the economy was the failure of the banking institutions. The banks did not possess efficient credit appraisal tools. Rather due to globalization, the amount of foreign direct investments in the economy was also high. This made the banks feel quite confident about its decision to expand the aggregate credit opportunities in the economy (Smyth and McQuinn, 2009). On the other hand, the soaring oil prices after the Gulf wars in the Middle-East caused the level of consumer price index to rise significantly at this point of time. This caused the fall in the level of disposable income of the individuals in Europe. Thus the deposit rates in the banks were comparatively lower than the lending rates. However, many of the financed projects by the commercial banks turned out to be bad debts in the economy. The banks had to offer many bail outs to the failed projects. Thus, the commercial banks faced severe financial crisis in the European economy during Sovereign Debt Crisis. This crisis in the commercial banks had first taken place in the small economies like Spain and Portugal but soon its impact triggered the recessionary phase to spread out to the other economies. The crisis in the money market had immediately trickled down to the economy on the whole and reduced the aggregate supply of money in the European economy (Gerlach and Wensheng, 2004). Foreign Exchange Rate Market In the era of globalization and liberalization, most of the economies in the world are by nature, open economies. Exchange rate of a country is the price of the currency of that country in terms of the price of the currency of another country. It can be measured in real and nominal terms. However for the purpose of analysis, real exchange rates are given more importance. Real Exchange Rate (e) = P*/P. Where P* = Price of the foreign currency (country B) and P = price of the domestic currency (country A). Thus if e rises = exchange rate of the home currency depreciates and vice versa. Figure 4: Falling Exchange Rates during Sovereign Debt Crisis (Source: Keohane, 2013) The above graph shows the falling exchange rate of four nations in the Euro Zone owing to the crisis. The impact of these economies affected all the other economies in the zone and weakened the currency of the EMU. It was found that the crisis in the European economy depreciated the currency value of the economy in the global market. The exports of the economy became cheap and the imports had become expensive. Though there was surplus in the current account, the balance of payment account became unfavourable due to the deficit in the capital account (Alsakka and Gyilym, 2013). Conclusion The state of business affairs in the contemporary world has become highly complex in nature. After the onset of globalization and liberalization in the world economy in 1990, the financial sectors of all the economies have become highly integrated. This is the reason for the international policy coordination to become a modern jargon in the economies. It has been analyzed that the same types of monetary policies adopted by the ECB for all the countries in the EMU is not correct. Rather the policies of the EMU overtime have been highly partial in favour of nations like Germany. This has gone against the interests of nations like Italy and Spain. Though the ECB have adopted tools like Quantitative Easing to increase the velocity of circulation of money in the European economy, it has been analyzed that the great negativities of the sovereign debt crisis cannot be recovered until unless the EMU adopts separate monetary policies for different economies in the Euro Zone (Taltavull and McGreal, 2008). Reference List Alsakka, R. and Gyilym, O. A., 2013. Rating agencies’ signals during the European sovereign debt crisis: Market impact and spillovers. Journal of Economic Behavior & Organization, 85, pp. 144– 162. Gerlach, S. and Wensheng, P., 2004. Bank lending and property prices in Hong Kong. Journal of Banking and Finance, 29, pp 461–81 Kennedy, G. and McQuinn, K. 2011. Scenarios for Irish House Prices. Financial regulator. Keohane, D., 2013. Markets. [online] Available at [Assessed 29 October 2013]. Klann, N. H., 2007. A bubble about to burst? The Spanish Real Estate Market. Norderstedt: GRIN Verlag. Laeven, L. and Majnoni, G., 2003. Loan loss provisioning and economic slowdowns: too much, too late? Journal of Financial Intermediation, 12(2), pp 178–97. Mistal, C., 2012. The authority stock market cycle. [online] [online] Availabke at [Assessed 29 October 2013]. Ross, S. A., 1979. The Economic Theory of Agency: The Principal's Problem. American Economic Review, 63, pp. 134-139. Smyth, A and McQuinn, K. 2009. Modelling credit in the Irish mortgage market. Economic and Social Review, 40(4), pp.371-392. Taltavull, P. and McGreal, S. 2008. Measuring price expectations: Evidence from the Spanish housing market. Journal of European Real Estate Research, 2(2). Read More