european sovereign-debt crisis word

7/21/2019 European Sovereign-Debt Crisis Word

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EUROPEAN SOVEREIGN

DEBT CRISIS

Submitted to Prof. Shraddha Kotak


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TABLE OF CONTENTS

Contents

INTRODUCTIONCAUSES AND EFFECTS

IRELAND

PORTUGAL

PROPOSED LONG TERM SOLUTION

CONCLUSION

TAKEAWAYS

SUBMITTED BY PGDM STUDENT SEM IV

Heli Jani 17

Tejas Kadam-19

Prasannajit Lahiry-22

Rupashree Mane-23


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EUROPEAN SOVEREIGN-DEBT CRISIS

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Introduction

Recent months have seen the transformation of the global financial crisis intoa sovereign debt crisis in the euro-area. Starting from Greece in autumn2009, the euro-area crisis has since caused Greece to withdraw frominternational bonds markets and has put intense pressure on the bonds ofother EMU countries, most notably Ireland, Portugal and Spain. The intensityof the crisis has prompted European policy makers to take extraordinarymeasures aiming to limit its fall-out on the real sector of the affectedcountries and prevent its further spreading. These measures, ratified in May

2009, include an unprecedented in size (110 billion euros) three-yearEU/IMF-financed emergency rescue package for Greece; and the creation of aEuropean stabilisation mechanism ring-fencing 750 billion euros forcountries that may find themselves in a position similar to the Greek onewithin the following three years. These measures, however, have so far notproved enough to ease the crisis. In November 2010 Ireland became thesecond EMU country to seek and obtain a rescue package for 85 billion euros.This event fuelled further debates on issues ranging from the optimum short-run response to the crisis to the eurozones overall long-term sustainability.

With so much political and economic capital at stake, it is not surprising thatthe economics literature has responded actively to the eurozone crisisthrough a series of empirical studies. The consensus emerging from thisliterature, reviewed in section 2, is summarized in two main findings. First,both the amount and the price of the perceived global risk associated withinvestments in sovereign bonds, relative to the safe havens of US andGermany, have increased during the global economic downturn. This explainsthe across-the board increase in EMU spread values. In this process, thetransfer of banking sector risk to sovereign borrowers, through bank bail-outs, has been central. Second, intra-EMU differences in spreads increasesare explained by heterogeneous transfer of banking sector risk to sovereignborrowers and the pricing of heterogeneous macro-fundamentals.


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The penalties imposed by markets are further exacerbated by the interaction

of macro fundamentals with the common international risk factor. Theexisting studies have shed much-needed light on the factors drivingincreasing EMU spreads, greatly enhancing our understanding of theeurozone crisis. Important questions, however, still remain unanswered.First, almost all existing studies are purely empirical. However informative,without a theoretical mapping to the events it aims to analyse no study canoffer a full set of explanations and traceable future policy implications.Second, existing studies have not explained the events characterising themost recent and intense phase of the crisis. Why did the Greek spread

escalate from 140 basis points in early?

November 2009 to 250 points by the end of the year and nearly 600 in lateMarch 2009?Third, why has the Greek spread been taking so much higher valuescompared to other periphery countries? Is the Greek macro-outlook so muchworse than Portugals to justify s as been the role, if any, of speculativetrading in the market for credit default? Swaps (CDS) on Greek and otherEMU government bonds? Such speculation has been suggested as one of thepotential culprits behind the present turmoil with subsequent proposals

ranging from tighter regulation of the CDS market to an outright permanentban on naked CDS trading. Are such proposals justified or is the role of CDSspeculation overestimated in the ongoing debate?First, during the period preceding the global credit crunch (January 1999 July 2007), with the possible exception of expected fiscal deficits, marketspriced neither macro fundamentals nor the very low at the time internationalrisk factor. This finding is consistent with the convergence-tradinghypothesis, according to which markets were discounting only the optimisticscenario of full real convergence of all EMU economies to the German one.

Second, we obtain evidence in favour of the hypothesis that the Greek debtcrisis is due to a background of deteriorating macro-fundamentals and adouble shift in private expectations:This regime-shift not only explains the sudden escalation of the Greek debtcrisis but also the difference in spread values observed between Greece and


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other periphery EMU countries with not too dissimilar macroeconomic

outlook: Compared to Ireland, Portugal and Spain, markets perceive a muchhigher probability of a Greek voluntary exit from the EMU, and/or a Greekdefault. In short, Greeces problems are as much about trust as they are abouteconomics.

Third, we confirm that up to the point covered by our econometric analysis(February2010), the overwhelming majority of EMU countries had experiencedcontagion from

Greece, most prominently Portugal, Ireland and Spain. This is interpreted asevidence that theGreek bond yield has become a proxy for EMU-specific systemic risk,increasing borrowing costs in other EMU countries beyond the level justifiedby the common international risk factor and their idiosyncraticfundamentals. In short, the Greek problem has become an EMU-wideproblem. Finally, we do not find evidence in favour of the hypothesis thatspeculation in the CDS market, including the Greek one, is a major forcedriving the eurozone debt crisis.

FINANCIAL HIGHLIGHTS

From late 2009, fears of asovereign debt crisisdeveloped among

investors as a result of the rising private andgovernment debt levels

around the world together with a wave of downgrading of government

debt in someEuropean states.

Three countries significantly affected,Greece,IrelandandPortugal,collectively accounted for 6% of the eurozone's gross domestic product

(GDP).


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In June 2012, alsoSpain became a matter of concern,when

risinginterest ratesbegan to affect its ability to access capital markets,leading to a bailout of its banks and other measures.

The crisis has had a major impact on EU politics, leading to power

shifts in several European countries, most notably in Greece, Ireland,

Italy, Portugal, Spain, and France.


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CAUSES

Rising household and government debt levels

Trade imbalances

Structural problem of Eurozone system

Monetary policy inflexibility

Loss of confidence

The European debt crisis which began at the end of 2009 and appeared

clearly as a major threat in 2010 is actually a byproduct of combing

CAUSES

Risinghousehold

andgovernmentdebt levels

Tradeimbalances

Structuralproblem ofEurozone

system

Monetarypolicy

inflexibility

Loss ofconfidence


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factors that yielded in the undergoing grim situation which is full of

uncertainty about when will the crisis come to an end.

If factors to be summarized, it could be mentioned that five main

factors have participated in forming the debt crisis saga.

1-Violation To EU Rules

The very beginning of the story is actually coming back to earlier

stages at the time European nations were eager to form a monetary

union that took several steps ending with the inception of the euro in

1999 as many participants violated the conditions needed under the

Maastricht Treaty in 1992.

Countries such as Greece and Cyprus did not give real data about the

financial and economic situation and the EU probably knew but

ignored and accepted the accession of such counties to enlarge the

European cartel. The problem does not stand at that extent but that the

EU also accepted highbudget deficit and debt levels by many countries

during the crisis .

2-Banking Sector Problem

The European banking sector appeared to be vulnerable as it has

showed a dramatic collapse since it got involved in the global financial

chain that was dragged down in the 2007 financial crisis, which was

buoyed by the burst of the mortgage bubble in the United States.

The usage of financial instruments that included high risk such asCDOs in addition to Credit Default Swaps that was ignited by

speculations the euro bloc will collapse have left banks in a weak

position as they have to use their money in financing government
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budget deficits rather than doing their key role of providing lending to

businesses and households.

3-Rating Agencies

It is clear that rating agencies have played a principle in letting the

crisis reach what it has reached so far as they continued, since the

beginning of the crisis, to downgrade troubled euro area nations due to

the risks stemming from the debt crisis, causing further rise in bond

yields and tensions in bond market as well as creating difficulty in

raising money by governments due to the low trust Creditors had afterthe downgrade in their ability to repay at maturity.

4 -Political Conflict

As is well known, politics and economics are two sides of one coin and

the role of politics in the debt dilemma cannot be ignored as the

different political perspectives between parties having different

ideologies have created a kind of conflict between European decision

makers as Germany and other rich nations were on one hand refusing

to let taxpayers pay for the crisis and have refused any decisive

methods including violation to their sovereignty while the other camp,

which is so-called peripheral nations, have been asking for more

flexibility.

In spite of the changes in Parliaments throughout the years of the

crisis, Germany has remained stick to its austerity-led strategy to deal

with crisis even if this would come at the expense of nations that haverefused sharp spending cuts and tax levies and have expressed their

rage in the form of strikes and giving punishing votes to anti-austerity

parties like what happened in elections in Greece and Italy.
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5-Slow and Indecisive Actions From European Officials

The debt crisis which was triggered by Greece did not remain only in

the Hellenic country but transferred from one country to another due

to the slow response from European leaders to solving the problem as

their actions were always late and not decisive.

The fact of having 17 nations having different point of views has

caused prolonged discussions that were dominated by insistence from

Germany for adopting strict austerity measures to trim budget deficit

while delaying every decision till the approval of national parliamentsand sometimes constitutional courts has caused the debt problem to

remain uncontained.

Just at the end of last year, European leaders have begun to announce

some steps that could be described as fruitful as they had reached a

deal for Greece and announced the ECB as chief supervisor of euro

zone banks which is deemed a step of a paramount importance as it

paves the way for a strong European banking union that seems to beone of the key solutions to get out of the debt crisis inferno.

Actions announced by European officials, aside from being late, were

not decisive and was like transferring the problem from place to

another instead of cutting the cancer from its roots. The main remedies

to the crisis were mainly in the form of bailouts for troubled nations

and loans by the ECB to ailing banks, while lacked effective methods

such as having banking union, using Eurobonds to ease concerns in

bond market, or forming a fiscal union.

During the crisis, the ECB opted to leave interest rate at low level to

bolster economic growth, while raising it in some occasions to lower

inflation to target, and then used unconventional methods that are
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mainly lending more than $1 trillion euro to banks in the form of two

rounds of cheap three-year loans which not only did not solve theproblem of the banking sector, but also ended up with the reliance of

many European banks on ECB loans in creating liquidity. These loans

were targeting banks directly while failed to have a real contribution

on investment and growth in eurozone economies that are still

suffering fromrecession and high unemployment.

The most recent problem in Cyprus has showed that European officials

have adopted new methods that also come at the expense of nations asthey agreed to let depositors and stakeholders participate in financing

bailout.

Hence, thecrisis is expected to continue for additional years as long as

no decisive measures are taken by officials.

Rising household and government debt levels

A number of economists have dismissed the popular belief that the

debt crisis was caused by excessive social welfare spending.

According to their analysis, increased debt levels were mostly due to

the large bailout packages provided to the financial sector during

thelate-2000s financial crisis.

The averagefiscal deficitin the euro area in 2007 was only 0.6% before

it grew to 7% during the financial crisis.

TheInternational Monetary Fund (IMF) reported in April 2012 that inadvanced economies,the ratio of household debt to income rose by an

average of 39 percentage points, to 138 percent in Denmark, Iceland,

Ireland, the Netherlands.
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In the same period, the average government debt rose from 66% to

84% of GDP.

By the end of 2011, real house prices had fallen from their peak by

about 41% in Ireland, 29% in Iceland, 23% in Spain and the United

States, and 21% in Denmark.


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TRADE IMBALANCES

A trade deficit can also be affected by changes in relative labor costs,

which made southern nations less competitive and increased trade

imbalances.

Since 2001, Italy's unit labor costs rose 32% relative to Germany's.

Greek unit labor costs rose much faster than Germany's during the last

decade.


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STRUCTURAL PROBLEM OF EUROZONE SYSTEM

There is a structural contradiction within the euro system, namely that

there is a monetary union without a fiscal union (e.g., common

taxation, pension, and treasury functions).

In the Eurozone system, the countries are required to follow a similar

fiscal path, but they do not have common treasury to enforce it.

That is, countries with the same monetary system have freedom

infiscal policiesin taxation and expenditure.

Eurozone, having 17 nations as its members, require unanimous

agreement for a decision making process.

This would lead to failure in complete prevention of contagion of other

areas, as it would be hard for the Euro zone to respond quickly to the

problem.

That is, countries with the same monetary system have freedom

infiscal policiesin taxation and expenditure


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TIME-VARYING IMPACT ON EUROPEAN BANKS

The average time-varying potential spill over to European banks. Therewe show the differences between the effects from a shock in Spanishsovereign CDS and from a shock in German sovereign CDS.

During the entire data sample the mean impact from DE is slightlybelow the mean impact from ES (15.6% compared with 16.7%).

The average potential spill over effect on banks is the mean of a shock from

the respective country (here e.g. ES and DE) at the end of each rollingwindow. As can be seen in Figure 6, at the beginning of April 2012, theaverage impact from a shock in Spanish sovereign CDS exceeds the meanimpact (over the entire period) and exceeds the previous peak that wasreached at the end of November 2011. By mid-May 2012 the averagepotential spill over effects from a Spanish shock reaches the level of 65%. Inother words, the entire European banking system reacted strongly to theSpanish sovereign debt crisis during the April-June 2012 period.After the G20 and EU summits, the potential contagion pressure to theEuropean banking system mitigates. This analysis highlights the advantage of

monitoring the time-varying potential impact from each variable of thesystem.


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MONETARY POLICY INFLEXIBILITY

The Economic and Monetary Union (EMU) is anumbrella term for the groupof policies aimed at converging the economies of all member states of theEuropean Union at three stages. Both the 19eurozone states and the 9 non-euro states are EMU members. A Member State however needs to comply andbe a part of the "third EMU stage", before being able to adopt the eurocurrency; and as such the "third EMU stage" has also become largelysynonymous with the eurozone.

All Member States of the European Union,except Denmark and the UnitedKingdom, have committed themselves by treaty to join the "third EMU stage".The Copenhagen criteria is the current set of conditions of entry for newstates wanting to join the EU. It contains the requirements that need to befulfilled and the time framework within which this must be done, in order fora country to join the monetary union. An important element of this, is aparticipation for minimum two years in the European Exchange RateMechanism ("ERMII"), in which candidate currencies demonstrate economicconvergence by maintaining limited deviation from their target rate against

the euro.

Nineteen member states of the European Union, including most recentlyLithuania, have entered the "third EMU stage" and have adopted the euro astheir currency. Denmark participate in the Exchange Rate Mechanism (ERMII). Denmark and United Kingdom has received a specialopt out from theEUTreaties, allowing for a permanent membership of ERM II, without beingrequired to enter into the "third EMU stage". In regards of the remaining non-euro member states (Sweden, Poland, Czech Republic, Hungary, Romania,Bulgaria and Croatia), they are committed by treaty to enter the third stageupon the time of complying with all convergence criteria; of which the lastone (ERM II membership) however is something the member state canchoose not to apply for, if they do not want to adopt the euro.
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Eurozone establishes a singlemonetary policy, individual member states can

no longer act independently, preventing them fromprinting moneyin orderto pay creditors and ease their risk of default.

By "printing money", a country's currency isdevaluedrelative to its(eurozone) trading partners, making its exports cheaper, increased GDP andhigher tax revenues innominal terms.


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LOSS OF CONFIDENCE

The loss of confidence is marked by rising sovereign CDS (credit-defaultswaps) prices, indicating market expectations about countriescreditworthiness.Since countries that use the euro as their currency have fewer monetarypolicy choices certain solutions require multi-national cooperation.


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IRELAND

The Irish sovereign debt crisis was not based on government over-spending, but from the state guaranteeing the six main Irish-basedbanks who had financed aproperty bubble.

Irish banks had lost an estimated 100 billion euros, much of it relatedto defaulted loans to property developers and homeowners made inthe midst of the property bubble, which burst around 2007.

Unemployment rose from 4% in 2006 to 14% by 2010, while thenational budget went from a surplus in 2007 to a deficit of 32% GDP in

2010, the highest in the history of the eurozone, despite austeritymeasures.


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PORTUGAL

Portugal requested a 78 billion IMF-EU bailout package in a bid tostabilise itspublic finances.

These measures were put in place as a direct result of decades-longgovernmental overspending and an over bureaucratisedcivil service.

On 16 May 2011, the eurozone leaders officially approved a78billionbailout package for Portugal, which became the third eurozonecountry, after Ireland and Greece, to receive emergency funds.

The average interest rate on the bailout loan is expected to be 5.1

percent. As part of the deal, the country agreed to cut its budget deficitfrom 9.8 percent of GDP in 2010 to 5.9 percent in 2011, 4.5 percent in2012.

EUROPEAN FISCAL UNION

Proposedlong-termsolution

Europeanfiscal union

Eurobonds

EuropeanMonetary

Fund

Drastic debtwrite-off

financed bywealth tax

Debt defaultsand national

exits fromthe Eurozone


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Increased European integration giving a central body increased controlover the budgets of member states.

Control, including requirements that taxes be raised or budgets cut,would be exercised only when fiscal imbalances developed.

EUROPEAN MONETARY FUND

On 20 October 2011, theAustrian institute of economicresearchpublished an article that suggests transforming the efsf into

aEuropean monetary fund(emf), which could provide governmentswith fixed interest rate euro bonds at a rate slightly below medium-term economic growth

These bonds would not be tradable but could be held by investors withthe EMF and liquidated at any time.


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Conclusion and Lesson

CONCLUSION

The Economic and Monetary Union (EMU) was more a political than an

economic project at the time of its establishment.

The internal European market has led to a huge gain in prosperity,

particularly in the Netherlands. The gain is one months salary; and this

will increase in the years to come.

The gain from the introduction of the euro is less clear, approximately

one weeks salary.

The cost of breaking up the EMU and the re-introduction of national

currencies would be huge.

The European debt crisis is just as much a banking crisis as a crisis of

government debt and, consequently, cannot simply be attributed to the

countries on the periphery of Europe.

The crisis cannot be solved without a rapid recapitalization of the

European banking sector. The EMU is performing less well than the US monetary union because

in the US the budgets of the individual member states are considerably

smaller and those of the federation considerably larger.

Opposition to restructuring Greek debt at the expense of private

creditors is difficult to understand and contrary to the no-bail out

clause. Although there are good reasons to transfer powers to

European institutions, almost no Member State is excited at the

prospect.

For a structural solution of the crisis, it is essential for one regulatory

authority and one European rescue fund to be established for

European banks.


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In addition, a permanent European emergency fund should ensure

that in times of crisis countries can avoid liquidity problems which arenot directly their own fault.

Finally, there should be preventative European supervision of national

budgetary policy.

Currently, the political stalemate looks hopeless. However, given the

history of the development of Europe, this crisis could also lead to an

institutional breakthrough. Union (EMU) did not fulfil the criteria for

an optimal monetary union. At the time of its establishment, the EMU

was more a political than an economic project .A number of economists

predicted the EMUs current problems twenty years ago.

The European debt crisis is just as much a banking crisis as a crisis of

government debt and, consequently, cannot simply be attributed to the

countries on the periphery of Europe.

TAKEAWAYSOne important lesson from the European sovereign debt crisis, well-known

in emerging markets, is that borrowing on international markets is a delicate

matter. There can be benefits of such borrowing in some circumstances, but

too much can erode credibility and lead to a crisis in the borrowing country.

In short, countries cannot expect to borrow internationally and use the

proceeds to spend their way to prosperity. The U.S. fiscal situation is difficult

as well, with high deficits and a growing debt-to-GDP ratio. The U.S. has

exemplary credibility in international financial markets, built up over manyyears. Now that the U.S. economy is about to achieve recovery in GDP terms,

it is time for fiscal consolidation in the U.S. Irresponsibly high deficit and debt

levels are not helping the U.S. economy and could damage future prospects

through a loss of credibility internationally.

european sovereign-debt crisis word

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