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THECRISISOFTHESOVEREIGNDEBT
INTHEEUROZONE
ABSTRACT
The sovereign debt crisis that affected the European Union in the 2009, is
explained here through the identificationof three risk issues. These factorshave led the EuropeanUniontoface the greatestcrisisin its history,which
coulddestroyit,onlynineyearsafteritsestablishment.
Inthefirstsectionissummarized:thehistoricalcontextandmilestonesandthemainfactorsthathaveledtotheemergenceoftheserisks.
Thenthethreeriskissuesareexposed(aggregate,specificandcontagion)and
isexplainedhowthesearecombinedtogiverisetochangesinthespread.Themainideaisthatoneofthesefactorsalonecouldnotleadtoacrisisofthis
magnitude.Butthefuturescenariothatwasproposed,withtheconjunctionofthesethreeriskissues,couldbringEuropebackinthehistory,withenormous
consequencesforthewholeworld.
The theoretical treatment of these risk factors is explained through someexample,quotingseveralcountryinvolvedinthecrisis.
HowthecrisiswashandledandacomparisonwiththetheoreticaltreatmentofNormanAgustine,drawtoaclosethecasestudy.
Intheconclusionisadvancedananalysisofpossiblepastscenariosthatcould
haveavoidedthecrisis.Fromthisisderivedthelessonforthefuturessothat
othercrisesareaverted.Morespecificallyisclearhowinordertosurvive,theEuropeanUnionhavetochangeandevolve.Untilnowhasbeenaninterestingpolitical experimentbut if itdoesntwant togodown inhistory asa failed
experiment,themembersmustfindagreatercohesionineconomictermsfirst,
andinthepoliticalandculturaltopicsinthelongterm.Itisadifficultchallengeand its difficult to predict the outcome, surely this crisis has made the
membersbetterabletoworktogether,butitwillbedifficultforthecitizensof
thecountry,withasocomplexhistory,abandontheirtraditions,languagesandcultures,forthatwhichnow,isonlyabureaucraticsuperstructure,withfew
benefits.
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INTRODUCTIONANDAIM
TheaimofthereportistoassesstheriskfactorstheEuropeanUnionhadtodealwithduringthesovereigndebtcrisisthateruptedin2009,howitmanagedsuch
risks,andtheresultsoftheseactions.
Whilethedebtcrisisof2009wasanallencompassingproblemfortheEuropeanUnion,itisimportanttonotethateachcountryhasadistinctbackgroundand
thereforehastheiritsproblemstodealwith,individually.Obviouslytheissueislarger than for each separate country, but it is necessary to use each as an
exampletodealwiththelargerproblemfacingtheEUasoneentity.Therefore,
even if a complete report of the situation should analyse the issues of eachcountry,thisreportwillmainlyfocusontheriskfactorspertainingtotheEUasa
whole.
TherearethreemajorriskissuestheEUanditsmembershavehadtodealwith
toavoidthecollapseoftheirsystem.Theseriskissuescombinedhaveledovertimeinvestorstohavelessandless
confidenceinthePIIGSandintheEuropeanUnioningeneral.Thelackof
confidencewasexpressedinadecreaseinthedemandforgovernmentbondsandanincreaseinyield,triggeringaviciouscyclethathasprecipitatedEurope
intoadownwardspiral.
1. Theaggregaterisk:Thecrisisaroseoutofalackoffaithinthecurrenteconomic system, alongwith the aversionof themarkets to take risks
afterthefinancialcrisisof2007.Therewasalsothefearthatthesystem
and the bankswouldnot be able to deal with another crisis, and thattheremighthavebeenmorehiddenproblems.Allofthesefactors,with
the addition of a deep pessimism, led to demanding markets withhystericalbehaviour,highlightingthedifficultiesspecifictoeachcountry
insouthernEurope.
2. Specificrisk:particularlytheriskof default,was the coreofthematter,which increased the spread; meaning the likelihood of the probability
thatsomemembersintheeurozonewillfail.
3. Riskofcontagion:concernsthewholeoftheEuropeanUnionasaresultofthespillovereffectfromtheinitialproblemsinGreece.Thus,themarketsof Southern Europe lose confidence, compounding the already difficult
financialsituationofthePIIGS(PortugalIrelandItalyGreeceandSpain).
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CASESTUDY
ToanalysetheongoingEuropeaneconomiccrisiswefirstneedtoquicklyrecalltherecenthistoryoftheEuropeanUnionandtosummarizetheconsequencesof
thefinancialcrisisof2007intheUnitedStatesand,subsequently,intheworld
asawhole.
RECENTEUROPEANHISTORY
In1992,theMaastrichtTreatydefinedthelimitsofdeficitspendingandthedebt
capforthefuture.In2000theEuropeanUnionbecameamonetaryunion.Withtheintroductionof
theEuro,eachcountrylosttheopportunitytodevaluethecurrencyandtheonly
lender of last resort became the ECB (European Central Bank). However, theECBdoesnothavethejurisdictiontobuysovereigndebt.
Intheearly2000s,Germanywas the firstbigcountrytoexceedthedebt limitestablishedintheMaastrichttreaty.France,GreeceandItalywerenexttofollow
suit.
ThedebtincreasedinItalyandGreeceduetoeffortstosustainwelfareservice.MeanwhilethegrowthoftheGDP(GrossDomesticProduct)wasnotfollowing
thesametrend.
InGreece, for example, the public sector wages rose 50% between 1999 and2007.
Toaccumulatemorevotes,politiciansfinancedpublicspendingbyusingdebttokeep taxes from rising. In addition, the income was hit by widespread tax
evasion.
CONSEQUENCESOFTHEFINANCIALCRISIS
After the bursting of the bubble of
the subprime mortgage the banksstalled lending, and the financial
systemhadtofacealiquiditycrisis.Globally, governments and the
central banks started to save the
banks and the financial institutions
toavoidthecollapseofthefinancialsystem.Thegovernmentsstartedto
make loans in efforts to raise thefunds to save the system and as a
result there was a massive rise inglobaldebt.
Figure:SelectedEUDebt2007-2010At first themarkets had assumed that the Eurozone debt was safe, as it was
supportedbyallthemembers.Forthisreason,countrieswithahighdebtsuchasItalyandGreecewerethoughttobesecure.
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However,afterthecreditcrunch,peoplestartedtobecomemorescepticaland
riskaverse,especiallyinEuropewhereitwasunclearwhetherthecentralbankwould be able to support itsmember states. For example, UK debt has risen
faster thanmanyEurozone economies,yet therehasbeennorise inUKbondyields.OnereasonsinvestorsarecurrentlywillingtoholdUKbondsisthatthey
knowtheBankofEnglandwillinterveneandbuybondsifnecessary.ThecrisisstartedonOctober2009whenthenewPrimeMinisterofGreece,MrG. Papandreou, declared that the old government had lied about the public
finances.Therealdeficitwas13%insteadof6%andthedebitwasreassessedat
127%oftheGDP.Withthisdebtlevelandtherisinginterestrates,Greecewasnolongerableto
repayitsloansandwasforcedtoaskforaidfromtheEuropeanUnion.
RISKMANAGEMENTISSUE
Thespreadbetweentheyieldofnationalbondandtheriskfree(inthiscasethe10yearsGermanBUND)wasthemainindicatortomonitorthedevelopmentof
thecrisis.
Figure:Sovereignspreads(10yBonds)
Beforeanalysingtheriskissuesthatcausedthecrisisweneedtoanalysehowthesovereignyieldspreadcanvary.
Therearetwoconditionsbywhichthemarketsfixthespread:inthefirstone,
the normalcondition, the spread reacts onlybythe relativeprobabilityofacountrysdefault.
Inthe second one, the crisis regime,muchhigher spreadscan bedemanded
afterarelativelysmalldeteriorationinfundamentals.The regime switch may be related to the markets shifting perceptions of a
countrysfiscalsustainability,ortotheattitudetowardsrisk.
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Lets now examine the risk issue that led investors to demand a more high
remunerationonthesovereignbondofthesouthEurope:
1. AggregateRisk2. CountrySpecificRisk3. ContagionRisk
Figure:DeterminantsofGovernmentBondYields
1. AGGREGATERISK
Aggregateriskisalsoknownassystematicriskbecauseitaffectsthemarketandbecausetherisktakerhasnocontrol.Itisdrivenbychangesinmonetarypolicy,
globaluncertaintyandriskaversion.Theothersourcesofthiskindofriskaretheunwindingofthefinancialimbalancesandtheoccurrenceofmacroshocks.
After the breakdown of Lehman Brothers, also countries with solid fiscal
financialslikeAustria,Finland,andtheNetherlandssawtheirspreadrising.Thecausewasnotthemarketpricingre-assessmentofthegovernmentcreditrisk.
Infact,theratingdidnotchangeatall.
ThewidespreadaversiontowardriskmovedtheinvestortothesaferbondintheEuropeanregion,theGermanBUND,decreasingthedemandforthedebtof
theothercountry(eveniftheyweretriple-A)andasaconsequenceincreasingthespread.
2. SPECIFICRISK
Thecountryspecificriskhastwocomponents:thedefaultriskandtheforeign
exchangerisk.The firstone relates tovariations indefaultprobabilitiesand totheability to
raisefunds.TheriskofdefaulttendstoincreasewiththeratioofpublicdebttoGDP.
In2009forallthePIIGScountrythespreadhadbeguntogrow,reflectingthe
expectations ofdefault themarkets had onthe countries ofsouthernEurope.Public and private high debt were indeed quite large, and a self-fulfilling
prophecywherethefearthathigheryieldswouldmakethecountryinsolvent,hasincreasedtheyield.
InthecaseofGreece,whosegovernmenthadbeenburiedindebtdata,thehighvalueofthedebtmarketsledtothenotionthatadefaultwaspossible.
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However,thisisnotenoughtoexplainwhythespreadoccurredandbecameso
high,suchasinItaly.BeforetheintroductionoftheEurothespreadbetweenBUNDandBTPreached
itspeak,higher than any value in this crisis.However, in thatperiod nobodyworried about the possibilities of the default of Italy because the spread
incorporated not only the risk of default, but also the foreign exchange risk.Nowadays, the component ofthe spread, related tothe foreignexchangerisk,indicatedthepossibilityofthecollapseof theEuroandareturntothenational
currency.
Figure:ThespreadbetweenItalyandGerman
ThisexplainswhytheEuropeanCentralBankstartedtobuynationalbondsevenifthestatutewouldnotallowit.ThemarketworriednotonlyforthedefaultofthecountrybutalsoforthestabilityoftheEuro.
Thecountrywithdifficultyhadtoimprovefinancialpolicytorebalancethedebt
GDPratio,butis theresponsibilityoftheCentralBanktoensurethesoundnessofthecurrency.
3. RISKOFCONTAGION
Contagion is the scenario in which financial instability spreads to othereconomiesthatwereotherwisehealthy.
Thedevelopment inGreecewasoneofthereasonswhyMoodysinJuly2011downgraded Portugal. If Greece were to fail, it would be more likely othercountrieswouldalsobeinneedofaid.
InthesamemonthItalianandSpanishbondyieldshadincreasedbymorethan100and80basispointsrespectively.Thiswasbecausethedowngradeandthe
fearofaGreekdefaultpromptedasellingofSpanishandItalianbonds.
The investors want to reduce their exposure while they still have positivebalances,anddontwanttobeexposedtovolatilityorlargelosseslater.
Thecontagionstartsaviciouscircle:alowerdemandofbondincreasestheyieldand,forthecountrywithweakeconomicfundamentalsandwithahighdebtto
GDPratio,itbecomesunsustainabletorepaythedebt.Thisincreasestheriskof
defaultandyieldandsoon.Ifthesystemicriskhasanidiosyncraticorigin,contagiousoccursmorelikely.
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HOWTHEISSUESWEREDEALT
Two are the main protagonists involved in solving the crisis: the European
CentralBank,oneofthemostimportantcomponentsoftheEuropeanUnion,and
thesinglegovernmentsintheweakcountries.TheECBhadtoencouragefaithinthe European Union and had to insure its ability to act as a central bank,
becomingalenderoflastresort.Meanwhile the weak countries needed to re-establish the financial situation
decreasingtheDebttoGDPratiotoreducethedefaultrisk.
Firstofall, theECB started toreducethe interestrateand loanmoneytothe
financial system with an unlimited provision of liquidity through fixed rate
tenderswithfullallotment.Thismeasurehasensuredthatthesystemwouldnotcollapse.Then,inMay2011andinOctober2011,withthehelpoftheIMF
(InternationalMonetary Fund), it approved two tranches of bailout loans toGreece.
InFebruary 2011,the Eurozonefinanceministers set upapermanentbailout
fund,theEuropeanStabilityMechanism,worthabout550bneuros.BecauseofcontagionresultingfromthesituationinGreece,theECBstabilized
theexpectationoftheeuro,buyingItalianandSpanishgovernmentbondstotrytoreducetheirborrowingcosts.
Furthermore,thegovernoroftheECBdeclaredthatthecentralbankwouldhave
lentmoneyaslongasitwasindispensable:thiskindofdeclarationwasveryimportant for the faithin themarketsbecauseitensuredthe investorthatno
bankorcountrywouldbeabandonedforfailure.
AlltheECBactionsrequiredthatthesinglecountryshouldembarkonamajor
austeritydriveinvolvingdrasticspendingcuts,taxrises,andlabourmarketandpensionreforms.
Greece, Italy and Spain, approved these reforms even though there was a
consequenceoffallingintoanAusterityTrap,whereitwouldalmostdefinitelydeepen the recession. Meaning even higher unemployment rates and lower
wagesthatwouldjustmakeprivatedebtsallthemoredifficulttorepay.People
would therefore be more likely to cut their spending, making the economicrecoveryevenslower.
But otherwise if the countries dont cut
spending they risk a financial collapse,
where themarketwould lose confidencein them and the other European
governments may not have enoughmoneytobailthemout.
Figure:Austeritytrap
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EFFECTIVENESSWITHWHICHTHECRISISWASMANAGED
LetsknowcomparehowtheEuropeanUnionhadmanagedthecrisisinrelationwiththetheoreticalviewofNormanAgustine(ManagingtheCrisisYouTriedto
Prevent)inwitchsixstagesofcrisismanagementwerespecified.
a. AvoidingthecrisisTheEUcouldntavoidtheglobalfinancialcrisiswhowasbornintheUSA;theonlythingsthatitcoulddowastohaveaclosercontrol on the balance sheets of the member states, to avoid
inappropriate behaviour that would lead to lack of confidence in the
marketsalreadywary.b. Preparingtomanagethecrisis Whenthecrisisexplodedtherewasnoplan to manage it, a consequence of so many events, not all directly
controllable from the European Union, was unexpected. Besides, theEuropeanUnionwasnot readytomanage it, therewasno fiscalunion
and,aswesaidbefore,notenoughcontrolonthebalancesheetsofthecountries. Furthermore, the European Institutions had not enough
power: as young supranational Institutions, in which the member
countries still have personal interest in the management of theinstitution, and of the crisis inparticular, itwas really difficult totake
sharepolicy.c. RecognisingthecrisisAssoonastheGreekgovernmentdeclaredthebiglie, the European Union understood that this could have big
consequencesforthewholecontinent.d. Containingthecrisis IttooklongtimetodecidetosaveGreeceandtobuy sovereign bond. Sooner this kind of action is take better is the
reactionofthemarket,waitingtoomuchtimemakeitdifficultandmoreexpensivetohandlethecrisislater.
e. Resolving the crisis The crisis is not solved and just fewweeks agoanothercountry(Cyprus)becameinvolvedinthecrisis.Wecansaythat
the actions taken were able to save the European Union, but many
actionshavetobeundertakentoreturninastablesituation.f. ProfitingfromthecrisisAfterthemonetaryunionnothingwasdonetoimprove the political or fiscal union in Europe; this crisis united the
countriesandthiscouldbethefirststepforaEuropeanFederation.
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CONCLUSIONS
SCENARIOANALYSIS:HOWTHECRISISCOULDHAVEBEENAVOIDED
In this section some lessons will be extracted for the future by analysingdifferentscenariosthatcouldhaveavoidedthecrisis.
Evenifitisdifficulttodeterminewhetherthecrisiscouldhavebeenavoidedornot,whatisclearisthatafter1999theinterestratesonthedebtofalleuro-zone
countries have aligned themselves downwards. This happened after a long
periodofausterityrequiredto complywith theparameters inputinthe euro.Thesetwofactorsledcountries,banksandprivateindividualstobeencouraged
togetintodebt.Lessexcessiveuseofdebt,albeitatlowcost,andthereforeabalance with equity (GDP) would make the countries now weaker and less
attackedbythisseriesofunfortunateevents.
Clearly the solution here is that countriesmust have a thriving economy, in
whichwelfarepoliciesarefinancedbytaxes.Especially in countries like Greece and Italy, that would mean a complete
innovation of the national economy, restructuring the labour market, and apromotioninternationalcompetitiveness.
These measures, if they had been enacted over the years, would have beenpainlessandproductive.Now thecountriesofsouthernEuropecannotrefrain
fromengaginginthiswayinashorttime,leadingtosufferingandimpoverished
citizens.
Aspreviouslystated,theinitialshockduetotheliesofGreececouldhavebeenavoidedonlyiftherehadbeenstrictcentralizedcontrol.However,before2009
theEuropeanUnionwasstillmuchtooyoungandthereforelackedthepolitical
unitythatwouldallowsuchcentralizedcontrol.
TopreventthecrisisoftheinsolvencyofGreecethatwasexpandingthroughout
Europe,theallocationoffundswouldhavetobefaster.DerailingGreecewouldhavebeenanalternativethatwouldnothavepreventedtheinfection.Mostof
the Greek debt is currently held in European banks (especially German andFrench ones). A possible default of Greece would bring great losses and the
attendantrisksoffailureinthemajorfinancialinstitutionsofEurope,dragging
thewholesystemtocollapse.
PREVENTFUTURECRISIS
To prevent future crisis, it is important that the EU and its members closelymonitorallthreeissuescharacterizedinthiscrisis.
The aggregate risk is themost difficult to control; it can lead to devastating
consequencesand,inaworldsoglobalized,itcanoriginatefromanywhere.Theimportantthingisthatcountries'policiesaretransparentandtheireconomies
areinorder,especiallythecountrybalancesheet.Forthestabilityofthesystemthebanksshouldstopspeculatingwithfinancialinnovation,andgobacktopure
credit, with the right amount of risk aversion that characterizes this sector.
Moreover,iftheinstitutions(banksandgovernments)areeconomicallystrongandclean,itwillbemoredifficultforacrisistobringthecountrytocollapse.
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It isessential toensure that institutionshavestrong credibilitysoas toavoid
riskaversioninthemarket.TheECB,especially,needstoreassurethemarketthatitwontletanycountryfail.
For those concerning the Default risk, it would be sufficient that countries
adheretotheEUdirectives.TightercontrolwillbenecessarytopreventindividualcountriesfromabusingoftheeconomiccoverageoftheEuropeanUnion.
Moreover,theEuropeanInstitutionsmuststronglydeclaretothemarketsthat
theywilldoeverythingnecessarytosavetheuniquecurrency;inthiscrisistoomany internal struggles have made the expectations uncertain about the
stabilityoftheeuro.
Theriskofcontagionrequiresquicklyrealizingandexecutingasolutiontostem
thecrisis.TheactionstakenbytheEUwerefartooslow,causingthemarketsto
worry and obsess over other countries with weak economic situations. Thiswould not only be more economical to save Greece, but it would have also
preventedlosingthemoneyrequiredtobuyItalianandSpanishbonds.If the EuropeUnionwants tosurvive through future crises, a strongerunion,
bothpoliticallyandfiscally,isimperative.ThisisobviouslyahardtaskbecauseoftheuniquenessoftheEU,havingsomanycountrieswithculturalandlingual
differences, followingnomodel orblueprint fromthepast.IftheEUwantsto
last a long time, themember states have tostartcooperating toalleviate thecompetitivebehaviourbetweenindividualmembers.
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