Ntroduction Of European Sovereign Debt Crisis

Published Date: 02 Nov 2017

Abstract

The main objective of this paper is to analyses and find out what is European Sovereign Debt Crisis is all about. Throughout the studies, we managed to identify how the crisis began in the global economy. The global economy has experienced slow growth and brought great impact to the world economy. Besides, we also managed to explain the spread of this crisis badly to the main five of the regions countries which are Greece, Portugal, Ireland, Italy and Spain. The European Union and International Monetary Fund’s have taken action, but it has moved slowly since it requires the consent of all 17 nations in the union. Besides, we also discussed on the effect of euro zone crisis in advanced and also in emerging economies. European sovereign debt crisis had also brought great impact to the Malaysia economy. Though the crisis had brought great impact to the world but it is now in the stage of recovering slowly.

Table of Contents

1.0 Introduction of European Sovereign Debt Crisis 2010

According to (Mouchakkaa, 2012), the genesis of the sovereign debt crisis could be distilled into a simple miscalculation of risk. The European Sovereign Debt Crisis, which started in early 2010 have led to superior strains in financial markets. In the face of very big support programs conducted by central banks in advanced economies, banks still face a challenging operating environment, which has been reflected in repeated ratings downgrades, widening funding spreads, and declining equity prices (Chan Lau, Liu, & Schmittmann, 2012). The European debt crisis in the shorthand term for Europe’s struggle to pay the debts it has built up in recent decades. The European sovereign debt crisis was brought to heel by the financial guarantees by European countries, who feared the collapse of the euro and financial contagion, and by the International Monetary Fund (IMF). Ratings agencies downgraded the debt of several euro zone countries, with Greek debt at one point being moved to junk status. As part of the loan agreements, countries receiving bailout funds were required to meet austerity measures designed to slow down the growth of public sector debt. Nevertheless, five of the region’s countries which are Greece, Portugal, Ireland, Italy, and Spain have to varying degrees and failed to generate enough economic growth to make their ability to pay back bondholders the guarantee it was intended to be. Although these five were seen as being the countries in immediate danger of a possible default, the crisis has far reaching consequences that extend beyond their borders to the world as whole. In fact, the head of the bank of England referred to it as "the most serious financial crisis at least since the 1930s, if not ever," in October 2011 (Nemeth, 2011).

The European Sovereign Debt Crisis begins when the global economy experiences slow growth since the U.S. financial crisis of 2008 to 2009, which has exposed the unsustainable fiscal policies of countries in Europe and around the globe. Greece which spent heartily for years and failed to undertake fiscal reforms was one of the first to feel the pinch of weaker growth. When growth slows, so do tax revenues were making high budget deficits unsustainable. The result was that the new Prime Minister George Papandreou, in late 2009, was forced to announce that previous governments had failed to reveal the size of the nation’s deficits (Guraziu & Zeqo, 2012). In truth, Greece’s debts were so large that they actually exceed the size of the nation’s entire economy, and the country could no longer hide the problem. Investors responded by demanding higher yields on Greece’s bonds, which raised the cost of the country’s debt burden and necessitated a series of bailouts by the European Union and European Central Bank (ECB). The markets also began driving up bond yields in the other heavily indebted countries in the region, anticipating problems similar to what occurred in Greece (Nemeth, 2011).

The European sovereign debt crisis has increased superiorly and grown rapidly over the year 2010. Since then, the crisis has increasingly spread to Italy, Spain and now recently to France (Eichengreen, 2010). The Europe nation now battling sensitive systemic debt crisis that triggers the global financial systems and the global economy. Besides, even the crisis getting worsening and constitutes the largest single threat to the global economy and its financial system. As a result, in whole the European Sovereign Debt Crisis triggers the economy developing countries.

.

2.0 Literature Review

In the early of 2010, the credibility of world’s second most important reserve currency, the euro was been threatened by the sovereign debt crisis (Overbeek, 2012). The crisis in Europe evolved from a banking crisis into a sovereign debt crisis and the structure and function of Economic and Monetary Union (EMU) is the key function that leads to the sovereign debt crisis. While, the launch of the single currency, the euro, on 1st January 1999, stabilized the credit ratings of the euro zone member states and formed a lot of interest in regional monetary integration and even monetary unification in various parts of the world, the sovereign debt crisis had the opposite effect, even raising the expectations of a breakup of the euro area. Competitiveness of a country, that is currency devaluation, was eliminated by the institutional and technical design of EMU (Taylor, 2011). In order to maximize surpluses on the external account, Germany, Belgium, Scandinavia, Austria, and Netherlands uses wage restraint and balanced budgets to achieve it.

According to Overbeek, (2012) conversely, this policy limits the access of Southern EMU members to their most important export markets. Current account deficits and household debt were rising in Southern Europe because they are insulated from currency crises and kept their interest rates low which exposed a deep rift among the seventeen countries in the Euro zone (Young and Semmler, 2011). Euro zone banks built up very high exposure to government debt. For example, German and French banks were exposed to government debt roughly USD500 billion for each bank. While, US and UK banks are exposed to USD400 billion for each bank. Besides, most European governments introduced stimulus programmers’ to resist the effects of lack of credit. Poor competitiveness, lacking export markets, low interest rates, domestic political pressures, and the cost of bank bailouts (business's downfall) and stimulus programmes, are the factors that causes the rise in European sovereign debt (Overbeek, 2012). General government debts are 85 percent of GDP for the whole euro zone in 2010. It is considered high compared to 2008.

According to Volz (2012), eventhough Greece only accounts for only 3% of the euro area’s gross domestic product (GDP) and its considered to be a small country but it have caused so much troublesome to the European sovereign debt crisis in 2010. George Papandreou’s freshly elected Socialist government in Greece on 5th November 2009, exposed that the budget deficit for 2009 would be 12.7% of GDP and its more than double previously published figure.

At the same time, the Socialist government also added that the predecessor government had misled the public about the true state of Greece’s public finances. This situation raised serious doubts about the country’s capability to repay its debts (Santis, 2012). After the higher deficit was revealed, Greece was rated below investment grade for the first time in ten years. Additionally, the situation makes much more impossible for the government to refinance itself after the downgrades and ever rising interest rates led to a weakening of Greece’s access to capital markets, creating a downward twist for the Greek economy.

Similarly, according to Gros and Mayer (2010), Greece is considered as the weakest of the weak links, with high public debt (around 120% of GDP), compounded by a government budget deficit of almost 13% of GDP, a huge external deficit of 11% of GDP and the loss of credibility from its repeated cheating on budget reports. Besides, the debt of Greece has escorted in the second phase of the financial crisis, namely that of a public debt crisis. Several euro area members are now struggling with the implosion of credit financed construction and consumption booms after excess spending during the period of easy credit and were unable to be shielded from a financial market meltdown.

If the public debt positions are to become sustainable again, therefore Portugal, Spain and Greece as well as others in the EU must undergo painful adjustments in government finances and external (Gros and Mayer, 2010). But given the intense pressure from financial markets, it is likely that in some cases a tough fiscal adjustment programme might not be enough to avoid a "sudden stop" of external funding of the public sector. When this happens, the euro area will no longer be able to provide public financial support to one of its members.

In the same way, according to Jabtecki (2012), the housing disaster and the attendant financial crisis lead to the euro area sovereign debt crisis. While, thwarted market motivated to punish irresponsible sovereign borrowers by demanding higher interest rates on these borrowers’ bonds, the capital-adequacy rules transmission of a zero risk weight for the sovereign debt of all euro area countries irrespective of their creditworthiness. Over the years, euro area governments could borrow more economically than would have been the case outside of a monetary union, fueling fiscal profligacy and spread the seeds of the future sovereign debt crisis. If compared to other major industrialized economies, prior to the crisis of 2008, the fiscal situation in the euro area was not particularly bad and the culprits were capital regulations rather than fundamental global factors.

The regulatory and supervisory actions in the euro area couldn’t be blamed for dissolving market discipline and fueling fiscal profligacy (Jabtecki, 2012). However, they did encourage banks to invest in government bonds beyond the amount that might have occurred otherwise in 2007, 2008 and 2009, because sovereign debt was considered a risk-free. Once euro area fiscal tensions came to fore, banks’ over exposure to domestic sovereign debt put pressure on European governments to intervene and rescue banks since the banks’ huge accumulation of sovereign debt encouraged worries about their solvency. New capital requirements on banks been effectively forced by European Banking Authority to realize losses on sovereign exposures in the midst of a panic while the intervention, in turn, increased the riskiness of sovereign bonds, threatening banks even further.

On the other side, according to (Wignall & Slovik, 2011), from the research on market perspective, the sovereign debt crisis worsened on market concerns about the difficulty of budget consolidation. Beside, sovereign debt crisis exacerbated by recession, transfers to help banks and in some cases very poor fiscal management over a number of years. Private creditors bear some of the pain via mechanisms being put together to deal with future sovereign debt crises for the first time in 2010. Portugal and Spain faced lesser adverse movement if compared with and Ireland which faced very significant adverse movements in their yield spreads relative to euro area benchmark bonds.

The very weak growth and high unemployment resulting from fiscal consolidation and years of painful structural adjustment make the markets concerned for the temptation to restructure sovereign debt which is too great to be ignored (Wignall & Slovik, 2011). While the prevailing high interest rates increase their debt service costs, such concern adds to the crisis countries’ problems, making it difficult for them to borrow. Consolidation efforts become even more difficult to achieve when the marginal borrowing rate exceeds the average rate on the outstanding stock of debt which lead to the rise of debt service burden. Similarly, as growth weakens, tax revenues fall.

Furthermore, this debt crisis has been the plays of sovereign credit rating downgrades and credit default swap (CDS) spreads, pressures on stock markets and widening of sovereign bond (Arellano, Conesa, & Kehoe, 2012). Even though credit rating actions were concentrated in few countries such as Greece, Iceland, Ireland, Portugal and Spain; the financial markets throughout the Euro zone have been under pressure. Sovereign rating news may have overflow effect across countries and across financial markets through many potential channels. One example is the holding of foreign sovereign debt by domestic banks. The profitability of banks in other countries where banks are holding the debt will be affected whenever sovereign rating downgrades. According to (Arellano, Conesa, & Kehoe, 2012), this is the case of Europe where banks hold at times substantial amount of sovereign debt in both their trading and banking books.

Another example of channels through which sovereign rating news may fall over across countries and markets is when banks across countries hold claims on banks in other countries and are thus exposed to one another. This cross-holding feature is at the core of the European financial market convergence process in Europe. Financial instability would occur if sovereign rating announcements have statistically and economically significant spillover effects both across countries and financial markets implying that rating agencies announcements (Arellano, Conesa, & Kehoe, 2012). The sign and the magnitude of the spillover effects depends both on the type of announcements, the source country experiencing the downgrade and the rating agency from which the announcements originate. The large economies such as Greece would have a systematic spillover effects across Euro zone countries if downgrades to near speculative grade ratings.

Most of the authors look at the economical issues as a lead to the European sovereign debt crisis in 2010. On the other side, financial instability becomes so widespread that a crisis reaches systemic dimensions by the mechanism called contagion (Constancio, 2012). Contagion phenomena play a crucial role in exacerbating the European sovereign debt crisis while, without denying that imprudent fiscal behaviour and lack of effort to maintain the competitiveness of countries are the deep origins of the European sovereign debt crisis. The ability to maintain price stability in the euro area impairs by ECB’s interventions because the need to address contagion.

According to Constancio (2012), eventhough contagion plays a crucial role in the European sovereign debt crisis; it could not be denied that other sources of systemic risk are less important for the instabilities. Conversely an important role is also played by the unraveling of widespread financial imbalances, which contaminated fiscal balances and the lack of structural reforms ensuring countries’ competitiveness. The untying of widespread imbalances and aggregate shocks causing simultaneous failures or crashes. Besides, pollution may become much stronger if imbalances or aggregate shocks already weaken the system because of the different transmission channels. Beside, some countries have lost competitiveness and debt levels are relatively high since many financial intermediaries have not as yet overcome their problems.

According to Arellano, Conesa, and Kehoe, (2012), gamble for redemption is to bet that the recession will soon end and sell more bonds to smooth the government spending and reduce debt if the economy recovers. Government can do the best for its country and citizens if use this policy under certain situation. Governments have to stop increasing its debt or have to default its bonds if the recession continues. Just like other gamblers that keeps doubling their bet; government is hoping that recession will not continue for too long. But, government is doing something good for the country that is smoothing government expenditures. If recession continues, there are two possibilities for the equilibrium outcome, depending on the costs of default.

When the costs of default are high, government will borrow less (Arellano, Conesa, and Kehoe, 2012). If the costs of default are lower, the government will optimally choose to default after a predetermined number of periods. Self fulfilling crises are also possible when economy is in recession and which it might recover. In this case, governments have various incentives that are possible and reasonable. Government can choose either to pay its debt to the upper safe limit or continue to borrow and debts will raises continuously, that is gambling for redemption. The choice is depends on the costs of default, the probability of a crisis and the probability of recovery from recession. Defaults can also occur when GDP is very low. Low in interest rates and debt below upper safe limit causes countries to borrow large amounts.

While there are many problems that contributed to the European sovereign debt crisis in 2010, there is some policy required to solve the crisis in Europe. The policies must be anchored to fixing the financial system and requires a consistent growth strategy and specific solutions to the sovereign debt crises. Among the policy is a fiscal consolidation (Wignall, 2012). Through the fiscal consolidation, fiscal compact rules for deficits and debt burdens in the future will lead to the debt reduction or the affordability improves. The author, also added that this policy will improve the credibility of world’s second most important reserve currency, the euro, that was been threatened by the sovereign debt crisis.

As the ways to reduce the sovereign debts, there are some strategies that can be practiced. According to (Cionbanasu, 2011) most of the time, government spending is excessive and must be reduced. However, the way it is achieved is very important because government spending must be administered efficiently besides reducing redundant costs. Austerity by itself is not the solution. Economy as a whole will just slow down, determining a chain reaction in the private sector as well if austerity is the only way to reduce deficit. When this happens, everyone would hold back spending until better times and money would stop circulating.

Therefore, governments should become more efficient at spending taxpayers’ money on measures that keep the economy running (Ciobanasu, 2011). Efficient government should welcome investments that generate jobs and profits while times for big government are over. At the same time, consumer spending should be maintained at an adequate level because in the economy, one person’s spending is another’s income. There will be a falling production due to falling demand if everybody were to cut spending at the same time. In such cases, governments must step in to compensate through policies, the start of a downward spiral. Moreover, it is difficult to increase the taxes because it is a last resort measure which leads to a fall in spending and an increase in tax evasion.

Furthermore, politics play a big role in pushing developments and reducing debt (Ciobanasu, 2011). However, measures such as reducing welfare costs, raising taxes and cutting government spending are difficult to be practiced. The government may not go all the way with the implementation of the necessary measures because in some countries such risk is unacceptable by the ruling political party.

This might be the case of Greece, where the EU and IMF agreed in 2010 to a 110 billion Euro three year bailout package to rescue Greece's economy on condition that they push through severity cuts. This approach has not up to now solved the problem, but rather it has postponed it. It’s difficult to believe that Greece can reduce deficit and debt so fast.

3.0 The Global Effects during European Sovereign Debt Crisis

According to (Bullard, 2012), the recent studies on the global economic outlook have been indifferent. This is because Europe undergo in recessionary state which lead to uncertain effects of the ongoing sovereign debt crisis continue and reflect on the medium term outlook. Global investors are dividing Europe once again into member states, a sort of market-based disintegration of the continent. Nevertheless, during the crisis, most of the countries face major problems in their economy growth. For example, U.S is growing but at a slow-moving. Besides, recent data from China suggest a slower pace of growth than might have been expected earlier this year. Commodity prices have fallen to lower levels during recent months in part in response to the slowing global economy. Inflation readings have generally been lower. This collection of data is causing considerable discomfort in global financial markets and in policymaking circles. Much of the restlessness can be traced to the increasing realization that the European sovereign debt crisis may be more traumatizing and more inflexible (Bullard, 2012). In (Arghyrou & Kontonikas, 2010) point of view, they also stated the same as what Bullard, 2012 mentioned in his findings which is, both the amount and the price of the perceived global risk associated with investments in sovereign bonds, relative to the safe havens of US and Germany, have increased during the global economic downturn. This explains the across the board increase in EMU spread values.

3.1 The Effects of the European Sovereign Debt Crisis in Advanced Economies

3.1.1 The US Situation

The United States has strong economic ties to Europe, and many analysts view the Euro zone crisis as the biggest potential threat to the U.S. economic recovery. First of all, according to (Cottarelli, 2012), the markets have been worried about fiscal sustainability in the euro area and partially other advanced economies such as United Stated, Japan, United States and so forth. Although the most jarring effects of the European sovereign debt crisis have been largely contained to Europe, the continent’s problems have affected the world’s other advanced economies, including the U.S. and Japan (Christensen, 2012). During the wake of crisis, the investors bought U.S currency and bonds. But then the trade and investment between U.S and Europe have weakened.

As a result, the U.S. has managed to continue its economic recovery from the global financial crisis, but the European crisis has prevented that recovery from being stronger. Concerns about the rising dollar (which makes U.S. exports more expensive) and decreased European investment are warranted. Furthermore, an expected recession in the EU is likely to lower European demand for U.S. goods further and may also decrease profits for U.S.

3.2 The Effects of the European Sovereign Debt Crisis in Emerging Economies

According (Christensen, 2012), the European sovereign debt crisis has had relatively little effect on emerging economies. Indeed, many emerging economies experienced high economic growth in 2010 and throughout most of 2011. However, toward the end of 2011, emerging markets began to feel the effects of the European sovereign debt crisis as banks in Europe and the U.S. tightened credit in anticipation of a lengthened economic slowdown in Europe.

Based on (Sesric, 2011) report on European debt crisis state that, from the year 2008 to 2009 financial and economic crisis substantially impacted both the developed and developing countries. In the year 2008, the global industrial production declined by 20% as high income and developing country plugged by 23 and 15 per cent respectively. According to the World Bank, it’s estimated that developing countries would face a financing gap of $270-$700 billion depending on the severity of the economic and financial crisis. Nevertheless, there was some issue arise which has been triggered by the sovereign debt crisis issuance by high income countries would crowed out many developing countries. Besides that, the developing economies faced challenge on how to protect and expand necessary expenditures on social safety nets, human development, and critical infrastructure.

According to (Hutchison, Aizenman, & Jinjarak, 2011) states that after IMF enroll in European Debt Crisis in late 2010, brings the situation begins to heal slowly. In response to the crisis, some countries have pledged additional funds to the International Monetary Fund (IMF). Moreover, IMF the Obama administration opposes increasing the IMF’s role in the future because the IMF has played an important role in containing the crisis thus far by providing advice on the design of financial reforms and by contributing funds to the various bailouts. Emerging economies like China and Brazil, India has said that it would prefer to assist Europe through the IMF rather than make direct loans to troubled countries or purchase European Financial Stability Facility (EFSF) bonds.

3.3 The long term challenges during Euro zone debt crisis

The Europe nation faced four major long term challenges during Euro zone debt crisis which are (Nelson, Belkin, & Mix, 2012):

High debt levels and public deficits in some Euro zone countries.

As mentioned, three Euro zone governments which are Greece, Ireland and Portugal have had to borrow money from other Euro zone governments and the IMF in order to avoid defaulting on their debt. Meanwhile, Greece still had to restructure its debt in result substantial losses for private creditors, and investors are concerned that other governments could also restructure their debt, even though European officials have stressed that they consider Greece an exceptional case.

Weaknesses in the European banking system

According to (Adler, 2012), the crisis has also triggered capital inflow from banks in some Euro zone countries, and some banks are reportedly finding it difficult to borrow in private capital markets, causing some investors to fear a banking crisis in Europe that could have global reaction.

Economic recession and high unemployment in some Euro zone countries

Unemployment is particularly high in the Euro zone periphery, forecasted to be 19.3% in Greece and 24.2% in Spain in 2012. In Greece and Spain, more than half of young people of working age are unemployed.

Persistent trade imbalances within the Euro zone.

Persistent trade deficits in the margin countries are also making it difficult for these countries to pursue export-led growth in response to the crisis.

4.0 Euro Zone Crisis and the Malaysian Economy

Malaysia is a medium-income country in Southeast Asia (Country Report Malaysia, 2012). As a developing country and one which exports items to Europe countries, Malaysia is not exempted from the impacts of the Euro zone debt crisis. A hit of the euro zone crisis, could affect Malaysia indirectly. Although the impact does not seem visible, however it is still there and with no proper financial management at the crisis may be unavoidable (Times, 2012).

4.1 The impact of the European Sovereign debt crisis on Malaysia

The European sovereign debt crisis poses a key risk to the global economy, as its potential boom may have significant spillover effects on the real economy and the financial markets. The transmission of the impact of the Euro debt crisis to the Malaysian economy is through major channels, namely the trade and financial flows (Malaysia, 2011).

During the (Rosli, 2012), Dr Nungsari Ahmad Radhi of Khazanah Nasional says that Malaysia will not be secure from the effect of the Euro zone sovereign debt crisis as the European banks’ loans to Asia are higher than those of American banks. Generally, there is still much uncertainty in the Euro zone despite their leaders’ reform pledges. Investors are still unsure about the magnitude of the crisis in relation to the European economy and the world as a whole. The economic projections for the next few months are expected to be gloomy as there is doubt about the ability of the European Central Bank to solve the EU’s sovereign debt confusion. Secondly, the Malaysian ruling party is expected to undertake several popular decisions in gearing itself for the 13th General Elections expected in the first half of 2012. France, Russia, Taiwan and the United States will also hold their elections in 2012.  As such, normalizing fiscal and monetary policies, as well as other structural reform initiatives will be delayed. Political competition will inevitably lead to irrational decisions that will hinder economic growth.

4.2 Malaysia’s Exports during European Debt Crisis

According to (Massa, Keane, & Kennan, 2012) observation, Malaysia is as a developing country that had diversified trade structure, thus any shock to Malaysia’s overall trade arising from the EU would have a impact on the economy. The Euro zone debt crisis had clearly caused falling demand from the European Union (EU) countries. The weakening demand from the United States and Japan further weighed down Malaysia’s export growth in April.

From an exports perspective, Malaysia’s dependency on the US and Euro zone has declined to 12.2 per cent and 11 per cent respectively on average between 2007 and 2010, while intra-regional trade has risen to above 50 per cent. Nonetheless, some of these exports are still linked to demand in the developed economies as part of the regional production supply chain to the US and Euro zone. Besides, slow-moving performances in these regions will impact Malaysia’s trade performance.

Despite the consequences (AMB, 2012), analyze that, more concern over the Euro zone economies arising from the policy uncertainties following changes in political leadership, together with slowing China economy are the biggest downside risks to impact Malaysia’s export performance over the immediate term. With weakening global demand and sliding global commodity prices, the demand for Malaysia’s exports could have weakened more over the months of May and June. While export performance would be lack shine during the second quarter, the overall growth in GDP for the period will be sustained by a steady domestic demand. Finally, various analyses from many authors clearly tell that the European sovereign debt crisis poses a key downside risk to domestic growth prospect. Hence, the impact on the domestic economy has been overcome slowly.

5.0 Conclusion

The European sovereign debt crisis has affected countries throughout the world. After the big, dangerous shock of 2008-2009 world financial crisis and large banks supporting bail-out therapy or maybe leading to hyper inflation and we hear currently that world economy is already on the path of the recovery. Throughout the studies we had analyses on what is European Debt crisis and how it was begun. According to (Michnowski, 2009), there are several actions has taken to overcome European Sovereign Debt Crisis. There are two different proposals for overcoming this new form of European crisis.

The first one is to rebuild and sustain economy growth by continuation for some time up till now the economy growth stimulating bailout policy. It means to go with such new stimulus into larger state debts at the cost of not only future generations.

The second proposal to eliminate state deficit by means of cutting budget deficits severity measures. For example, cuts in social programs, pensions and wages.

But according to (Bednarczyk, 2010) author, he stressed on by imply monetary policy tools in the situation of crisis could help the European Central Bank reacted to the crisis phenomenon very quickly. In further consideration, it has been forecast by the World Bank, it has revised that in 2011 estimates for global economic growth down from 3.6% in 2012 and 2013 to 2.5% and 3.1% respectively. In a worst-case scenario for the Euro zone, the World Bank estimates global GDP could contract 1.5% in 2012 and 0.9% in 2013.As a result it is hard to know exactly when and how the European sovereign debt crisis will be resolved, but the entire global community has plenty at risk (Poghosyan, 2012).