EUROPEAN SOVEREIGN

DEBT CRISIS
Submitted to Prof. Shraddha Kotak

TABLE OF CONTENTS

Contents
INTRODUCTION
CAUSES 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

EUROPEAN SOVEREIGN-DEBT CRISIS

Introduction
Recent months have seen the transformation of the global financial crisis into
a sovereign debt crisis in the euro-area. Starting from Greece in autumn
2009, the euro-area crisis has since caused Greece to withdraw from
international bonds markets and has put intense pressure on the bonds of
other EMU countries, most notably Ireland, Portugal and Spain. The intensity
of the crisis has prompted European policy makers to take extraordinary
measures aiming to limit its fall-out on the real sector of the affected
countries and prevent its further spreading. These measures, ratified in May
2009, include an unprecedented in size (110 billion euros) three-year
EU/IMF-financed emergency rescue package for Greece; and the creation of a
European stabilisation mechanism ring-fencing 750 billion euros for
countries that may find themselves in a position similar to the Greek one
within the following three years. These measures, however, have so far not
proved enough to ease the crisis. In November 2010 Ireland became the
second EMU country to seek and obtain a rescue package for 85 billion euros.
This event fuelled further debates on issues ranging from the optimum shortrun response to the crisis to the eurozones overall long-term sustainability.
With so much political and economic capital at stake, it is not surprising that
the economics literature has responded actively to the eurozone crisis
through a series of empirical studies. The consensus emerging from this
literature, reviewed in section 2, is summarized in two main findings. First,
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. In this process, the
transfer of banking sector risk to sovereign borrowers, through bank bailouts, has been central. Second, intra-EMU differences in spreads increases
are explained by heterogeneous transfer of banking sector risk to sovereign
borrowers 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. The
existing studies have shed much-needed light on the factors driving
increasing EMU spreads, greatly enhancing our understanding of the
eurozone 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 can
offer a full set of explanations and traceable future policy implications.
Second, existing studies have not explained the events characterising the
most 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 late
March 2009?
Third, why has the Greek spread been taking so much higher values
compared to other periphery countries? Is the Greek macro-outlook so much
worse than Portugals to justify s as been the role, if any, of speculative
trading in the market for credit default? Swaps (CDS) on Greek and other
EMU government bonds? Such speculation has been suggested as one of the
potential culprits behind the present turmoil with subsequent proposals
ranging from tighter regulation of the CDS market to an outright permanent
ban on naked CDS trading. Are such proposals justified or is the role of CDS
speculation 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, markets
priced neither macro fundamentals nor the very low at the time international
risk factor. This finding is consistent with the convergence-trading
hypothesis, according to which markets were discounting only the optimistic
scenario of full real convergence of all EMU economies to the German one.
Second, we obtain evidence in favour of the hypothesis that the Greek debt
crisis is due to a background of deteriorating macro-fundamentals and a
double shift in private expectations:
This regime-shift not only explains the sudden escalation of the Greek debt
crisis 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 much
higher probability of a Greek voluntary exit from the EMU, and/or a Greek
default. In short, Greeces problems are as much about trust as they are about
economics.
Third, we confirm that up to the point covered by our econometric analysis
(February
2010), the overwhelming majority of EMU countries had experienced
contagion from
Greece, most prominently Portugal, Ireland and Spain. This is interpreted as
evidence that the
Greek bond yield has become a proxy for EMU-specific systemic risk,
increasing borrowing costs in other EMU countries beyond the level justified
by the common international risk factor and their idiosyncratic
fundamentals. In short, the Greek problem has become an EMU-wide
problem. Finally, we do not find evidence in favour of the hypothesis that
speculation in the CDS market, including the Greek one, is a major force
driving the eurozone debt crisis.

FINANCIAL HIGHLIGHTS
From late 2009, fears of a sovereign debt crisis developed among
investors as a result of the rising private and government debt levels
around the world together with a wave of downgrading of government
debt in some European states.
Three countries significantly affected, Greece, Ireland and Portugal,
collectively accounted for 6% of the eurozone's gross domestic product
(GDP).

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In June 2012, also Spain became a matter of concern, when
rising interest rates began 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
Rising
household
and
government
debt levels

Loss of
confidence

Trade
imbalances

CAUSES

Monetary
policy
inflexibility

Structural
problem of
Eurozone
system

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

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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 high budget 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 as
CDOs 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 after
the 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 have
refused 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 parliaments
and 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 be
one 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 the
problem 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 from recession 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 as
they agreed to let depositors and stakeholders participate in financing
bailout.
Hence, the crisis 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
the late-2000s financial crisis.

The average fiscal deficit in the euro area in 2007 was only 0.6% before
it grew to 7% during the financial crisis.
The International Monetary Fund (IMF) reported in April 2012 that in
advanced 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
in fiscal policies in 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
in fiscal policies in taxation and expenditure

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TIME-VARYING IMPACT ON EUROPEAN BANKS
The average time-varying potential spill over to European banks. There
we show the differences between the effects from a shock in Spanish
sovereign CDS and from a shock in German sovereign CDS.
During the entire data sample the mean impact from DE is slightly
below 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 rolling
window. As can be seen in Figure 6, at the beginning of April 2012, the
average impact from a shock in Spanish sovereign CDS exceeds the mean
impact (over the entire period) and exceeds the previous peak that was
reached at the end of November 2011. By mid-May 2012 the average
potential spill over effects from a Spanish shock reaches the level of 65%. In
other words, the entire European banking system reacted strongly to the
Spanish sovereign debt crisis during the April-June 2012 period.
After the G20 and EU summits, the potential contagion pressure to the
European banking system mitigates. This analysis highlights the advantage of
monitoring the time-varying potential impact from each variable of the
system.

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MONETARY POLICY INFLEXIBILITY
The Economic and Monetary Union (EMU) is an umbrella term for the group
of policies aimed at converging the economies of all member states of the
European Union at three stages. Both the 19 eurozone states and the 9 noneuro states are EMU members. A Member State however needs to comply and
be a part of the "third EMU stage", before being able to adopt the euro
currency; and as such the "third EMU stage" has also become largely
synonymous with the eurozone.
All Member States of the European Union, except Denmark and the United
Kingdom, have committed themselves by treaty to join the "third EMU stage".
The Copenhagen criteria is the current set of conditions of entry for new
states wanting to join the EU. It contains the requirements that need to be
fulfilled and the time framework within which this must be done, in order for
a country to join the monetary union. An important element of this, is a
participation for minimum two years in the European Exchange Rate
Mechanism ("ERM II"), in which candidate currencies demonstrate economic
convergence by maintaining limited deviation from their target rate against
the euro.
Nineteen member states of the European Union, including most recently
Lithuania, have entered the "third EMU stage" and have adopted the euro as
their currency. Denmark participate in the Exchange Rate Mechanism (ERM
II). Denmark and United Kingdom has received a special opt out from the EU
Treaties, allowing for a permanent membership of ERM II, without being
required to enter into the "third EMU stage". In regards of the remaining noneuro member states (Sweden, Poland, Czech Republic, Hungary, Romania,
Bulgaria and Croatia), they are committed by treaty to enter the third stage
upon the time of complying with all convergence criteria; of which the last
one (ERM II membership) however is something the member state can
choose not to apply for, if they do not want to adopt the euro.

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Eurozone establishes a single monetary policy, individual member states can
no longer act independently, preventing them from printing money in order
to pay creditors and ease their risk of default.
By "printing money", a country's currency is devalued relative to its
(eurozone) trading partners, making its exports cheaper, increased GDP and
higher tax revenues in nominal terms.

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LOSS OF CONFIDENCE
The loss of confidence is marked by rising sovereign CDS (credit-default
swaps) prices, indicating market expectations about countries
creditworthiness.
Since countries that use the euro as their currency have fewer monetary
policy choices certain solutions require multi-national cooperation.

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IRELAND
The Irish sovereign debt crisis was not based on government overspending, but from the state guaranteeing the six main Irish-based
banks who had financed a property bubble.
Irish banks had lost an estimated 100 billion euros, much of it related
to defaulted loans to property developers and homeowners made in
the midst of the property bubble, which burst around 2007.
Unemployment rose from 4% in 2006 to 14% by 2010, while the
national budget went from a surplus in 2007 to a deficit of 32% GDP in
2010, the highest in the history of the eurozone, despite austerity
measures.

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PORTUGAL
Portugal requested a 78 billion IMF-EU bailout package in a bid to
stabilise its public finances.
These measures were put in place as a direct result of decades-long
governmental overspending and an over bureaucratised civil service.
On 16 May 2011, the eurozone leaders officially approved a 78
billion bailout package for Portugal, which became the third eurozone
country, 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 deficit
from 9.8 percent of GDP in 2010 to 5.9 percent in 2011, 4.5 percent in
2012.

European
fiscal union

Debt defaults
and national
exits from
the Eurozone

Drastic debt
write-off
financed by
wealth tax

EUROPEAN FISCAL UNION

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Eurobonds

Proposed
long-term
solution

European
Monetary
Fund

EUROPEAN SOVEREIGN-DEBT CRISIS

Increased European integration giving a central body increased control

over 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, the Austrian institute of economic
research published an article that suggests transforming the efsf into
a European monetary fund (emf), which could provide governments
with fixed interest rate euro bonds at a rate slightly below mediumterm economic growth
These bonds would not be tradable but could be held by investors with
the 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 are
not 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.

TAKEAWAYS
One 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 many
years. 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.

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