spread of the european sovereign debt crisis
DESCRIPTION
European debt crisisTRANSCRIPT
-
1
The Spread of the European Sovereign Debt Crisis
By Lia Menndez
April 2012
In this section of the E-book, we look at how the debt crisis that began in Greece in 2010
spread to other countries in the Eurozone. Investors questioned Greeces ability to pay its debts
and soon doubted other countries abilities to pay their debts. Investors believed that these
countries shared similar financial features with Greece, especially high deficits and debts.
Part A first discusses how a sovereign debt crisis begins. It considers how high debt and
low economic growth can create a financial crisis when a country cannot afford to pay its debt,
as was the case with Greece. It also describes the loss of investor confidence that arises when
investors fear taking losses because a country lacks the funds to pay its debt.
Part B explains how the sovereign debt crisis that began in Greece migrated to other
countries in the Eurozone as investors also lost confidence in these countries. Economists agree
that the European sovereign debt crisis has multiple, inter-related causes. Although investors
believed that some countries in the Eurozone (e.g., Greece) posed risks of financial loss, other
affected countries (e.g., Ireland, Portugal, Spain, and Italy) were financially healthy by
comparison. Nonetheless, the crisis has affected these economies as well. Housing-market and
banking crises greatly impacted Ireland and Spain causing government deficits to rise when their
governments intervened to rescue their banking sectors that were heavily invested in failing
housing-markets. In Portugal and Italy, high public debts adversely affected each countrys
financial health and ability to pay investors.
Part C concludes by describing the impact the financial crisis might have on other
countries in the Eurozone, especially France, if investors lose confidence and stop investing in
-
2
them. It summarizes investors concern that the financial crisis is far from over and will continue
to spread to other vulnerable economies. The next section of this part of the E-Book will discuss
the measures the EU and Eurozone countries have taken to slow the spread of the crisis.
A. How Does a Sovereign Debt Crisis Begin?
To finance governmental operations, countries often sell bonds. When a bond matures,
the country must pay bondholders the face value of the bond, plus interest. If the countrys tax
revenues or cash reserves are low, the country may have to pay investors more than it can afford.
A country with low economic growth (like Greece) will have greater difficulty raising funds to
make bond payments as government tax revenues decline along with businesses and
individuals income. Moreover, during a financial crisis, investors may demand higher interest
rates on bonds to guard against the risk of loss that they would realize if a country defaults on its
debt. If investors lose confidence in a countrys ability to pay its debt altogether, they will stop
purchasing that countrys bonds.
If interest rates reach levels so high that a country cannot repay its debt or afford to
borrow more money to pay existing debt, a countrys options include renegotiating its debt,
monetizing its debt (financing debt by generating more money), or defaulting on its debt.
Renegotiating sovereign debt involves restructuring and reducing a countrys debt. Bondholders,
for example, may have to take haircuts on the value of their bondsthat is, the government
may unilaterally reduce the face value of the bond, and consequently, the amount it must pay
bondholders decreases. As discussed in the following section of the E-Book, Greece recently
used this option to lower its debt burden. A country can monetize sovereign debt by printing
more currency. A larger supply of money leads to increased spending, stimulating economic
growth and allowing a country to pay its debt with the increased government revenues. Countries
-
3
can also default on their debts (refuse to repay), which would result in losses for investors and
make it impossible for that country to borrow money by issuing bonds for a substantial period of
time until investors no longer fear that the country will default again.
Countries in a financial crisis can also devalue their currency, making their exports
cheaper and, therefore, more attractive globally. The government can use the increased revenue
from exports to reduce the size of its deficit and debt (the term deficit refers to the amount that
government spending exceeds revenue in a given year, while debt is the accumulated total of
annual deficits). Individual Eurozone countries, however, do not have the option of devaluing
their currency because they share a common currency and monetary policy as described in the
previous section.
1. Excessive Spending and a Lack of Competitiveness Led to Low Economic Growth
in Greece and Increased Debt
In 1979, Greeces government began implementing a new fiscal policy aimed at
promoting economic growth through increased household consumption. Consumption was
financed through heavy consumer borrowing. The government also borrowed to increase its
spending to stimulate growth. This pattern of borrowing continued when Greece joined the EU in
1981. The government benefitted from access to EU funds for agricultural subsidies and
infrastructure financing. The government also obtained other international loans that it used in
ineffective ways that did not improve economic performance. Instead, government officials often
used money for the benefit of political allies. They also used funds to expand social welfare
programs, such as providing pensions for workers to retire at age fifty-eight. Although social
welfare can promote economic growth by increasing consumers disposable income, in Greeces
case, it was so excessive (social welfare spending counted for more than half of all government
spending) that it added to the debt burden.
-
4
Greeces economy has also suffered because of a lack of competitiveness. It has failed to
attract investors and had low levels of foreign direct investment because of low entrepreneurship,
a small manufacturing sector, and government corruption. Excessive government regulations and
bureaucracy made Greece the worst country in the EU to do business. Greeces competitiveness
decreased after its entry into the EMU when it had to compete with Eastern European countries
that exported goods at lower prices.
2. High Debt and Low Economic Growth in Greece Spurred the Beginning of the
European Sovereign Debt Crisis
Despite its history of excessive spending, between 1997 and 2007, Greece had an average
of 4% GDP growth annually (almost twice the EU average). Greeces significant economic
growth resulted from its membership in the EU and its adoption of the euro in January 2002. It
continued to enjoy access to EU and international funds at low interest rates because Eurozone
member countries were considered financially and politically stable, regardless of their actual,
individual financial circumstances. Greeces economic growth, however, masked some of the
problems with the Greek economy that contributed to the financial crisis in 2010. In 2008, the
global financial crisis negatively affected the Greek economy and growth decreased to 2% of
GDP. By 2009, Greece was in the midst of a recession. As a result, it could no longer rely on the
sources that had previously fueled its economic growthaccess to international loans, trade, and
consumer spending.
The government spent about half of the countrys GDP every year between 1995 and
2008. To stimulate the economy during the global financial crisis in 2008 and 2009, the
government increased spending even further, which increased the debt to more than half of GDP
by 2009. In 2009, Greece had the highest debt in the EU at 126.8% of GDP. Economists predict
-
5
that Greeces debt will continue rising through at least 2014. As of April 2012, Greeces debt
was approximately 127.8% of GDP (about 286 billion).
Compounding the problem, the government falsely reported data and gave the impression
that its debt situation was not dire. The government originally reported its 2009 deficit at 3.7%,
but later revised it to 13.6% of GDP. The government also lost large amounts of potential tax
revenues from the shadow or underground economy, comprised of legal and illegal operations
that go unreported and untaxed each year. Between 1996 and 2006, the size of Greeces shadow
economy was 20% to 25% of GDP. Furthermore, revenue losses due to tax evasion amounted to
3.4% of GDP in 2006.
Greeces fiscal deficit has been above 3% of GDP almost every year for ten years, in
violation of the Stability and Growth Pact (SGP) (revised data from 2010 shows that it was at
5.1% in 2007 and 13.6% in 2009). Under the SGP, EU member states agreed to limit their
budget deficits to 3% of GDP, but the SGPs enforcement mechanisms were not sufficiently
effective to force countries to comply. As discussed above, the influx of EU funds and
international loans made it easy and cheap for Eurozone governments to borrow and build large
deficits and debts over time.
Government inefficiency also provoked the crisis in Greece. The inability of the
government to take control of Greeces debt by raising taxes or cutting spending led to a loss of
investor confidence in Greece. Greece implemented few fiscal reforms to stimulate growth and
reduce its debt after joining the EU. Since it was unwilling to raise taxes to pay for social welfare
programs (or cut those programs), the governments only option was to borrow to finance its
operations, which increased its debt.
-
6
To refinance its deficit, Greece began issuing bonds with short maturity periods, meaning
that it would have to repay the bonds in relatively short periods of time. As bond payments
became due, Greece had to pay investors more than it could afford because of its low revenue
due to slow economic growth. Concerned that Greece would be unable to pay them in full,
investors began requiring higher interest rates to purchase Greek bonds. As those concerns grew
along with Greeces debt, borrowing became prohibitively expensive and investors stopped
investing in Greek bonds because of the associated risks. As a result, Greece eventually required
two bailout packages to secure the funds needed to pay investors.
B. The Sovereign Debt Crisis Spread from Greece to Other Countries in the Eurozone as Investors Perceived that these Other Countries Shared
Economic Characteristics with Greece that Caused Greece to Experience a
Financial Crisis in the First Place
Contagion resulted in the spread of the sovereign debt crisis from Greece to Ireland,
Portugal, Spain, and Italy. Contagion occurs when investors believe that other countries, in
addition to the original country facing economic crisis, pose a risk of financial loss and act
accordingly. In the Eurozone, investors began to worry about other countries with high debts,
despite no other country having debt as high as Greece. Investors began demanding higher
interest rates on governments bonds to compensate for the perceived increased risk, whether
justified or not. Some investors withdrew from these markets altogether.
1. The Greek Financial Crisis First Spread to Ireland
Ireland was the first country after Greece to face the impact of the European financial
crisis. Unlike other countries that the crisis affected, Irelands financial markets were not
strongly linked to Greece. For example, Ireland did not hold a significant amount of Greek debt.
Irelands financial situation was also significantly different from Greece. Unlike Greece, Ireland
did not have a tax evasion problem, suffer from a lack of competitiveness, or falsify its fiscal
-
7
data. Furthermore, it began making spending cuts fairly quickly after its debt began to rise
rapidly in the aftermath of the global financial crisis and before it was forced to seek a bailout in
November 2010 to help cover the cost of rescuing its banking sector. In 2009, the government
announced a goal of cutting 4 billion from the 2010 budget. Despite these differences, Irelands
economy did have vulnerabilities that investors believed made it a risky investment. At the time
Ireland received a bailout in 2010, its deficit was 32% of GDP and its budget cuts did not
reassure investors that its debt was sustainable. Interest rates on bonds soared in the month prior
to the bailout. As of April 2012, Irelands debt was approximately 112 billion or 75.3% of
GDP.
a. Housing and Banking Crises Led to an Increase in Irelands Deficit
Ireland experienced outstanding economic growth from the mid- to late-1990s, largely
due to a construction and housing boom. Immigration increased along with the growth of the
construction sector and the economy in general as the Irish economy created approximately
90,000 new jobs annually and attracted over 200,000 foreign workers, many of whom were
employed in the construction sector. The higher population and number of income earners
increased the demand for housing, which led to an increase in housing prices.
To meet this growing demand, Irish banks financed mortgage loans by borrowing from
international lenders. However, the banks did not always ensure the creditworthiness of
mortgage applicants due, in part, to aggressive lending practices meant to help them compete
with foreign financial institutions that were operating in Ireland, particularly U.K. banks that also
financed mortgages. Because Ireland was a member of the Eurozone, international lenders
presumed Ireland was stable and posed little financial risk. Irelands continued economic growth
also convinced foreign lenders to extend credit to Irish banks. Lenders, therefore, provided
-
8
inexpensive loans to Irish banks at low interest rates. In 2008, Irish banks combined debt from
making loans for property purchases had reached over 60% of GDP. The banks could only afford
to repay funds they had borrowed from international lenders as long as they continued to receive
interest payments from their own borrowers.
By 2008, however, the housing demand in Ireland had fallen, which slowed the
construction sector and eventually the entire Irish economy. Unemployment increased as
construction jobs disappeared. Consequently, many newly-unemployed property owners began
falling behind on loan payments and defaulting on loans, leaving Irish banks unable to repay
their lenders. Government revenue also fell due to losses in property taxes.
By the start of 2008, it was also clear that Irish banks lacked the funds necessary to
finance their daily operations. The government intervened by providing investors with
guarantees for the banks bonds (encouraging investors to purchase those bonds) and taking large
ownership stakes in banks to prevent them from collapsing. The government also created the
National Asset Management Agency (NAMA) to purchase bad loans from banks at discounted
prices. NAMA was intended to stabilize the financial system by removing banks riskiest loans
from their balance sheets. By doing this, the banks could make more loans because they no
longer needed to hold as much money in reserve to cover the potential losses on bad loans.
The government borrowed to finance its rescue of the banking sector, which caused its
debt to rise from 24.4% of GDP in 2007 to 59.4% of GDP in 2009. By 2010, it was clear that the
Irish government could not cover the losses in the banking sector. As the economic situation
worsened in Ireland, investors lost confidence in Irelands ability to repay its debts, and the
government was no longer able to issue bonds on the international market to raise funds. Ireland,
therefore, sought a bailout package from the EU and IMF in November 2010. It accepted a three-
-
9
year bailout package of 85 billion to help with government funding and the rescue of failing
banks. In return, Ireland committed to reducing its deficit to 3% of GDP in four years by cutting
at least 15 billion from its budget.
b. The Bailout Failed to Restore Investor Confidence in Ireland or Other
Financially Vulnerable Countries in the Eurozone
European Union finance ministers hoped that the Irish bailout package would stabilize
Irelands economy and encourage investment in Ireland. However, as news of the bailout spread,
interest rates on Irish bonds increased, indicating a lack of investor confidence about whether
Ireland could meet its debt obligations, even with the bailout, and whether investors would
experience losses if Ireland were forced to restructure its debt. The credit rating agencies
Standard & Poors and Moodys decisions to downgrade Irelands credit rating following the
bailout reflected the lack of reassurance the global market felt.
The Irish bailout was also supposed to calm investors fears that the financial crisis would
spread to other countries in the Eurozone, particularly Portugal and Spain. Investors were
concerned that like Ireland, Portugal and Spain would need bailouts as well. Although Portugals
banks were healthier than Irelands, investors lost confidence in Portuguese bonds after the Irish
bailout because they worried that Portugals slow growth and large budget deficit would lead
Portugal to seek a bailout. Despite Spanish protests that Spain was not like Greece, Ireland, or
Portugal, investors were not convinced that Spain was financially healthy either. Spain was
heavily exposed to Portuguese debt, so as the Portuguese crisis worsened, Spain faced an
increasing risk of financial loss. Furthermore, like Ireland, it experienced a housing-market crisis
and had high levels of unemployment.
In 2011, Irelands successful efforts to meet budget deficit targets reassured some
investors. Ireland reduced its deficit from 22.3 billion in the third quarter of 2010 to 21.4
-
10
billion in the third quarter of 2011. Its commitment to fiscal responsibility set it apart from
Greece and Portugal. Unlike these countries, Irelands economy is forecasted to grow in 2012
due, in part, to an increase in exports, especially manufactured goods. Even before the crisis,
Irish exports were attractive to international customers, especially pharmaceuticals, chemicals,
and software-related products. Ireland has also facilitated trade by removing barriers and Irish
exports are more affordable because the euros value against the dollar has decreased because of
the crisis.
Not all investors, however, are convinced that Ireland is on the mend. Moodys, for
example, lowered Irelands credit rating further to below investment grade in July 2011, stating
that even with the bailout, Ireland does not have sufficient funds to meet its obligations. Moodys
also expressed concern that investors would have to take haircuts on the their bonds if Ireland
were to restructure its debt. As a result of Moodys actions and a continued lack of investor
confidence in Irelands recovery efforts, Ireland will probably not be able to reenter the
international bond market in 2013 as it hoped.
2. The Crisis Spread Next from Ireland to Portugal
It is not difficult to see why the financial crisis spread next from Ireland to Portugal,
although Portugal did not experience the same financial problems as Ireland. Since it joined the
euro in 1999, Portugal has had the lowest growth in the Eurozone and suffered from low
productivity and competitiveness. Between 2001 and 2007, Portugal experienced only 1.1%
average annual growth. Meanwhile, increased government spending and decreasing tax revenue
caused the deficit to rise. As the countrys deficit grew, it did not have sufficient funds to pay its
increasing debt. Nevertheless, other aspects of Portugals financial situation seemed comparable
-
11
to countries in the Eurozone that investors did not think posed substantial financial risks. For
example, Portugals debt was 77% of GDP in 2010, as compared to 83.2% of GDP in France.
a. Portugals Slow-Growing Economy, Increasing Deficit, Low Productivity, and Lack of Economic Competitiveness Made the Country Vulnerable to the
Sovereign Debt Crisis
Portugal joined the EU in 1986 hoping that EU membership would lead to greater
economic and political stability after decades of authoritarian rule. Joining the EU was supposed
to provide Portugal with the incentive to enact reforms that would lead to economic growth.
Portugal hoped to benefit from access to cheaper credit available either from the EU or
international lenders that believed all Eurozone countries were safe investments. At first,
Portugal enacted some economic reforms that stimulated economic growth and attracted
investors, such as removing some barriers to trade like high tariffs.
Between 1986 and the late 1990s, Portugal experienced relatively high GDP growth due,
in part, to an increase in trade. Portugals low labor costs and an influx of EU funds contributed
to the development of its infrastructure. As a result of joining the EMU and adopting the euro,
Portugals exchange rate stabilized and inflation decreased. However, the government did not
use newly-available funds to increase production and promote entrepreneurship, which would, in
turn, promote economic growth. Instead, it channeled the funds into sectors that government
officials and their supporters favored. From the mid-1990s onwards, Portugal lacked the
incentive to continue implementing economic reforms and scaled back reform measures because
it had easy access to EU and international funds despite whatever flaws its economy may have
had. These developments contributed to very low economic growth in the 2000s. In the late
1990s, Portugals growth rate was an average of 3.9% of GDP, but had fallen to an average of
0.4% of GDP by the late 2000s.
-
12
Portugals lack of competitiveness also contributed to low economic growth. Portugal
mainly exports low-tech, inexpensive goods that have lost market share to cheaper producers
in emerging markets. Although Portugal was once competitive in the service industry because of
low labor costs, Eastern European countries with even lower labor costs decreased Portugals
competitiveness in this area when they joined the EU.
While Portugals deficit was under 3% between 2002 and 2004, it rose to 5.9% in 2005.
The government then unsuccessfully attempted to reduce the deficit, which reached a high of
10.1% of GDP in 2009. This increase resulted from an 11% drop in tax revenue due to the
economic slowdown resulting from the global financial crisis. With less revenue, the government
had to rely on borrowed funds to finance spending on its generous social programs. In 2010,
Portugals debt was 93% of GDP and was projected to increase to 97.3% of GDP in 2011.
To finance the growing debt, the government issued new bonds. However, investors
demanded higher interest rates as incentives to buy, causing the debt to increase further. The
government relied on domestic banks to buy government bonds, which left the banks holding
risky debt. As Portugals debt continued to grow, investors became increasingly unwilling to
lend to the country. By the spring of 2011, it became clear that the Portuguese government would
not be able to repay its debt. In the beginning of the year, it had 2 billion in cash reserves and
was due to repay investors 4.2 billion on government bonds in April and another 4.9 billion in
June. The Portuguese parliament complicated matters by rejecting proposed austerity measures.
Portugal became the third Eurozone country to request a bailout from the EU. Portugal received
a bailout package of 78 billion on the condition that it reduce its deficit. In 2011, Portugal was
supposed to reduce its deficit to 5.9% of GDP from 9.1% in 2010, but failed to do so. Under the
-
13
terms of the bailout agreement, Portugal has until 2014 to lower its deficit to below 3% of GDP
as mandated by the SGP.
b. The Portuguese Bailout Failed to Restore Investor Confidence
The credit rating agencies were not optimistic upon hearing the news of the Portuguese
bailout. Moodys downgraded Portugal to junk status due to its belief that the bailout would not
be enough to stabilize Portugals economy. Standard & Poors and Fitch Ratings have since done
the same. In October 2011, Moodys downgraded nine individual Portuguese banks because it
doubted that these banks could be recapitalized since they have a number of loans on their books
that are either already non-performing or are at risk of becoming so. Although international
lenders have been unwilling to lend to Portuguese banks for over a year, credit rating agencies
attitudes could lead to a greater loss of investor confidence that could continue to shut Portugal
out of financial lending markets.
The region of Madeira has complicated Portugals efforts to comply with the bailouts
terms and has shaken investors confidence further. After agreeing to the bailout in 2011,
Portugals government discovered that Madeiras regional government had underreported its
debt since 2004, which increased Portugals public debt by 1.668 billion. Although Madeira is
an autonomous state, its debt counts as part of Portugals total public debt. Thus, this revelation
has made it harder for Portugal to meet the budget deficit targets the EU and IMF set as a
condition of the bailout. Madeira does not want to impose austerity measures on its population
and wants to continue spending on public projects, which will likely continue increasing
Portugals debt. As of April 2012, Portugals debt is 131 billion or 82.4% of GDP.
As Portugal implemented austerity measures to try to bring its deficit under control, the
economy contracted further. As a result, many workers left Portugal in search of jobs after the
-
14
government cut wages and benefits for public sector employees and raised taxes throughout the
country. Portugal is largely dependent on its exports for revenue, but most of its trading partners
have been affected by the crisis70% of its exports go to the EU, including 24% to Spain. As a
result of reduced trade, Portugal cannot rely on exports to generate the revenue necessary to pay
its debts. The crisis in Portugal poses financial risks for countries that have significant exposure
to Portuguese debt, especially Spainthe next country to face the effects of the crisis.
3. From Portugal, the Crisis Moved to Spain
Similar to Ireland, housing-market and banking crises provoked a sovereign debt crisis in
Spain. Spain enjoyed substantial economic growth prior to 2007, but with the end of a housing
boom in 2007 and the recession in 2008 resulting from the global financial crisis, Spains deficit
increased. Despite the high level of private debt Spanish citizens held prior to the crisis, the
countrys deficit was relatively low when compared to the rest of the Eurozone. In 2007, Spains
deficit was 1.132% of GDP compared to the Eurozone average of 1.83%. By 2008, however,
Spains deficit had risen to 4.9% of GDP compared to the Eurozone average of 2.58% of GDP.
By 2010, Spains deficit had risen to 9.7% of GDP. As the fourth-largest economy in the
Eurozone, Spain has been characterized as too big to fail, but the EU and the IMF do not have
enough money to bail out an economy the size of Spains.
a. Housing-Market and Banking Crises Led to Increased Deficit and Debt in
Spain
Between 1995 and 2007, a construction boom fueled remarkable economic growth as
housing prices rose 220%. The demand for housing soared as homeownership became a goal for
the majority of Spaniards due to the unavailability of affordable rental options in the mid-
twentieth century and a tax policy introduced in the 1980s that made mortgage principal and
interest tax-deductible. Increased immigration to Spain due to the availability of construction
-
15
jobs also increased demand for housing. Unemployment fell from 23% in 1986 to 8% in mid-
2007.
The availability of cheap credit from international lenders to banks and other lending
institutions like the cajas de ahorros (Spains savings and loan banks) allowed Spanish
households and businesses to borrow heavily to finance real estate purchases. Like other
countries in the Eurozone, Spain benefitted from the low interest rates available to Eurozone
members. As a result, Spain turned from a country relying on virtually no external funding in
1996 to one that relied heavily on international lenders in the 2000s. By 2008, Spain had
borrowed the equivalent of 9.1% of GDP.
In 2007, housing prices began to drop because property was overvalued. Unemployment
subsequently rose as jobs in construction disappeared. As the housing market slowed, lenders
issued loans to homebuyers that posed risks of default. As a result of growing unemployment
(which rose to over 20%), many people could not afford to make their mortgage payments.
Developers also began to default on their loans as the demand for new construction dropped, so
banks ended up holding bad loans from both individuals and businesses. As bad loans increased,
Spanish lenders revenue fell to the point that they lacked the funds to pay their own foreign
lenders.
The government eventually stepped in to rescue the banking sector. It first selectively
targeted the most indebted banks, but it soon provided funds to the entire banking sector,
including 99 billion to recapitalize the cajas. It feared that without more robust stimulus
measures to help the banking sector, the country risked a financial collapse and recession. As
government spending increased, so too did the deficit. The government had a budget surplus of
1.9% of GDP in 2007, but by 2009 it had a deficit of 11.2% of GDP. Consequently, its debt rose
-
16
from 26.52% of GDP in 2007 to 43.73% of GDP by 2009. As of April 2012, Spain owes
approximately 614 billion or 61.1% of GDP.
b. Spains Attempts to Impose Fiscal Discipline Have Not Reassured
Investors
The major credit rating agencies have downgraded Spains credit rating. They argue that
Spain faces great difficulty in significantly reducing its debt because reforms will not restore
market confidence and economic growth quickly enough to avoid a debt default. The
government has imposed a number of austerity measures that have burdened citizens already
facing the challenges of a recession. A new government has recently taken charge because of
citizens dissatisfaction with the effects of the crisis.
Interest rates on Spanish bonds were dropping in early 2012 after the European Central
Bank (ECB) helped stabilize Eurozone banking sectors by making low-interest loans to
Eurozone banks. In March 2012, however, the government announced that it would not meet the
4.4% of GDP budget deficit target set by the European Commission for 2012. Instead, it aims to
cut the deficit to 5.3% of GDP from the 2011 deficit of 8.5% through a proposed deficit-
reduction package of 27 billion. The government stated that the 2011 deficit was greater than
what had been forecast by the previous administration, meaning that it would have to make much
larger cuts than previously thought to meet the original targetsomething it was unwilling to do.
Following this announcement, interest rates on Spanish ten-year bonds rose, reaching 5.81% in
April 2012their highest level since the beginning of December 2011. The increase reflected
investors concern that more austerity would cause the economy to contract further, leading to
more unemployment, loss of tax revenue, and increased social welfare costs.
4. The Crisis Advanced to Italy Next
-
17
Italy did not experience a banking crisis like Ireland and Spain. Although it had the fourth
highest sovereign debt in the world (119% of GDP as of November 2011), its budget deficit
(4.6% of GDP as of November 2011) was low compared to the Eurozone average of 6% of GDP.
Nevertheless, Italy was the next country after Spain to experience the threat of a sovereign debt
crisis. Despite having the third-largest economy in Europe and one of the largest in the world in
terms of GDP, Italy had a slow-growing economy and high debt, much like Greece and Portugal.
Investors, therefore, began to question whether Italy would be able to repay its debts.
a. Italys Slow-Growth Following the Global Financial Crisis Strained Its
Ability to Pay Its Debt
In the late 1980s and early 1990s, Italys strong manufacturing and export sectors,
especially in areas such as automobiles, clothing, and chemicals propelled strong economic
growth. Reduced public spending, a declining deficit, and lower inflation also fueled growth.
Italys economic growth eventually stagnated, however. Investors often found Italy unattractive
because of its high level of corruption and strong labor regulations that increased labor costs. A
lack of investment in infrastructure and research, particularly in southern Italy, also hampered
economic growth. More recently, Italy struggled to compete with China in industrial
manufacturing due to Chinas lower labor costs. Between 2001 and 2008, Italy had an average
growth of only 0.8% of GDP.
The global financial crisis caused the economy to contract further as domestic and global
demand for Italian goods fell. In 2008, the economy shrank by 1.3% followed by a 5.2%
contraction in 2009. The government increased spending in an effort to stimulate the economy,
but Italys debt increased to over 1.88 trillion in 2011 (120% of GDPthe second-highest in
Europe behind Greece) as a result. As Italys economy slowed, investors became concerned that
-
18
Italy could not generate sufficient revenue for the government to repay its debts (the IMF expects
it to grow only 0.3% in 2012).
b. The Slow Pace of Italian Reforms Has Failed to Restore Investor
Confidence
The Italian governments delay in passing austerity measures due to political
disagreements decreased market confidence as investors feared that Italy would fail to take
action. In June 2011, Parliament approved an austerity package to cut the nations budget deficit
by 70 billion over three years by, among other things, cutting spending on many social services.
The EU, however, did not consider these measures sufficient to substantially decrease the debt,
so Parliament passed another austerity law in November 2011. Parliament intended this law to
prevent the crisis from spreading to France, which holds a large amount of Italian debt and
would, therefore, experience significant financial losses if Italy could not repay its debt.
The slow-moving pace of Italys government in dealing with the crisis and failure to
calm investors fears resulted in the prime minister stepping down. The new Italian government
proposed an austerity package in November 2011 that aimed to eliminate the deficit by 2013, but
had to scale back many of its proposals under heavy protests from political opponents, especially
labor unions. Like Spain, the latest austerity package failed to reassure investors immediately,
and long-term borrowing costs neared 7% in late 2011 (which most economists regard as too
high to sustain), though they have since fallen.
Standard & Poors downgraded Italys credit rating in May 2011, and Moodys and Fitch
Ratings soon followed, citing Italys high public debt and slow pace in implementing reforms.
They also announced that further downgrades are possible given Italys high risk of default. Such
downgrades would make it harder and more expensive for Italy to continue borrowing from
international lenders. Like Spain, the size of Italys economy makes it too big to fail. The EU
-
19
and IMF do not have the funds necessary to bailout such a large economy. Nevertheless, in the
first few months of 2012, investors seemed optimistic that the Eurozone was stabilizing. As a
result, interest rates on ten-year bonds dropped to 5.24%the lowest they had been in seven
months. By the beginning of April 2012, however, the yield on ten-year bonds rose to 5.41%.
Experts believe that the increased interest rates reflected investor concern over Italys high debt
and low economic growth.
c. The Size of Italys Bond Market Puts Investors at Risk of Financial Loss
Italy has the largest bond market in Europe and third-largest in the world behind the
United States and Japan. Therefore, if Italy were to default on its debt obligations, it would cause
massive repercussions globally, but particularly throughout the Eurozone and especially in
France and Germany. Many French and German banks own a significant amount of Italian
bonds, meaning that an Italian default would result in major losses for these banks. The United
States also owns more Italian bonds than any other Eurozone countrys bonds. Investors took
note of the potential danger of financial loss when Fitch Ratings issued a warning on the United
States Eurozone exposure in November 2011, which resulted in a drop in shares in U.S. banks.
While Italy issues the most bonds in the Eurozone, Italians own about half of those bonds.
C. The Future of the European Sovereign Debt Crisis
France, the EUs second-largest economy, is the next country that may feel the effects of
the European sovereign debt crisis. Standard & Poors downgraded Frances sovereign bond
rating in early 2012. Unlike Spain and Italy, however, interest rates on French bonds had not
substantially increased as of April 2012. If Frances economic situation were to deteriorate, the
EU and IMF would not be able to afford to bail it out.. French banks have loaned heavily to
Eurozone countries in crisis, including Italy and Spain. Therefore, if those countries were to
-
20
default, French banks would suffer considerable losses. The U.K. and Germany, in turn, hold
significant amounts of French debt. Thus, if France becomes the next domino to fall in this crisis,
they too may be vulnerable. Furthermore, France and Germany are providing much of the
funding to help other countries in crisis, so the continued availability of bailout funds for smaller
economies would come into question if France succumbs its own financial crisis.
Although Europes situation seemed to be improving in early 2012 as interest rates on
Spanish and Italian bonds fell following the injection of ECB loans into their banking sectors, by
late March of 2012 interest rates were on the rise. Escalating interest rates reflected investors
concern over whether the ECB and the EUs central banks would continue their financial support
of markets facing the effects of the crisis. Investors were also cautious over countries abilities to
meet deficit reduction targets, especially after Spains inability to do so.
Some experts believe that the Eurozones current focus on cutting as much spending as
possible will not solve the crisis. Austerity measures have brought on recessions in many
countries, meaning that those countries are losing revenue as they cut spending, thereby
preventing them from reducing their debts. Data for the countries most affected by the crisis
showed that unemployment was on the rise and manufacturing was on the decline in 2012.
Relatively healthy Eurozone countries, like Germany and France, have also had decreases in
manufacturing, although unemployment has not increased as of April 2012. Experts especially
criticize the European Commissions support of austerity programs to reduce deficits in countries
like the Netherlands and France that have lower interest rates. Instead, experts believe that such
countries should focus on boosting economic growth. In countries that import more than they
export, like France, Italy, Spain, and the United Kingdom, they suggest increasing investment
and exports to generate revenue. For countries that have surpluses in export revenue, like
-
21
Germany and the Netherlands, experts advocate increasing domestic consumption to stimulate
economic growth. Though experts disagree on methods, all agree that Europe must stop the crisis
from spreading to other countries as the consequences of failing to do so may be dire.