the crisis of the sovereign debt in the eurozone

7/30/2019 The Crisis of the Sovereign Debt in the Eurozone

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THECRISISOFTHESOVEREIGNDEBT

INTHEEUROZONE

ABSTRACT

The sovereign debt crisis that affected the European Union in the 2009, is

explained here through the identificationof three risk issues. These factorshave led the EuropeanUniontoface the greatestcrisisin its history,which

coulddestroyit,onlynineyearsafteritsestablishment.

Inthefirstsectionissummarized:thehistoricalcontextandmilestonesandthemainfactorsthathaveledtotheemergenceoftheserisks.

Thenthethreeriskissuesareexposed(aggregate,specificandcontagion)and

isexplainedhowthesearecombinedtogiverisetochangesinthespread.Themainideaisthatoneofthesefactorsalonecouldnotleadtoacrisisofthis

magnitude.Butthefuturescenariothatwasproposed,withtheconjunctionofthesethreeriskissues,couldbringEuropebackinthehistory,withenormous

consequencesforthewholeworld.

The theoretical treatment of these risk factors is explained through someexample,quotingseveralcountryinvolvedinthecrisis.

HowthecrisiswashandledandacomparisonwiththetheoreticaltreatmentofNormanAgustine,drawtoaclosethecasestudy.

Intheconclusionisadvancedananalysisofpossiblepastscenariosthatcould

haveavoidedthecrisis.Fromthisisderivedthelessonforthefuturessothat

othercrisesareaverted.Morespecificallyisclearhowinordertosurvive,theEuropeanUnionhavetochangeandevolve.Untilnowhasbeenaninterestingpolitical experimentbut if itdoesntwant togodown inhistory asa failed

experiment,themembersmustfindagreatercohesionineconomictermsfirst,

andinthepoliticalandculturaltopicsinthelongterm.Itisadifficultchallengeand its difficult to predict the outcome, surely this crisis has made the

membersbetterabletoworktogether,butitwillbedifficultforthecitizensof

thecountry,withasocomplexhistory,abandontheirtraditions,languagesandcultures,forthatwhichnow,isonlyabureaucraticsuperstructure,withfew

benefits.


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INTRODUCTIONANDAIM

TheaimofthereportistoassesstheriskfactorstheEuropeanUnionhadtodealwithduringthesovereigndebtcrisisthateruptedin2009,howitmanagedsuch

risks,andtheresultsoftheseactions.

Whilethedebtcrisisof2009wasanallencompassingproblemfortheEuropeanUnion,itisimportanttonotethateachcountryhasadistinctbackgroundand

thereforehastheiritsproblemstodealwith,individually.Obviouslytheissueislarger than for each separate country, but it is necessary to use each as an

exampletodealwiththelargerproblemfacingtheEUasoneentity.Therefore,

even if a complete report of the situation should analyse the issues of eachcountry,thisreportwillmainlyfocusontheriskfactorspertainingtotheEUasa

whole.

TherearethreemajorriskissuestheEUanditsmembershavehadtodealwith

toavoidthecollapseoftheirsystem.Theseriskissuescombinedhaveledovertimeinvestorstohavelessandless

confidenceinthePIIGSandintheEuropeanUnioningeneral.Thelackof

confidencewasexpressedinadecreaseinthedemandforgovernmentbondsandanincreaseinyield,triggeringaviciouscyclethathasprecipitatedEurope

intoadownwardspiral.

1. Theaggregaterisk:Thecrisisaroseoutofalackoffaithinthecurrenteconomic system, alongwith the aversionof themarkets to take risks

afterthefinancialcrisisof2007.Therewasalsothefearthatthesystem

and the bankswouldnot be able to deal with another crisis, and thattheremighthavebeenmorehiddenproblems.Allofthesefactors,with

the addition of a deep pessimism, led to demanding markets withhystericalbehaviour,highlightingthedifficultiesspecifictoeachcountry

insouthernEurope.

2. Specificrisk:particularlytheriskof default,was the coreofthematter,which increased the spread; meaning the likelihood of the probability

thatsomemembersintheeurozonewillfail.

3. Riskofcontagion:concernsthewholeoftheEuropeanUnionasaresultofthespillovereffectfromtheinitialproblemsinGreece.Thus,themarketsof Southern Europe lose confidence, compounding the already difficult

financialsituationofthePIIGS(PortugalIrelandItalyGreeceandSpain).


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CASESTUDY

ToanalysetheongoingEuropeaneconomiccrisiswefirstneedtoquicklyrecalltherecenthistoryoftheEuropeanUnionandtosummarizetheconsequencesof

thefinancialcrisisof2007intheUnitedStatesand,subsequently,intheworld

asawhole.

RECENTEUROPEANHISTORY

In1992,theMaastrichtTreatydefinedthelimitsofdeficitspendingandthedebt

capforthefuture.In2000theEuropeanUnionbecameamonetaryunion.Withtheintroductionof

theEuro,eachcountrylosttheopportunitytodevaluethecurrencyandtheonly

lender of last resort became the ECB (European Central Bank). However, theECBdoesnothavethejurisdictiontobuysovereigndebt.

Intheearly2000s,Germanywas the firstbigcountrytoexceedthedebt limitestablishedintheMaastrichttreaty.France,GreeceandItalywerenexttofollow

suit.

ThedebtincreasedinItalyandGreeceduetoeffortstosustainwelfareservice.MeanwhilethegrowthoftheGDP(GrossDomesticProduct)wasnotfollowing

thesametrend.

InGreece, for example, the public sector wages rose 50% between 1999 and2007.

Toaccumulatemorevotes,politiciansfinancedpublicspendingbyusingdebttokeep taxes from rising. In addition, the income was hit by widespread tax

evasion.

CONSEQUENCESOFTHEFINANCIALCRISIS

After the bursting of the bubble of

the subprime mortgage the banksstalled lending, and the financial

systemhadtofacealiquiditycrisis.Globally, governments and the

central banks started to save the

banks and the financial institutions

toavoidthecollapseofthefinancialsystem.Thegovernmentsstartedto

make loans in efforts to raise thefunds to save the system and as a

result there was a massive rise inglobaldebt.

Figure:SelectedEUDebt2007-2010At first themarkets had assumed that the Eurozone debt was safe, as it was

supportedbyallthemembers.Forthisreason,countrieswithahighdebtsuchasItalyandGreecewerethoughttobesecure.


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However,afterthecreditcrunch,peoplestartedtobecomemorescepticaland

riskaverse,especiallyinEuropewhereitwasunclearwhetherthecentralbankwould be able to support itsmember states. For example, UK debt has risen

faster thanmanyEurozone economies,yet therehasbeennorise inUKbondyields.OnereasonsinvestorsarecurrentlywillingtoholdUKbondsisthatthey

knowtheBankofEnglandwillinterveneandbuybondsifnecessary.ThecrisisstartedonOctober2009whenthenewPrimeMinisterofGreece,MrG. Papandreou, declared that the old government had lied about the public

finances.Therealdeficitwas13%insteadof6%andthedebitwasreassessedat

127%oftheGDP.Withthisdebtlevelandtherisinginterestrates,Greecewasnolongerableto

repayitsloansandwasforcedtoaskforaidfromtheEuropeanUnion.

RISKMANAGEMENTISSUE

Thespreadbetweentheyieldofnationalbondandtheriskfree(inthiscasethe10yearsGermanBUND)wasthemainindicatortomonitorthedevelopmentof

thecrisis.

Figure:Sovereignspreads(10yBonds)

Beforeanalysingtheriskissuesthatcausedthecrisisweneedtoanalysehowthesovereignyieldspreadcanvary.

Therearetwoconditionsbywhichthemarketsfixthespread:inthefirstone,

the normalcondition, the spread reacts onlybythe relativeprobabilityofacountrysdefault.

Inthe second one, the crisis regime,muchhigher spreadscan bedemanded

afterarelativelysmalldeteriorationinfundamentals.The regime switch may be related to the markets shifting perceptions of a

countrysfiscalsustainability,ortotheattitudetowardsrisk.


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Lets now examine the risk issue that led investors to demand a more high

remunerationonthesovereignbondofthesouthEurope:

1. AggregateRisk2. CountrySpecificRisk3. ContagionRisk

Figure:DeterminantsofGovernmentBondYields

1. AGGREGATERISK

Aggregateriskisalsoknownassystematicriskbecauseitaffectsthemarketandbecausetherisktakerhasnocontrol.Itisdrivenbychangesinmonetarypolicy,

globaluncertaintyandriskaversion.Theothersourcesofthiskindofriskaretheunwindingofthefinancialimbalancesandtheoccurrenceofmacroshocks.

After the breakdown of Lehman Brothers, also countries with solid fiscal

financialslikeAustria,Finland,andtheNetherlandssawtheirspreadrising.Thecausewasnotthemarketpricingre-assessmentofthegovernmentcreditrisk.

Infact,theratingdidnotchangeatall.

ThewidespreadaversiontowardriskmovedtheinvestortothesaferbondintheEuropeanregion,theGermanBUND,decreasingthedemandforthedebtof

theothercountry(eveniftheyweretriple-A)andasaconsequenceincreasingthespread.

2. SPECIFICRISK

Thecountryspecificriskhastwocomponents:thedefaultriskandtheforeign

exchangerisk.The firstone relates tovariations indefaultprobabilitiesand totheability to

raisefunds.TheriskofdefaulttendstoincreasewiththeratioofpublicdebttoGDP.

In2009forallthePIIGScountrythespreadhadbeguntogrow,reflectingthe

expectations ofdefault themarkets had onthe countries ofsouthernEurope.Public and private high debt were indeed quite large, and a self-fulfilling

prophecywherethefearthathigheryieldswouldmakethecountryinsolvent,hasincreasedtheyield.

InthecaseofGreece,whosegovernmenthadbeenburiedindebtdata,thehighvalueofthedebtmarketsledtothenotionthatadefaultwaspossible.


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However,thisisnotenoughtoexplainwhythespreadoccurredandbecameso

high,suchasinItaly.BeforetheintroductionoftheEurothespreadbetweenBUNDandBTPreached

itspeak,higher than any value in this crisis.However, in thatperiod nobodyworried about the possibilities of the default of Italy because the spread

incorporated not only the risk of default, but also the foreign exchange risk.Nowadays, the component ofthe spread, related tothe foreignexchangerisk,indicatedthepossibilityofthecollapseof theEuroandareturntothenational

currency.

Figure:ThespreadbetweenItalyandGerman

ThisexplainswhytheEuropeanCentralBankstartedtobuynationalbondsevenifthestatutewouldnotallowit.ThemarketworriednotonlyforthedefaultofthecountrybutalsoforthestabilityoftheEuro.

Thecountrywithdifficultyhadtoimprovefinancialpolicytorebalancethedebt

GDPratio,butis theresponsibilityoftheCentralBanktoensurethesoundnessofthecurrency.

3. RISKOFCONTAGION

Contagion is the scenario in which financial instability spreads to othereconomiesthatwereotherwisehealthy.

Thedevelopment inGreecewasoneofthereasonswhyMoodysinJuly2011downgraded Portugal. If Greece were to fail, it would be more likely othercountrieswouldalsobeinneedofaid.

InthesamemonthItalianandSpanishbondyieldshadincreasedbymorethan100and80basispointsrespectively.Thiswasbecausethedowngradeandthe

fearofaGreekdefaultpromptedasellingofSpanishandItalianbonds.

The investors want to reduce their exposure while they still have positivebalances,anddontwanttobeexposedtovolatilityorlargelosseslater.

Thecontagionstartsaviciouscircle:alowerdemandofbondincreasestheyieldand,forthecountrywithweakeconomicfundamentalsandwithahighdebtto

GDPratio,itbecomesunsustainabletorepaythedebt.Thisincreasestheriskof

defaultandyieldandsoon.Ifthesystemicriskhasanidiosyncraticorigin,contagiousoccursmorelikely.


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HOWTHEISSUESWEREDEALT

Two are the main protagonists involved in solving the crisis: the European

CentralBank,oneofthemostimportantcomponentsoftheEuropeanUnion,and

thesinglegovernmentsintheweakcountries.TheECBhadtoencouragefaithinthe European Union and had to insure its ability to act as a central bank,

becomingalenderoflastresort.Meanwhile the weak countries needed to re-establish the financial situation

decreasingtheDebttoGDPratiotoreducethedefaultrisk.

Firstofall, theECB started toreducethe interestrateand loanmoneytothe

financial system with an unlimited provision of liquidity through fixed rate

tenderswithfullallotment.Thismeasurehasensuredthatthesystemwouldnotcollapse.Then,inMay2011andinOctober2011,withthehelpoftheIMF

(InternationalMonetary Fund), it approved two tranches of bailout loans toGreece.

InFebruary 2011,the Eurozonefinanceministers set upapermanentbailout

fund,theEuropeanStabilityMechanism,worthabout550bneuros.BecauseofcontagionresultingfromthesituationinGreece,theECBstabilized

theexpectationoftheeuro,buyingItalianandSpanishgovernmentbondstotrytoreducetheirborrowingcosts.

Furthermore,thegovernoroftheECBdeclaredthatthecentralbankwouldhave

lentmoneyaslongasitwasindispensable:thiskindofdeclarationwasveryimportant for the faithin themarketsbecauseitensuredthe investorthatno

bankorcountrywouldbeabandonedforfailure.

AlltheECBactionsrequiredthatthesinglecountryshouldembarkonamajor

austeritydriveinvolvingdrasticspendingcuts,taxrises,andlabourmarketandpensionreforms.

Greece, Italy and Spain, approved these reforms even though there was a

consequenceoffallingintoanAusterityTrap,whereitwouldalmostdefinitelydeepen the recession. Meaning even higher unemployment rates and lower

wagesthatwouldjustmakeprivatedebtsallthemoredifficulttorepay.People

would therefore be more likely to cut their spending, making the economicrecoveryevenslower.

But otherwise if the countries dont cut

spending they risk a financial collapse,

where themarketwould lose confidencein them and the other European

governments may not have enoughmoneytobailthemout.

Figure:Austeritytrap


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EFFECTIVENESSWITHWHICHTHECRISISWASMANAGED

LetsknowcomparehowtheEuropeanUnionhadmanagedthecrisisinrelationwiththetheoreticalviewofNormanAgustine(ManagingtheCrisisYouTriedto

Prevent)inwitchsixstagesofcrisismanagementwerespecified.

a. AvoidingthecrisisTheEUcouldntavoidtheglobalfinancialcrisiswhowasbornintheUSA;theonlythingsthatitcoulddowastohaveaclosercontrol on the balance sheets of the member states, to avoid

inappropriate behaviour that would lead to lack of confidence in the

marketsalreadywary.b. Preparingtomanagethecrisis Whenthecrisisexplodedtherewasnoplan to manage it, a consequence of so many events, not all directly

controllable from the European Union, was unexpected. Besides, theEuropeanUnionwasnot readytomanage it, therewasno fiscalunion

and,aswesaidbefore,notenoughcontrolonthebalancesheetsofthecountries. Furthermore, the European Institutions had not enough

power: as young supranational Institutions, in which the member

countries still have personal interest in the management of theinstitution, and of the crisis inparticular, itwas really difficult totake

sharepolicy.c. RecognisingthecrisisAssoonastheGreekgovernmentdeclaredthebiglie, the European Union understood that this could have big

consequencesforthewholecontinent.d. Containingthecrisis IttooklongtimetodecidetosaveGreeceandtobuy sovereign bond. Sooner this kind of action is take better is the

reactionofthemarket,waitingtoomuchtimemakeitdifficultandmoreexpensivetohandlethecrisislater.

e. Resolving the crisis The crisis is not solved and just fewweeks agoanothercountry(Cyprus)becameinvolvedinthecrisis.Wecansaythat

the actions taken were able to save the European Union, but many

actionshavetobeundertakentoreturninastablesituation.f. ProfitingfromthecrisisAfterthemonetaryunionnothingwasdonetoimprove the political or fiscal union in Europe; this crisis united the

countriesandthiscouldbethefirststepforaEuropeanFederation.


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CONCLUSIONS

SCENARIOANALYSIS:HOWTHECRISISCOULDHAVEBEENAVOIDED

In this section some lessons will be extracted for the future by analysingdifferentscenariosthatcouldhaveavoidedthecrisis.

Evenifitisdifficulttodeterminewhetherthecrisiscouldhavebeenavoidedornot,whatisclearisthatafter1999theinterestratesonthedebtofalleuro-zone

countries have aligned themselves downwards. This happened after a long

periodofausterityrequiredto complywith theparameters inputinthe euro.Thesetwofactorsledcountries,banksandprivateindividualstobeencouraged

togetintodebt.Lessexcessiveuseofdebt,albeitatlowcost,andthereforeabalance with equity (GDP) would make the countries now weaker and less

attackedbythisseriesofunfortunateevents.

Clearly the solution here is that countriesmust have a thriving economy, in

whichwelfarepoliciesarefinancedbytaxes.Especially in countries like Greece and Italy, that would mean a complete

innovation of the national economy, restructuring the labour market, and apromotioninternationalcompetitiveness.

These measures, if they had been enacted over the years, would have beenpainlessandproductive.Now thecountriesofsouthernEuropecannotrefrain

fromengaginginthiswayinashorttime,leadingtosufferingandimpoverished

citizens.

Aspreviouslystated,theinitialshockduetotheliesofGreececouldhavebeenavoidedonlyiftherehadbeenstrictcentralizedcontrol.However,before2009

theEuropeanUnionwasstillmuchtooyoungandthereforelackedthepolitical

unitythatwouldallowsuchcentralizedcontrol.

TopreventthecrisisoftheinsolvencyofGreecethatwasexpandingthroughout

Europe,theallocationoffundswouldhavetobefaster.DerailingGreecewouldhavebeenanalternativethatwouldnothavepreventedtheinfection.Mostof

the Greek debt is currently held in European banks (especially German andFrench ones). A possible default of Greece would bring great losses and the

attendantrisksoffailureinthemajorfinancialinstitutionsofEurope,dragging

thewholesystemtocollapse.

PREVENTFUTURECRISIS

To prevent future crisis, it is important that the EU and its members closelymonitorallthreeissuescharacterizedinthiscrisis.

The aggregate risk is themost difficult to control; it can lead to devastating

consequencesand,inaworldsoglobalized,itcanoriginatefromanywhere.Theimportantthingisthatcountries'policiesaretransparentandtheireconomies

areinorder,especiallythecountrybalancesheet.Forthestabilityofthesystemthebanksshouldstopspeculatingwithfinancialinnovation,andgobacktopure

credit, with the right amount of risk aversion that characterizes this sector.

Moreover,iftheinstitutions(banksandgovernments)areeconomicallystrongandclean,itwillbemoredifficultforacrisistobringthecountrytocollapse.


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It isessential toensure that institutionshavestrong credibilitysoas toavoid

riskaversioninthemarket.TheECB,especially,needstoreassurethemarketthatitwontletanycountryfail.

For those concerning the Default risk, it would be sufficient that countries

adheretotheEUdirectives.TightercontrolwillbenecessarytopreventindividualcountriesfromabusingoftheeconomiccoverageoftheEuropeanUnion.

Moreover,theEuropeanInstitutionsmuststronglydeclaretothemarketsthat

theywilldoeverythingnecessarytosavetheuniquecurrency;inthiscrisistoomany internal struggles have made the expectations uncertain about the

stabilityoftheeuro.

Theriskofcontagionrequiresquicklyrealizingandexecutingasolutiontostem

thecrisis.TheactionstakenbytheEUwerefartooslow,causingthemarketsto

worry and obsess over other countries with weak economic situations. Thiswould not only be more economical to save Greece, but it would have also

preventedlosingthemoneyrequiredtobuyItalianandSpanishbonds.If the EuropeUnionwants tosurvive through future crises, a strongerunion,

bothpoliticallyandfiscally,isimperative.ThisisobviouslyahardtaskbecauseoftheuniquenessoftheEU,havingsomanycountrieswithculturalandlingual

differences, followingnomodel orblueprint fromthepast.IftheEUwantsto

last a long time, themember states have tostartcooperating toalleviate thecompetitivebehaviourbetweenindividualmembers.


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