The Impact Of The European Sovereign Debt Crisis On Financial Markets

Background Information on the European Sovereign Debt Crisis

The European sovereign debt crisis was a major focus for international financial markets during 2010-2014. Economies fell into recession and financial market volatility was high. Critically analyse how the government debt problems initially faced by a few relatively small economies could trigger such a wide impact in financial markets. The essay must be completed in groups of 2 or 3 students. Your essay must be strongly focused on the impact on financial markets, not on other aspects of the European sovereign debt crisis. You could consider the impact of the crisis on any one or two of the following: equity markets, bond markets, money markets, derivatives markets and foreign exchange. Contagion is an important theme. The essay must include some theoretical content as well as practical considerations.

Here in this topic which summarizes the financial crisis and tell us how the financial crisis became economic crisis and also tells us about the sovereign crisis. Europe presently encounters an extreme monetary emergency. The crisis first started in the US. Us banks have granted loans with the variable interest rates to the poor households. The loans were then favoured through securitization which means banks did not need to keep their loans in the balance sheet as they were sold to others. After that authority in charge of the monetary policy decided to increase interest rates in the year 2005 & 2006 to reduce inflation. So it made difficult for the household to repay loans. Hence banks started facing problems. Banks were having huge losses as were not paid by the households. As we all know that if you owe your banker a thousand pounds you are at his mercy but if you owe your banker a million pounds, he is at your mercy. (Lane, 2012)

 So the many US bankers were at the mercy of their borrowers. Then there was also another problem where short term financing was a major issue as loan losses and securitization has raised doubt regarding repayment of the loans hence this facility was also not availed by them. There was high uncertainity as there were high losses. As there were no official registration for tracing the over the counter transactions hence banks were scared to lend money to others and this led to the fall in the liquidiy as there were no source from where the short term financing can be obtained. As we all know that many banks are dependent on the other banks for their short term financing so there was problem being faced by the banks and hence they ended uo by closing their banks due to this failure. As per the survey, there were total 465 banks which were closed in the year between 2008 and 2012 in the US. But in the European countries banks were nationalized and they received state support which prevented failure. After the financial crisis there emerged the economic crisis and this was mainly due to the reduction in the credit supply by banks. (Krugman, 2015)

Causes and Effects of the Crisis

As there were huge losses and there was difficulty in obtaining the short term refinancing so the banks were not willing to grant loans as a result of which both the investment and consumption got diminished. There was also rise in the pessimism. This was like the bad news which was spreaded in the mass media and it contributed in the weakness in the aggregate demand in the economy by reducing incentives for the households to consume and this was due to the fear of the greater unemployment. The firms were also scared to invest because of the threat of the lower demand of the production. This was due to the greater pessimism which led to the fall in the consumer confidence. The crisis was so strong that it resulted in the reduction in the investment and consumption in the European Countries and this led to the lower production and hence generated huge unemployment. Europe then faced the worst economic recession since the 30s.

Then the economic recession gets converted into current sovereign debt crisis as because if it was the unusual level then it would have been lasted for 1 to 2 years but this does not happen and it lasted for many more years which gave rise to sovereign debt crisis. The economic crisis which came in the year 2009 has provided to the European countries the incentives to increase their public debt to limit the detrimental effects of the crisis. There was also reduction in the tax and hence there was increase in the public expenses. This was done to support aggregate demand in line. Then there was also European countries which increased their public debt to supply money to large banks from failure . As European countries has high level of  debt before the financial crisis so this was the big trouble. (Lachman, 2012)

There was a rise of public debt which dramatically hampered the budgetary situation of the European Countries. There was a major problem where additional debt resulting from the financial crisis which led to the major difficulties for countries to finance their debt. The key issue is that a country is dependent on the financial markets to obtain new financing which are needed to finance new public debt and to repay old public debt through new borrowings. It is understood that if investors on finance markets become reluctant to lend money to a country which cannot otherwise finance its debt, then this country faces a sovereign default. All this led to the future predictions which is always a difficult task for economists. (Featherstone, 2011)

The European debt crisis is a multiyear debt crisis that has occurred in the several eurozone member states since the year 2009. Due to this crisis many states were unable to repay their government debt and refinance. This crisis erupted in the year 2009 when there was great recession. There was huge government structural deficits and debt levels were accelerating. The states were adversely affected and faced a strong rise of interest rates for government bonds. The main causes of debt crisis were that there were high structural debt, ageing population in many European countries. The recession caused sharped rise in the budget deficit. There was credit  crunch which caused losses for the commercial banks. Investors become more and more cautious and fearful in all types of debt.

Impact on Financial Markets

The southern European economies were uncompetitive as there were higher labour costs and they were unable to restore competitiveness which caused lower growth and lower tax revenues in these countries. There were no lender of last resort like in US and UK made the market nervous of holding Eurozone debt. There were no effective bailout for a country like Italy. Due to this crisis, it raised the fear of default in bonds yield which made the market more expensive due to which payment of interest on debt became expensive. This was the dramatic event which took place in the European Union. The crisis had significant adverse economic effect and labour market effects for the worst hit countries, with unemployment rates in Greece and Spain.The impact of such crisis led many Eurozone countries bearing excessive public debt. This crisis spreaded from Greece and then to the neighbouring countries as there was connection between Eurozone banking sector and the public sector debt. (Lane P. , 2012)

The crisis arised mainly because there are five countries like Greece, Portugal, Ireland, Italy, and Spain which failed to generate enough economic growth to pay their bondholders the guarantee they have given. These five countries were seen as the countries in immediate danger. The crisis has far reaching consequences which got spreaded in the whole world. This was the most serious crisis since 1930s. The global economy witnessed slow growth since the US financial crisis of 2008-2009.It exposed the unsustainable fiscal policies of the countries in Europe and around the globe. Greece failed to take the fiscal reform and was the first to feel the pinch of weaker growth. This made the budget unsustainable and hence tax revenues got reduced. It was so felt by the new prime minister to announce that previous government failed to reveal the size of the nation’s deficit. (Driscoll, 1998)

Later it came to the fact that Greece’s debt were so large that it exceeded the nation’s entire economy and the problem was so high that it was no longer hidden. This has effected the financial market as there was possibility of a contagion which made the European debt crisis affected the financial market. It made the people to behave in such a way that investors started selling out anything risky and buy the government bonds of the largest and of the most financially sound countries. European bank stocks and European markets as a whole performed much worse than their global counterparts during the times when crisis was on the center stage. The bonds market also performed very poor as rising yields means that prices are falling. The government  are so indebted and can no longer afford to pay of the debts. This was not the problem of Europe only. Cost of borrowing is so high because of the uncertainity to pay of the loans. The other problem is of banking system. Banks in the European countries like france and germany owns lots of bonds from struggling European countries such as  Spain and Ireland. Many banks have bad loans in their books of accounts as the result of the collapsing real state markets. (Estrella, 1998)

The European market is not at all booming infact it is in recession and the recession spreaded in the whole economy which resulted in the closure of the many companies and resulted in lot of unemployment. The office of the statistics of the European union has said that in the year 2012 in September the gross domestic product has contracted by 0.2% then in the first quarter. Europe recession is no coincidence. Lot of problems arised in the financial market and which led to the European sovereign debt crisis considered to be a long term debt crisis. Each and every bond market were analysed but there was negative impact on the national stock indices of Greece, Portugal, Spain, and Slovenia. There was a partial default of Greece which does not created negative spillover effects on bond and stock markets of the whole eurozone or the group of the southern economies but there was a positive spillover effects on the northern European countries. Popular exchange traded funds that track equities in these countries include the ishares, EWI, EIRL etc are the shares in which investment was made.

Due to the recession there was huge unemployment in the year 2007 which was 5-10% and in the year 2013 it has been raised to 25-30%. The GDP was reduced from 2% to -4%. When there was downturn in the economy the job of the government bond analyst got tough as there was eurozone crisis. They need to explain concerns over public finances, deterioration of the fundamentals, financial sector credit risk and European institutional coordination failures. The financial market was such affected that in spain public debt amounted to less than 60% of GDP even by the end of 2009. The Italian fiscal surplus implied that if interest rates had stayed low, only the modest fiscal adjustment would have been necessary to serve the debt. This crisis led to the development of unemployment and trade deficits. Weakness in the banking sector also appeared only gradually after the property bubbles bursted. There was lot of deficit in Italy in the GDP that is 4.6% and 4.3% in Germany and little less in UK and France. There showed multiplex two layered networks which was more fragile and were especially critical in financial networks. The effect was such on the foreign  exchange market that euro depreciated against US Dollar. External value of Euro changes. Rising default of risk of medium and large eurozone banks lead to depreciation of the eurozone. Sovereign Bond market is considered to be risk free and government rarely fail to default on coupan payments but here government are expected to raise taxes and create money supply.

There was also effect on the gold market also as the crisis began, gold spot prices have been continuously increasing. Gold prices followed the upward trend since 2008 till date. Gold prices almost increased by 300%. There was also decrease in the market confidence on euro. The bonds are basically represent country economic health to a large degree as because bonds are specifically government debts. Sovereign defaults is basically an event where a country is unable to repay its debts incurred from banks and investors. This led to the country to enter into financial distress which led to restructuring of debt. European crisis has caused severe turbulence not only in the peripheral countries but also the core ones. 

References

Driscoll, J. (1998). Review of Ecnomics and statistics. MIT Press , 1-1.

Estrella, A. (1998). Review of Economics and statistics. MIT press , 1-1.

Featherstone, K. (2011). A european debt agency. Journal of common market studies , 1-1.

Krugman, P. (2015). European debt crisis. New york times , 1-1.

Lachman, D. (2012). Lessons from Europe’s Debt crisis for the United States. Cato Journal , 233-243.

Lane, P. R. (2012). The European Sovereign Debt Crisis. Journal of Economic perspectives , Pages 49-68.

Lane, P. (2012). The European sovereign debt crisis. The Journal of economic perspectives , 1-1.