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The European Sovereign Debt Crisis

Introduction

The financial crisis in the US affected most European countries due to their reliance on US banks as their source of debt finance (Brooks, Faff, & Wu 2011). Between 2008 and 2009, the European Central Bank did not pay much focus on sovereign debt despite the global financial crisis. The involved parties focused more on measures to deal with the global financial shock (European Central Bank 2012). Among the measures implemented by the European Central Bank included reducing the short-term interest rates, entering into currency swap agreements, and providing European banks with euro-denominated liquidity (Lane 2012). These measures are aimed at providing European banks with an opportunity to access dollar-denominated liquidity (Kaminsky & Reinhart 2000, p. 35). In 2008, foreign liquidity flows dried up due to investors becoming more risk aversive. Countries that heavily relied on foreign short-term debt markets such as Ireland were the most adversely affected (Paravisini 2008, p. 2161). The sovereign debt crisis entered a more acute phase in 2009. Most small European countries such as Spain and Ireland reported a significant increment in their deficit to Gross Domestic Product ratios (Lane 2012). Investors within the banking sector prospected an increment in losses arising from bad loans. Consequently, there was an increment in the degree of perceived risk amongst investors.

The aim of this paper is to illustrate how the government debt problems, initially faced by a few relatively small economies, could trigger such a wide impact in financial markets. To illustrate how the effects of the debt crisis spread to other countries, the paper illustrates the concept of financial contagion and its impacts. Some of the financial markets analysed include the sovereign bond market, money market, equity market, foreign exchange market, and derivatives market.

Contagion theme

According to Constancio (2012), financial contagion describes a phenomenon whereby market instability within a particular economy is spread to one or more regions or markets. Contagion is an indispensable element in economic policy formulation. Despite its importance, contagion presents a significant challenge to financial markets. Many countries have experienced a decline in their competitiveness due to high debt levels and fiscal deficits. Kaminsky and Reinhart (2000) assert that contagion intensifies the degree of financial instability. The occurrence of extreme macroeconomic shocks in addition to contagion underscores some of the factors associated with the 2010-2012 sovereign debt crises in the eurozone. On 5th July 2011, Moody’s, which is a renowned credit rating agency, downgraded Portugal after recognising that Portugal’s creditworthiness would be adversely affected by increased defaults in Greece (European Central Bank 2012). Downgrading a country’s credit rating adversely affects current and potential investors. Additionally, downgrading leads to price falls thus diminishing the value of various investment vehicles, for example, bonds. Consequently, in such a scenario investors cannot achieve their wealth maximisation objectives. Due to their risk-averse characteristics, most investors considered withdrawing their investments from Portugal due to the high degree of volatility (European Central Bank 2012).

Impact on equity market

The recent developments in the Eurozone have shown that equity markets in the region are characterised by a relatively low level of heterogeneity across countries compared to bond markets. Cross-country equity holdings depicted minimal discrimination despite the country of origin. Despite the fact that the debt crisis adversely affected equity markets, there was minimal divergence with regard to factors that drive change within the market (Ricks 2011). The occurrence of the sovereign debt crisis has shown that equity markets in Europe are increasingly becoming susceptible to external shocks. Additionally, the crisis has shown that the shocks emanating from the Euro region are higher when compared to external shocks from the United States (Rengasamy 2012, p.37). Findings of a recent study conducted on equity markets showed that stock price indices are responding to both firm-specific and cross-border shocks.

Over the past decade, countries within the Eurozone have experienced significant growth in the volume of cross-border equity holdings. Despite the occurrence of the sovereign debt crisis, equity holdings by the Euro area residents have increased significantly while the proportion of equity holdings by non-euro residents has declined. There has also been a significant reduction in the volume of investment funds (Kacperzyk & Schnabl, 2012). This scenario arises from the panic disposal of shares in countries such as Spain and Italy. European banks have experienced a significant underperformance in their share prices (Radin 2011). Additionally, most European banks were downgraded. The graph below illustrates the performance of share prices within the eurozone.

Share Price Indices
Source: (Reserve Bank of Australia 2012).

The risk-averse characteristic of investors in Europe has made investors consider the negative effects of the crisis with keen interest. Due to the sovereign debt crisis, investors in the eurozone are reviewing their investment portfolios. Most investors in the region are integrating international assets as their investment vehicle (European Central Bank 2012).

Contagion within the sovereign bond market

Contagion refers to the process whereby a crisis in one part of the world increases the probability of another region or country experiencing a similar crisis. Currently, the high rate of globalisation is exposing different economies to contagion effects (Rajan 2006, p.130). The sovereign debt crisis led to an increment in the degree of volatility within the sovereign bond markets in Europe. In 2010, only three small countries in Europe were adversely affected by the sovereign debt crisis (Lapavitsas 2010). However, bond yields from larger countries were affected in 2011 due to the contagion effect. During the last half of 2011, most investors experienced a decline in their sovereign yields.

The financial crisis has negatively affected the rating of most European c ountries’ long-term sovereign debt (Becker & Ivashina 2012). Some of the countries whose rating has been downgraded include Belgium, Italy, Germany, Austria, Portugal, Greece, France, Spain, Finland, Ireland, and the Netherlands (European Central Bank 2012). From 2000 to 2011, Belgium had maintained a sovereign debt rating of AA. However, in 2012, the country’s sovereign debt rating has been downgraded to AA-. On the other hand, Greece had a rating of A- in 2009. However, its sovereign debt rating has been downgraded to CCC- in 2012. This shows that the country is currently not an attractive investment destination (European Central Bank 2012). Additionally, the sovereign bond market has also experienced a significant decline in the level of market liquidity. The decline in liquidity has arisen from the fact that the money market in Europe has increasingly become fragmented in recent years. The degree of fragmentation is relatively high across countries. On the other hand, the degree of risk aversion in the market has increased notably (Radin 2011).

Increases in government debts in countries such as Germany have also led to an increment in bond yield spread. This had a negative impact on the value of the countries’ sovereign bonds. Countries such as Greece continued to experience budget deficits leading to escalation of sovereign debt spreads (Lynn 2011). Prior to the occurrence of the financial crisis, the annual spread with regard to yields of a 10-year sovereign bond between Germany and other European countries [Spain, Italy, Greece, Portugal and Ireland] was near zero (Mink & Haan 2012). However, the sovereign bond markets in Europe have become strained and dysfunctional. This assertion stands out conspicuously in the light of the prevailing degree of cross-country correlation with regard to credit default swaps (Kolb 2011). The debt crisis has also increased pressure within the corporate bond market. One of the most notable impacts on corporate bonds relates to an increment in the risk premium.

Money markets

Money market funds in the United States are a crucial source of credit finance for European countries. Roughly, the EU banks borrow more than $650 billion from the United States’ money markets (Chernenko & Sunderam 2012). Chernenko and Sunderam (2012) further assert that money markets in Europe were adversely affected by the recent government sovereign debt crisis. In 2011, most European countries experienced a decline in the volume of funds. The decline arose from investors perceiving high risks in their investment process. This scenario has further increased the money market funds’ vulnerability (Lane 2012). The degree of vulnerability in the European money markets was enhanced by increased redemptions undertaken by investors. Currently, investors consider investing in European money markets such as banks as a dangerous and imprudent financial decision (Chernenko & Sunderam 2012).

Since its inception, the Euro Zone has undergone significant growth with regard to money markets. However, the intensity of the sovereign crisis has made money markets in European countries become impaired. For example, some money market segments in Europe such as the repo market have experienced intense price differentiation.

The debt crisis struck most European countries by forcing them to implement measures aimed at stimulating operations within the money market segment. In an effort to increase liquidity with the European money markets, the European Central Bank implemented a number of measures. One of the measures entailed the implementation of 12-month and 36-month tenders in 2011 and 2012 respectively. The European Central Bank also undertook a number of open-market operations, which culminated in the growth of liquidity within the sector (Lane 2012).

Derivatives market

In addition to bonds and shares, derivatives form another category of investment vehicle that investors consider in developing their investment portfolio. In an effort to promote accessibility of finance, economies within the eurozone formulated a framework that aimed at establishing a common market for derivatives (Nic & Usher 2012). Despite being an effective investment portfolio, the contagion effect has exposed derivatives within the eurozone to external shock due to contagion. Consequently, derivatives have become exposed to systematic risk and thus most investors in the eurozone have experienced a significant decline in the value of their investment (European Central Bank 2012). The decline in the rate at which investors are considering derivatives as an alternative investment vehicle has adversely affected the availability of capital for most economies in the Eurozone.

Foreign exchange market

Foreign exchange is a term used to describe the rate at which a particular currency is exchanged for another (Kolb 2011). The debt crisis had negative impacts on European foreign exchange markets. In an effort to deal with the crisis, most European countries were forced to undertake currency swaps. This exercise led to a depreciation in the value of the euro compared to other key currencies. One of the factors that led to a depreciation in the value of the euro is that most investors speculated that Greece would default on its debt payment (Kolb 2011). For example, from 2011, the euro’s exchange rate against the Japanese Yen has declined with a margin ranging between 10 percent and 20 percent (Reserve Bank of Australia 2012).

With regard to other Scandinavian countries’ currencies and the pound, the euro declined with a margin of 4 percent to 8 percent. Other currencies that the euro has significantly depreciated against including the Swiss Franc. From September 2012, the Swiss Franc has appreciated significantly due to the imposition of a ceiling by the Sweden government against the US dollar. The US dollar has also undergone significant appreciation against the euro (Reserve Bank of Australia 2012).

The depreciation of the euro against the leading currencies has led to a reduction in its attractiveness as an investment vehicle compared to other leading currencies. In 2011, the Euro experienced the highest rate of depreciation (Chernenko & Sunderam 2012).

In addition to the euro, the value of other currencies in Europe has also been adversely affected by the debt crisis. Other European currencies have been affected due to the spill over effect (Claeys & Vasicek 2012, p.223). The graph below illustrates the performance of the euro against other key currencies over the past few years. From the graph, it is evident that the Euro has experienced a high rate of depreciation against currencies such as the Yen and the UK pound.

Euro Against Selected Currencies
Source: (Reserve Bank of Australia 2012).

Conclusion

A comprehensive analysis of the government sovereign debt crisis in Europe has revealed the degree of contagion that prevails within the financial markets. The sovereign debt crisis mostly affected small economies in Europe such as Greece, Spain, the Netherlands, and Portugal. The crisis emanated from overdependence on foreign money markets funds as the source of credit finance. However, the effects of the crisis spilled over to other larger economies. From 2010 to 2012, the severity of the financial crisis that originated from the United States increased and deteriorated to the sovereign debt crisis in Europe. This aspect had adverse effects on most European countries. The crisis’ impacts were most evident within financial markets. Some of the markets that adversely experienced the crisis include the equity market, the bond market, the money market, the derivatives market, and the foreign exchange market. Equity markets have increasingly become susceptible to external shocks due to the crisis. Over the past few years, the eurozone has experienced significant growth in the volume of cross-border equity holdings. However, the crisis led to a decline in cross-border investment as investors reduced their equity holding. The crisis has also led to an increment in the degree of volatility within the bond market. In addition, the decline in the volume of investment has led to a reduction in money market funds. Consequently, most countries within the Eurozone have experienced a decline in their liquidity level. Foreign exchange markets have also been adversely affected as illustrated by increased depreciation of the euro against leading currencies.

Reference List

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