What was the European Sovereign Debt Crisis?
In order to be able to fully analyze the causes of European Sovereign Debt Crisis its important to understand what the Crisis is. The genesis of the European sovereign debt crisis began in Greece where a higher risk premium was assigned to the Eurozone region. By late 2009 the PIIGS countries (Greece, Spain, Ireland, Portugal and Cyprus) has admitted that their debt was at a level where they couldn’t repay or refinance their debt. In 2010 the International Monetary Fund and leaders of the Eurozone agreed to provide a €750 billion rescue package to save these countries from bankruptcy, the amount was also later revised to €1 trillion. Leading from this intra-eurozone capital flows then fell sharply, resulting from a strong tightening of financial conditions due to the crisis. During this crisis many of these countries had their sovereign debt lowered to junk status by international credit agencies, which further worsened the situation.
Greece’s level of debt being at almost two times the level which is mandated by the EU. With debt levels supposed to be capped at 60% Greece’s level was at 113%. Greece and the other PIIGS’s countries debt were at a level where they required assistance from a third-party such as the (ECB) European Central Bank. In a report it was established that the towards the end of 2009 after a Greek change of government resulting with new government providing a false budget deficit. Which was against EU policy set in the Maastricht treaty. At the beginning of 2010 Greece has plans to lower its budget’s deficit to 3% however later in the year Greece let the EU know that their debt was at such a level that they may default. This was a result of irresponsible fiscal policies, and other factors.
Source: Macrobond, IMF
The EU accepted to provide an emergency bailout package in return for Greece implementing austerity measures to deal with its level of debt which was so out of control. The EU made the decision to stand behind its member and help Greece with a bailout package, as not bailing out would have serious costs to the EU as a whole. The resulting austerity measures required Greece to cut expenditure reducing the costs of government public servants. Also dealing with a large problem in Greece which is tax evasion. Resulting from this an independent tax collector was initiated to help reduce tax evasion. “In May 2010 a €110 billion provided by euro area Member States and the International Monetary Fund (IMF).” (Powerpoint) These measures also required Greece to sell off a large proportion of its state-owned assists, which was aimed to reduce the power of unions and parties. One of the main reasons for Greece’s demise was that the administrative efficiency within Greece was extremely low. Greece is regarded as a “poor student” in the euro zone economy, having a relatively weak economic base with most of the population having low living standards. Combined with a the very reliance on tourism and manufacturing which was greatly impacted by the Great recession, Greece’s economy was not in good shape going into the crisis.
For the second PIIG’S country Ireland. Irelands economy in 2007 had become highly dependent on construction and housing which they used as the primary source of economic growth. This was funded by the external borrowing of Irish Banks as worldwide lending rates at the time where relatively low. However late 2007 the Irish property bubble started to burst which lead to a decline in property prices across Ireland, and lead to a stagnation in property development across the country. This then had a flow through effect causing large losses in property development and a country wide collapse in construction activity. This causes huge stain on the countries Irish banking system, and a huge pull back from domestic property investor. These banks were deemed too big to fail, however in 2008 the first of the large banks filed for chapter 11 bankruptcy protection. This led to a provision which the Irish government put into place to protect the rest of the remaining national banks. Providing sustained liquidity so that more bankruptcies wouldn’t occur. Matters continues to worsen and in 2010 the Irish government requested aid from the EU to avoid defaulting on its debt.
Spain was a similar case to Ireland, with a heavy reliance in the property and construction industry. The property industry increased almost exponentially to the point where property became the citizens preferred destination for savings. With the Spanish government weighted tax benefits in favor of property which further increased its investment popularity. Property values continued to increase, with people expected values to continue to rise, without slowing down. Similarly, in the case of Ireland. One of the key benefits for Spain joining the European Union, was the reduction of interest rates. This greatly increased to availability and access to low interest rate loan. Which led to a large-scale channeling of capital into the real estate sector. Leading from this the construction sector became a large part of the countries GDP. With it accounting for 13.3% of the country’s total employment. This boom didn’t last however spurring from the US financial crisis, in 2008 the property bubble began to burst. Firstly, saving banks began to collapse within the country, when markets began to crash. Bankruptcy and bad debts started to spiral out on control. Investor confidence began to shrink, and government bailouts kept a large proportion of banks from bankruptcy. With the Spanish economy beginning to show signs of failure, and Bankia which was the fourth largest bank in Spain failing for bankruptcy. With many of the country’s investors only escaping bankruptcy through refinancing there loans many times. From this the rate of economy in Spain begin to stagnate in 2008 and started to shrink in 2009 and 2010. Again, largely due to the supply of liquidity drying up internationally. Which lead to a collapse in the Property and construction sector. This in turn then lead to wide scale unemployment and putting strain on the countries social protection system. This caused the countries debts to get to a level in which they were running away. Which then in turn required the Spanish government asking the EU to provide support as the country’s debts where at a level where the Spain could make its interest repayments on its public debt.
Similarly, to other PIIG’S countries the leading up to the European sovereign debt crisis, Italy was already substantially heavily indebted. To a level where the amount of government debt exceeded the countries GDP. Which was also well above the 60% level of debt mandated by the Maastricht treaty. The government deemed that this that this was not an issue for the country. As the government was able to continuously able to refinance this debt, up until 2010.
With the failure of the US markets, this had a systemic effect on the Italian financial institutions. This caused a wide scale lack of liquidity, starting with banks refusing to participate in inter-bank lending due to the lack of financial soundness. Leading to a greater contraction of liquidity. This resulted in a slump in the economy’s growth due to a lowering in public consumption and investment. Exports in the country then began to decline with sectors such as transport and manufacturing falling by as much as 35%.
Italy’s rate of growth during the crisis.
Year GDP rate of growth
2000 5.00%
2001 3.60%
2002 2.70%
2003 3.10%
2004 3.30%
2005 3.60%
2006 4.00%
2007 3.60%
2008 0.90%
2009 -3.70%
2010 -0.10%
2011 0.70%
Source: Eurostat
After a change of government, Mario Monti Italy’s new prime minister implemented strict austerity measures. This involved reducing government agency expenditure, raising the retirement age and reducing the level of tax evasion. This proved effective and because of these measures the banking system within Italy only required a small bailout package compared to other EU countries. During a stress test conducted by the ECB in 2011 it showed that “…the Italian banking system seems to have low exposure to government debt; it holds less than 10% of domestic public debt –against more than 40% in the case of Spanish banks – as well as low exposure to foreign sovereign risk, which represents only 23% of the total government debt Italian banks hold” (Bolton P, Jeanne O (2011)) The main cause for Italy being effected by the European sovereign debt crisis was there heavy reliance on public debt. This became a large issue for the country in when the economic climate for the European region began to worsen in 2009.
For the last of the PIIGS countries Portugal’s hardship started showing in 2008 when the growth of the country’s economy slowed to a point where it showed no growth. Continuing to fall in 2009 to a point where it shrunk by 3%. During this time the Portuguese government struggled to deal with a rapidly growing budget deficit, rising from 2.6% to just under 10% in 2009. Looking further into this one of the large factors that main Portugal vulnerable during the economic downturn was that the countries industry has a strong focus on producing low value goods, such as clothing. Even before the economic crisis this industry was struggling to deal with growing competition from countries such as the Philippines and China. Production efficiency did not grow within the region and the industry was rapidly losing its competitive advantage. Meanwhile the business sector was borrowing heavily, which was rapidly increased the countries level of debt. The Portuguese government continued to spend quite heavily depend the economic downturn, particularly in infrastructure. When the other southern European countries began to see the effects of the sovereign debt crisis international investors began to have doubts as to Portugal’s ability to pay back its debt. This caused Portugal to ask for a bailout package from the ECB. Assistance was provided after austerity measures where promised to return Portugal’s deficit to a manageable state. These measures included large scale cut back to government spending such as salary cuts for public servants and several tax increases, with the government also turning to increase to competitiveness of its industry. Portugal requested a €78 Billion bailout package from the EU and the International Monetary fund which was provided. These measures went a long way to stabilize the Portuguese economy and put them on track to get there economy back in a stable position. The effects of this where felt within the Portuguese economy for a long time, with the European sovereign debt crisis leading to a substantial increase in the nations level of unemployment peaking at 15% the effects of the sovereign debt crisis will be felt for years to come.
Once the effects of the financial crisis calmed down the President of the ECB announced that they would become the lender of last resort for Eurozone countries. The countries that were affected by the European sovereign debt crisis where made to implement Austerity measures. In measures where used to make these countries take dramatic budget cuts so that debt repayments are still able to be made. These austerity measures take a multistep approach to reducing the government deficits which can surmount to a level which can cripple a country. The first is to reduce government spending. Austerity measures target spending in both the social and developmental. This is done in with the goal of cutting mounting level of debt, so that the country has the opportunity of repaying its existing debts. With the idea that the percentage of debt compared to GDP will decline. The next austerity measure that was implemented was the raising of taxes within the country. The intention of this is to increase the governments capital further increasing the government ability to repay its debts. It is important to note however in most countries debt reductions have been a result of increase tax rates, and not a decrease in spending. Meaning that tax revenues increase faster that the rate of spending. With Eurostat statistics point out that tax revenues have increased 12.9% from 2009 to 2012. Meaning that governments have not needed to borrow as much however, they still rely heavily on public debt.
It is now important to look into the European Central Banks role during the Sovereign debt crisis. The ECB took on an important role introducing a range of bailout policies to aid countries in the crisis. This included lowering interest rates, expanding the range of collateral assets, acting as a moderator with other central banks worldwide, introducing a securities market program (SMP), Long- term refinancing operations, financing via Target-2 system and providing outright monetary transactions (OMT). Midway though 2012 the president of the ECB made an accountment stating that the ECB would become the European Union lender of last resort, though the purchase member states sovereign bonds. Being hugely beneficial allowing the affected governments time to plan how to solve the problem. One of the main achievements was the establishment of the ESM. This was a European union agency that was established to provide financial assistance to countries that are requiring liquidity for their banks. Being able to lend up to €500bn. This was important for the EU as it provides a mean to deal with their no bail out policy, though offering recapitalization packages directly to the financial sector. In addition to this the ECB began to offer long term refinancing operations (LTRO), which was offered at a fixed rate and easing was offered with the maturity able to be extended. This was used greatly by the troubled EU PIIGS countries which faced such a great deal of trouble. The aided the nation’s banks offering much need liquidity keeping the banks operational, which in turn provided around 80% of the liquidity provided by the ECB. By the end of 2012 aggressive easing allowed the ECB to reach it 2% inflation target and growth restarted within the EU, bringing back stability to the region.
Closing Remarks:
The European Union and its policy makers did the remarkable steering the EU though the Eurozone crisis. Going into the future it calls for all countries to manage there fiscal policy more responsibly. Following mandated ratios such as to keep “sound fiscal policies, with debt limited to 60% of GDP and annual deficits no greater than 3% of GDP”9(LOYAL AND NEWS). What would also be extremely benefical to the EU and would greatly increase stability would be the introduction of a banking union. This would ensure that banks within the EU are stronger and better supervised, and would provide a stronger and more uniform insurance coverall to all depositors in the union.
What Europe needs is smaller governments, not just in terms of public spending but also as regards deregulation of the job market and other structural reforms to encourage entrepreneurship, private investment, and job creation. There will be sustained growth in Europe only when governments, and not citizens or businesses, finally bear the brunt of austerity.