The European Sovereign Debt Crisis

Business Communication Assignment

Literature Review

The European Sovereign Debt Crisis

Submitted By:

Akshay Chiripal

Roll No. 305

Section C

[pic 1]

Faculty of Management Studies

University of Delhi

Delhi-110007

1. Introduction: Why did Euro come into existence?

The Euro was launched in 1999 after eleven European countries decided to denominate their currency into a single currency. The European Monetary Union (EMU) conceived in 1988-89 established budgetary and monetary guidelines for the countries wishing to be a part of the EMU. The criterion were designed to be a basis for qualifying for the EMU and pertained to the size of budget deficits, national debt, inflation, interest rates, and exchange rates.

The overarching justification for Euro was not merely economic, but political. A single currency was seen as the symbol of political and social integration post World War II.  On the economic front the use of a common currency had implications both at the Micro as well as Macro level. At the micro level the use of a single currency was expected to increase cross- border competition, integration and efficiency in the markets for goods, services and capital. At the macroeconomic level, a single monetary policy in the euro area was expected to ensure price stability.

The Euro system's commitment to price stability was expected to contribute to the long- term stability and credibility of the Euro and promote its attractiveness as a trading and investment currency. In the long run, the development and integration of the Euro area financial markets was expected to enhance the attractiveness of the Euro. The Euro was also expected to become an important currency in the foreign exchange markets.

2. What is Eurozone Crisis?

The Eurozone Crisis also known as European Sovereign Debt Crisis is a multi-year debt crisis that has happening in the European Union since the end of 2009. Several Eurozone member states namely Greece, Portugal, Spain, Ireland and Cyprus were unable to repay or refinance their government debt and failed to bail out their over indebted banks under national supervision without the assistance of third parties like other Eurozone countries, European Central Bank and The International Monetary Foundation.

The Eurozone Crisis began in late 2009 when the New Greek government revealed that the previous government had been misreporting the government budget data. Once the accurate data was revealed higher than expected deficit levels eroded the investor confidence, leading to rise of bond spreads to unsustainable levels. Fear regarding a similar position of other European countries quickly gripped the markets. In May 2010, Greece received a financial bailout package from other European countries and IMF in order to avoid defaulting on its debt. Investors became increasingly nervous about public finances in Ireland and Portugal, and, as their bond spreads rose, the two countries also requested European-IMF financial assistance packages that were finalized in December 2010 and May 2011, respectively.

The economic crisis has increasingly become a political crisis as well. In Eurozone countries under the most market pressure for instance Greece; the crisis has provoked protests and backlash against austerity measures imposed by well off Eurozone Countries like Germany. In the economically stronger economies that have been providing financial assistance to the weaker economies, there has been resentment against what is perceived as “bailing out” other countries that have failed to implement “responsible” policy choices. Disagreements among key policymakers over the appropriate crisis response, and what many consider to be a slow, complex EU policy-making process, are seen as having exacerbated anxiety in markets.

3. What caused the Eurozone Crisis?

The global financial crisis in 2007–08 acted as the trigger that set the snow ball of debt rolling across Europe and in the euro zone as growth declined sharply. The financial crisis led to disruption in financial intermediation. Falling interest rates supported the credit boom from 2003 lasting till early 2007. But from 2006, interest rates across euro zone started to diverge, marking out the weak from the strong economies. Excessive lending had left banks with bad debts and governments with large fiscal deficit and public debt in the peripheral economies.

The inflow of capital and subsequent build-up of public and private debt over the past decade into the Eurozone “periphery” countries was a key factor in build-up to the current crisis. When these countries made the transition from national currencies to Euro their bond rates fell dramatically to the level offered by stronger economies of Eurozone “core” countries. Both public as well as private sector began taking advantage of the new, cheap credit. The capital inflows, however, were not always used for productive investments in the economy that could generate the resources with which to repay the debt. As a result, the debts level started rising. In some countries such as Greece the debt was concentrated in the public sector in other such as Ireland and Spain the debt was concentrated on the private sector.

During the global financial crisis of 2008-09, the capital markets froze up. As a result it became difficult for governments, households and firms to get access to new loans and roll over the existing debts. The financial crisis and ensuing recession further strained the public finances as expenses rose and tax collection fell. In some case such as Ireland, government guaranteed bank debt.

The cheap credit fueled domestic demand as a result there was high growth combined with inflation in some “periphery” countries. Increased prices in periphery countries rendered their exports unattractive in comparison to other Eurozone countries like Germany, which had implemented a tight wages control to keep inflation in check. As a result these periphery countries started to run trade deficits. Membership in the Eurozone constrained the ability of the periphery governments to respond to growing trade deficits. If the periphery countries had not been in the Eurozone, they could have reduced their trade deficits through currency depreciation, which would have helped bolster exports to other Eurozone countries and stem imports. Likewise, the periphery countries could have raised interest rates to slow economic growth in response to a potentially over-heating economy. But as members of the Eurozone, neither devaluation nor an increase in interest rates were available policy options for individual member states.