European Sovereign Debt Crisis 2010-12 and the Impact on Bond Markets - Essay Example

European Sovereign Debt Crisis 12 and the impact on Bond markets” The European Sovereign Debt crisis was first brought into the global consciousness on 5 November 2009, when Greece introduced that its budget deficit was 12.7% of gross domestic product (GDP)- having grave impacts on the authority of the Euro and the European financial markets. The Greece deficit was the first explicit sign that the Euro-zone was facing and had been facing severe problems in their financial structure and regulations, and these problems would go on to affect all the nations in the European nations. The Background: “The Euro zone sovereign debt crisis is rooted in the dysfunction of a monetary union without political union” (Liu) The European Sovereign debt crisis could not be contained as the problems only in the Greek region, given the economical and financial structure governing the European nations it was apparent that this crisis was a truly ‘European’ crisis and couldn’t be handled in isolation with any one country. The Greek deficit was a direct result of the Structure and player’s of Europe’s institutions which allowed the nation (and others) to indulge in economic practices and fraudulent reporting which had obvious long term negative consequences. The European Nation came into being in 1992 through the signing of the Maastricht Treaty. The treaty established the euro as legal tender for all the participating nations, with the exclusive responsibility of forming the monetary policy for the euro zone falling on the European Central Bank. The treaty promised great benefits for the nations admitted to the euro zone. There were two major economic rewards firstly it increased the ease of borrowing for individual governments based on the average rating for the whole of euro zone; nations with high deficits and low GDP would enjoy the same average rating as a benefit from the high economic performance of stronger euro zone economies. Secondly, the uniform monetary policy meant that no nation could devalue its currency or lower interest rates etc to increase their competitive advantage. This leveled the playing field for all participants of the Euro zone. However, the mechanics behind these ‘benefits’ were risky and the major criticism for the treaty. The countries were still held responsible for designing their fiscal policies in order to positively influence the economy, but without the control of monetary measures, they could not manage their sovereign debt problems through devaluation of currency or lowering the interest rates. Another concern, which would later prove to be true, was the idea that some economies might become ‘free-riders’ and depend on other participating nations in the euro zone to indulge in high debt to finance economic activities without the required increase in productivity. In order to put a check and balance on the system, a “convergence criteria” was set upon for the euro zone nations. Among these was the Price development and Exchange rate criteria, to ensure participating nations had a low and stable inflation and currency exchange rate. Fiscal developments demanded that annual government budget deficits should not exceed 3% of GDP and total sovereign debts should be less that 60% of GDP. These rules were included in the Stability and Growth Pact, with another very important regulation: the no-bail-out principle for nations with deep deficit. But from the start it was apparent that there was in fact no enforcement mechanism for these rules with the nations often bending or breaking them through a consented vote of action (Dombret, 2011). The breakout of the crisis: If the convergence criteria had been followed the situation for the European Union might have been different. As it turns out, nations had lied and manipulated their reports to fit in with the requirements. Greece had announced a budget deficit at 1.7% of GDP in 2003 but it was actually been 4.6% of GDP as reported by Eurostat in its 22 November 2004 report titled, “Report by Eurostat on the Revision of the Greek Government Deficit and Debt Figures. (Voss, 2011). At this point, 13 of 17 countries in the Euro zone have debt levels over and above the convergence criteria maximum of 60% including large economies like Germany, France and Italy. IMF estimates state that from 2006 to projected year-end 2012, euro zone will have incurred a debt increase from €5,870 billion to €8,714 billion (a difference of  €2,844 billion). The European Sovereign Debt crisis did not begin in one single step. The First stage (the trigger), was the US subprime Crises. As the real estate bubble burst in the US, devaluing assets amounting to billions of dollars the effect was felt throughout the global finance networks. “The high exposure of major European banks to losses in the U.S. market in asset-backed securities has been major well documented, as has the dependence of these banks on U.S. money markets as a source of dollar finance” (Lane, 2012). Though the integration of the economies was expected to have positive benefits for the corporate bond markets, the banks in euro zone were the ones who enjoyed the low lending costs and became one of the strongest players in the euro zone economy. The subprime mortgage crisis brought the focus to the balance sheets of Europe’s banks. This then led to the 2nd stage of the crisis which was loss of confidence within international financial systems (Dombret, 2011). The banks were holding hundreds of billions of Euros worth of depressed-value real-estate assets and with the risk and uncertainty in the market the investors were pessimist about the conditions of the bank to act as drivers of economic activity. The money supplies diminished and more worryingly Cross-border financial flows dried up in late 2008 which were a secondary life line for Europe’s countries. These had been relying on external funding, especially international short-term debt markets (Blundell-Wignall, 2012) to finance their budget deficits and suddenly this funding was unavailable. In late 2009, the third stage occurred. This was the declaration of the countries about their budget deficits and the debt problems they were facing. The larger than expected increase in deficit/GDP ratios was a shock was financial observers. Among the countries which had been highly leveraged, Italys debt is 121 percent the size of its economy. 109 percent for Ireland, and that figure In Greece is 165 percent. These revelations led to the downgrading of these economies as the investors started to demand ever high returns on the sovereign bond as their confidence decreased. This was reflected in rising spreads on bonds and the Government bond yields started to diverge, something which had not been expected for nations working a single currency. The low demand for sovereign bonds was not limited just to the key participants of the crisis –Portugal, Ireland, Italy, Greece and Spain- as the euro zone scrambled to put in place rescue measures through bailouts orchestrated by ECB all the economies suffered from low willingness of the investors to spend in the economies.”The euro-area countries are now so closely integrated that problems in one country can spread quickly to envelop the entire euro area, in a phenomenon known as contagion” (Dombret, 2011). So the stronger nations have had to absorb the debt of troubled nations even as austerity measures are being undertaken by the countries’ with severe debt conditions. This is proving to be an unpopular move among the people of those countries and creating political backlash which can further harm the economies as the long term affects of these austerity measures may not be positive for on unemployment rates, and other economic factors necessary for ‘real’ economic development. The impact on the bond market: From the market point of view, the situation couldn’t be any worse for these nations. They need to finance their debts but the private investors are unwilling to take the risk of sovereign debt and the banks are already burdened with hundreds of billions of Euros of euro zone sovereign debt. The banks had invested heavily in European sovereign debt and these securities sharp price fluctuations affect collateral values and true mark-to-market harshly. (Blundell-Wignall and Slovik, 2011). After the announcement of the budget deficits an abrupt and disruptive re-pricing of sovereign credit risk had to be done and the concerns about their solvency immediately transformed into a liquidity crisis. The poor liquidity and high volatility led to a self-fulfilling scenario where the investor’s pessimism regarding a loss of market access for some constituent States of the euro zone led to a decrease in overall investment and made their expectations come true. Greece was the first country to be shut out of the bond market in May 2010 with Ireland following in November 2010, and Portugal in April 2011. Italy and spain, the euro zone’s third and fourth biggest economies, were also in the center of the market turbulence with investors wanting an accelerating rate of premium for taking on the high risk of the sovereign bonds. The downgrading of the ratings given to sovereign bonds and extreme levels of bond yields themselves exerted an undesirable influence on other financial market components including the banking sector (Cœuré, 2012). Many international investors transferred their funds to the safer US treasury bills across the ocean, further driving up the yield and lowering prices of the European Union sovereign bonds. Even as debt restructuring, bailouts and austerity measures are being put in place to help the nations, injecting liquidity into the banks strapped with risky securities has been a crucial step in the ECB’s plan for restarting economic activity in the areas. “Europes politicians had hoped that Greeces second bailout, and a battery of emergency measures unleashed by the European Central Bank, including its long-term "repo" operation, which offered cheap money to troubled banks, would draw a line under months of economic chaos.” (Stewart et al, 2012) The importance of the banks in the euro zone can be seen from the fact that the corporate sector in the region depended more heavily on external funding from the banks than their US counterparts (Atkins and Stothard, 2012). However as the investors have moved away from sovereign bonds the capital market has started to thrive as larger companies with good ratings are turning to the markets to raise funds. 73 per cent of corporate debt at the end of 2011 was funded through bonds, an increase from 53 per cent in 2008. These non-financial companies can actually borrow at a cheaper rate from markets as the banks are now facing greater regulations and pressure to maintain their profit margins in return from help from ECB. The intention was always for the bond market to benefit from the euro zone treaty but it was one of the failures of the system that the market had been unable to develop beyond the dominance of the banks. As the banks have been occupied with funding the sovereign debt, the borrower’ and lenders have started to interact directly in the capital markets with the corporate bonds a more attractive option for the investors right now. Conclusion: The European Sovereign Debt crisis was caused by a variety of reasons which can be adequately connected to the mechanisms and players in the euro zone economies. Nations manipulated their way into the euro zone in order to take advantage of the borrowing cushion provided by a unified currency. A lack of control on their monetary policy and high borrowing coupled with low productivity and devalued assets led to the current state of nations like Greece, Ireland and Portugal. The banks who had taken in a lot of sovereign debt suffered as the securities were downgraded and investors moved away looking for better, less risky opportunities. The capital markets had been underdeveloped in the Euro zone as firms’ preferred to borrow from the banks. As these banks tightened their lending policies after the crisis, the corporate sector has started to take advantage of funds available to investors by putting their securities to sale directly in the market. 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