European Sovereign Debt Crisis - Research Paper Example

? European Sovereign Debt Crisis Introduction The European sovereign debt crisis is the financial crisis that made it difficult for countries in Europe to repay their debt obligations without seeking help from third parties. Governments prepare deficit budgets and, therefore, have to borrow resources from either internal or external sources in order to finance the deficit. This situation, if not well controlled and monitored, increases the total government debt. The credit ratings of most European countries like Spain, France, and Italy significantly declined as revealed by the moody and S&P during the year 2010 and 2011 (Mora, 2006). Attempts by international monetary fund (IMF) to avail 750 billion Euros to financially support countries with high debt situation did not mitigate the situation. The paper will, therefore, explore on the causes and evolution of the debt crisis, its impact on the US market, and some interventions undertaken by the US to mitigate the impact. Causes of the Crisis Many factors can be attributed to the crisis that has seen the credit ratings of countries decline and caused shock in the global financial markets. The European Union has been accused of failing to take timely actions and of lingering until the situation ran out of hand. The crisis resulted from a mixture of several complex factors like the globalization of finance, international imbalances in trade, housing bubbles, ease credit conditions between 2002 and 2008 that resulted into high risk lending, and the slow economic growth in the year 2008 (Frangakis, 2006). The factors are elaborated below. a) Increased debt level EU members signed a Maastricht treaty in 1992 where members promised to limit their deficit spending and debt amounts. However, the member countries like Greece and Italy failed to adhere to the agreements of the treaty and instead used complex currency and credit derivatives to increase their debt levels. From the data, the debt levels rose because of the large bailout given to financial sector in the late 2000s and the 2008 economic recession. In 2007, the percentage of fiscal deficit was 0.6 before it rose to 7% during the crisis (Frangakis, 2006). The government debt simultaneously rose to 84% from 66% of the GDP. The crisis can thus be attributed to the inappropriate fiscal policy choices and the actions by the governments to bail out troubled banks. The variations in how different countries used borrowed funds resulted in different effects. Ireland banks, for example, increased their lending to property developers, which later led to the housing bubble. Greece, on the other hand, increased its pledge to the government workers of salary increment and pension rise. These actions increased the government level of debt, which later made it difficult for the states to meet their obligations as they became due. b) Trade imbalances The crisis grew because of the increasing trade imbalances. An increase in the amounts of trade deficits increases the levels of debt hence increasing the debt crisis. Before the commencement of the debt crisis, the trade deficit of Italy, France, and Greece increased, while that of Germany recorded trade surplus. However, Greece position has improved because of the decline in the imports and increment for exports. c) Loss of confidence Immediately after the crisis developed, it became clear that the bonds of weaker economies like Greece were risky. Because of this loss of confidence, sovereign CDS prices rose to match the market expectation of the increased debt. Investors also doubted the ability of the countries to contain the crisis because EU countries have few monetary policy choices. d) Monetary Policy Inflexibility Monetary policy inflexibility of all member states of EU established a common monetary policy and used one currency. Countries were, therefore, unable to print money in order to devalue their currency to stimulate exports and reduce the debt level through trade surpluses. Greece and other member states, therefore, lacked the ability to adjust to the increasing debt levels in order to correct the situation. Impacts of the Crisis on US market The interconnection of the financial markets implies that, if one nation experiences default in its debt or enters into a recession, it will spread across other financial markets in what is referred to as financial contagion. The concept of debt protection also results in interconnection amongst institutions that enter into credit default swaps (CDS), which results into payments when defaults occur on specific debt instruments. The European bond crisis, therefore, has an impact on the US financial markets because of the interconnections in the financial markets. Financial crisis in a small country like Greece will, therefore, send a shock to other larger economies. The US will be affected in the following ways. To begin with, European banks are at the center of the debt crisis. Since there are interconnections between the banks in the US and those in Europe, the risk exposure of the US markets is expected to increase (Frangakis, 2006). Banks in Europe will definitely look for bailout from their counterparts banks in the US. This is likely to increase the lending risk in the US that could further increase the level of losses that will be incurred by American banks (Wignall-Blundell & Slovik, 2010). Moreover, the banks in America that had previously lent to Greece, France, and other troubled countries, will also experience defaults in their loan repayment and, therefore, experience a decline in the returns (Olivares-Caminal, 2010). The US banks have almost outstanding loans of $170 billion in Europe. To take precautions on the potential risks, the US banks will take stringent measures before extending loans to the affected nations, and this will reduce the profits posted or reduce the interest earnings of the US banks. Secondly, the US exports to Europe will be severely affected by the debt crisis. Europe is the largest trading block for the US and, therefore, a slight reduction in the level of trade would significantly reduce the US earnings from Europe. The debt crisis in Europe could send panic in the European financial and trading factor, hence slow down the level of economic activity or lead to a recession. In such cases, this will spread to the US and reduce the level of trading in the US markets. However, some economists argue that the percentage of exports to the countries in the crisis is not enormous, and this will not result into even a 1% decrease in the US economy (Wignall-Blundell & Slovik, 2010). In addition, the debt crisis will as well impact adversely the US companies’ investments. Because of the debt crisis, the US companies with direct investments in the European market recorded a decline in the balance sheet figures, especially the automotive industries. Ford and General Motors recorded declining sales in the European markets. The increased risks reduced the amounts of borrowings in the banks, which later translated into reduced level of sales. The US companies have also increased the level of financial arrangements including hedge funds, insurance, and credit defaults to help shield them from the increased risk. This will amplify the adverse effects of the crisis to US. Besides, US investors will also be affecting their investment plans in Europe. Individuals and companies from America with investment plans in America will have to monitor the changes in the exchange rate between the Eurodollar and the US dollar. Because of the depreciation in the Eurodollar, investing in the euro market will be expensive since it will be expensive to buy the euro currency when making investments (Mora, 2006). This will reduce the number of foreign investments made in Europe. The US direct investment in Euro zone countries constitutes 26% of the US investments abroad. The US investors will shift their investments to emerging markets, a factor that will continue to hurt the US parent companies (Sy, 2004). This can only be mitigated by the increased demand of the cheaper European stocks and assets. Consequently, the long term US foreign earnings will reduce, and this will adversely affect the balance of trade between US and Europe. The crisis will affect not only the financial markets but also the US budget. International monetary fund (IMF) intervened in the crisis with the objective of bailing out the highly indebted states. IMF derives a larger proportion of its capital from the United States. If the amount pledged by IMF increases, the US will be obliged to increase the amount of capital extended to IMF, which will increase US expenditure (Hoekstra & Wiedemann, 2008). Consequently, US taxpayers will dig deep into their pockets in order to pay increased tax to finance the budget. EU tried to rescue countries from the high debt levels by bailing nations that were highly indebted. A country like Greece received about $ 163 billion to help rescue the situation. At the same time, the European central bank had the objective of buying the government debt and engaging in long term refinancing operations. This option of printing money to buy the government debts was, however, feared because of the possible economic effects of increasing the price levels. The courses that were pursued by EU took relatively long because of the bureaucracy that is involved, since all the member states approval had to be obtained. Obama’s administration has limited options to reduce the impact of the crisis on the economy. The Federal Reserve Board has the option of providing unlimited dollars to other foreign central banks and, consequently, of having the authority to control the situation. For example, Fed swapped dollars for Euros with an intention of provided ECB with liquidity to restore the capital markets in 2007, 2008, and in September 2011 (Hoekstra & Wiedemann, 2008). Fed could also extend short-term loans to distressed commercial banks to protect the US financial system from shock. The US also has the last option of exhorting European officials to take appropriate measures in having the crisis resolved. Conclusion In conclusion, the European debt crisis influences across the globe because of the connectivity of the financial markets. The US as a country was heavily affected by such a crisis because of the bilateral trade that exists between the US and Europe. Countries should take measures in the most appropriate time to ensure that their economic performance does not influence negatively on the global economy. Policy makers must not remain myopic on the impacts of their policies on the general economy. The US and other nations need to take effective measures to mitigate the impacts of the foreign debt crisis on their economic performance. References Frangakis, M. (2006). The Rising Public Debt in the EU: Implications for Policy. Journal of Contemporary European Studies, 19(1), 7-10. Hoekstra, R., & Wiedemann, S. (2008). The Stability and Growth Pact – Germanising the Euro. International Journal of Public Policy, 3(2), 100-117. Mora, N. (2006). Sovereign credit ratings: Guilty beyond reasonable doubt? Journal of Banking and Finance, 30, 2041-2062. Olivares-Caminal, R. (2010). Sovereign debt defaults: Paradigms and challenges. Journal of Banking Regulation, 11(2), 91-94. Sy, A. (2004). The rating agencies: Anticipating currency crisis or debt crisis? Journal of Banking and Finance, 28, 2845-2867. Wignall-Blundell, A., & Slovik, P. (2010). A Market Perspective on the European Sovereign Debt and Banking Crisis. OECD Journal: Financial Market Trends, 20(2), 23-25. Read More