What is the European Sovereign Debt Crisis?

What is the European Sovereign Debt Crisis?

The European sovereign debt crisis was a period when several European countries experienced the collapse of financial institutions, high government debt, and rapidly rising bond yield spreads in government securities.

The debt crisis began in 2008 with the collapse of Iceland’s banking system, then spread primarily to Portugal, Italy, Ireland, Greece, and Spain in 2009, leading to the popularization of a somewhat offensive moniker (PIIGS). It has led to a loss of confidence in European businesses and economies.

The crisis was eventually controlled by the financial guarantees of European countries, who feared the collapse of the euro and financial contagion, and by the International Monetary Fund (IMF). Rating agencies downgraded several Eurozone countries’ debts.

Greece’s debt was, at one point, moved to junk status. Countries receiving bailout funds were required to meet austerity measures designed to slow down the growth of public-sector debt as part of the loan agreements.

Causes of the Crisis

A series of events and factors played a role in the debt crisis, such as:

Common Currency, the Euro

All members of the EU shared a common currency and a common monetary policy. However, each country independently controlled their fiscal policies—which decide government spending and borrowing.

This, in addition to the low costs of borrowing, encouraged countries like Greece and Portugal to borrow and spend beyond their limits.

The 2008 Global Financial Crisis

The 2008-09 Global Financial Crisis sent shockwaves across the globe. Investor confidence plummeted as financial institutions crashed, and housing bubbles exploded. As a result, investors demanded higher interest rates from banks—increasing the cost of borrowing.

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Economies like Greece, which relied heavily on debt, struggled to survive. To make matters worse, the value of their existing debt also increased with interest rates.

High Sovereign Debts

High sovereign debts and deficit spending, along with high costs of borrowing and a global financial crisis, resulted in a widespread failure in the EU’s financial system. Greece’s debt was at 113% of GDP, and the country needed multiple bailouts to pay back its creditors. Following Greece, Ireland, Portugal, Cyprus, and Spain all requested bailouts in order to start their economic recoveries.

Countries that requested assistance received it from organizations, such as the

World Bank and International Monetary Fund (IMF) and Germany – the only financially stable, strong economy at the time.

Many other factors were at play, but the Euro, the global financial crisis, and excessive deficit spending all played major roles in the eurozone’s sovereign debt crisis.

A currency’s valuation also significantly affects exchange rates and exports. In times of financial crises, countries often resort to a devaluation of their currency to boost exports.

However, devaluing a currency also increases the dollar value of existing sovereign debt that is borrowed from foreign countries – as was the case for EU countries like Greece. It limited the EU from devaluing the Euro and increasing exports and worsened the European sovereign debt crisis.

Example of European Crisis

In early 2010, the developments were reflected in rising spreads on sovereign bond yields between the affected peripheral member states of Greece, Ireland, Portugal, Spain, and most notably, Germany.

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The Greek yield diverged with Greece needing Eurozone assistance by May 2010. Greece received several bailouts from the EU and IMF over the following years in exchange for the adoption of EU-mandated austerity measures to cut public spending and a significant increase in taxes.

The country’s economic recession continued. These measures, along with the economic situation, caused social unrest. With divided political and fiscal leadership, Greece faced sovereign default in June 2015.

The Greek citizens voted against a bailout and further EU austerity measures the following month. This decision raised the possibility that Greece might leave the European Monetary Union (EMU) entirely.

The withdrawal of a nation from the EMU would have been unprecedented, and if Greece had returned to using the Drachma, the speculated effects on its economy ranged from total economic collapse to a surprise recovery.

In the end, Greece remained part of the EMU and began to slowly show signs of recovery in subsequent years. Unemployment dropped from its high of over 27% to 16% in five years, while annual GDP when from negative numbers to a projected rate of over two percent in that same time.