Europe - It’s as if there’s been a continuous fire burning under the Euro Area, right out of the 2007 Global Financial Crisis.
In today’s piece, we cover The European Sovereign Debt Crisis.
Welcome back guys, hope you’re all good & looking forward to this macro note ;)
As always, lend me your attention from here on out:
The Sovereign Debt Crisis Explained
Maintaining price stability and healthy economic conditions for an economy is extremely challenging as we know, just look at the UK & the U.S. Let alone managing this across a whole union of countries.
The markets are deluding themselves when they think at a certain point the other mem- ber states will put their hands on their wallets to save Greece.
— ECB Executive Board Member, Júrgen Stark (Jan 2010)
As you already know from previous articles, everything is interconnected. Everything. So, in the case of a debt crisis, the costs and benefits associated with a default within a monetary union are magnified for both the debtor and creditor countries. Because a “monetary union facilitates financial integration,” and also cross-border-holding of government debts (majorly by banks) inside the monetary union (EU), in the case of a default, the knock-on effects are catastrophic. The cost of default to the creditor in this scenario is multiplied, here’s how.
Although Greece wasn’t the only European nation to default on its debt we’ll use it as an example; the costs of a default for the creditor not only is the principal amount loaned out, but even greater collateral damage, through the contagion risk, aka widespread risk associated in being within the same union. Things such as:
disruption of international trade
financial flows within the union (access to liquidity)
foreign investments
Liquidity seems to be at the heart of every crisis we’ve seen, or most. In the case of Greece, a sovereign default would put domestic banks within the eurozone at risk mainly because they would have been holding Greek bonds & potentially using those debt instruments as collateral to access liquidity from either the ECB or other financial/sovereign institutions. One man’s debt, another man’s asset, that’s until the first man defaults!
All in all, everything would have had a torn apart due to the default of Greece and other countries such as Portugal, Ireland, Cyprus, Spain & Italy who were unable to pay or refinance their government loans or even bailout indebted banks under their supervision without support from third party organisations (IMF).
After scanning through documents and fillings online, I found out that a “sovereign default inside the eurozone has been interpreted by many policymakers and economists as the first step towards the potential exit of the defaulter from the monetary union.”
Now, I’m not too sure how much truth this statement holds but I can see how such countries may be sidelined and disregarded when it comes to important policy decisions that have to be carried out within the eurozone.
Here’s the backstory of how this all fell apart.
The Global Financial Crisis
After the recession and crisis of 2007, what became apparent within the euroarea was the absurd level of debt to GDP as a percentage, amongst certain nations within the ECB. Debt is a great instrument to drive growth, but as the interest rate environment starts to heat up, restructuring and financing debt becomes extremely hard. Additionally, the sudden halt of foreign investment to countries such as Greece sparked fears that the Greek government would not be able to finance such levels of debt.
You’re probably looking at the chart thinking, this can’t have happened. Yes, it really did. Yields on 10-year debt instruments from Greece hit as high as 29.24%!
But why you may ask?
Here’s the reason:
Greece’s debt to GDP was 109% in 2008 and rose to 146% just two years later! Bear in mind, the eurozone put in place a pledge which said the debt of any country within the eurozone shouldn’t exceed 60% and the government budget shouldn’t exceed 3% of its GDP, Greece doubled that by 2009-10 and their government deficit was -15%.
Unsustainably high debt to GDP = greater risk of default = greater reward demanded by investors
A lesson I have broken down a number of times talking about how credit ratings can cripple an economy. But back to the point. The talk around Greek bonds became so negative that the only way they could attract investors was to offer high double digit yields on their loans. This only accelerated the downgrading of Greek bonds as perceived risk grew, access to capital dried.
Here’s the collateral knock on effect. As investors demanded more yield from Greece, they also began looking at Portugal, Spain, Cyprus and many others demanding higher yields on the debt instruments - so the bond market of these countries also suffered major blows as they had to offer +10% on their yields!
Knowledge drop:
I was speaking with a friend who’s works at an emerging markets research firm, very knowledgeable on that forefront to say the least and he said when bond yields hit 10% funds call it ‘loosing market access’ because these countries are no longer able to raise money in international markets, due to the risk associated that their sovereign debt has reached a certain distressed point that it’s not worth purchasing as its near defaulting/bankruptcy.
Now that’s emerging markets, Europe is considered a domestic market so you can imaging how rough financial conditions would have been in Greece, Ireland and Portugal, all countries whose bonds were >10%.
By early 2010, Greece requested for a bailout to help pay back its creditors and received support from an EU-IMF( International Monetary Fund) package totalling €110 billion to rescue Greece from defaults. Following Greece, Ireland, Portugal, Cyprus and Spain all requested bailouts to stay afloat.
Why Not Devalue The Euro?
This may be a question arising in your head. Heck, it did in my mind after some research.
China is a perfect example of a country that uses currency devaluation to its benefit. Here’s why.
Devaluing a domestic currency reduces the purchasing power and strength of that currency, let’s say the Chinese Yuan in this example. What this does is make the devalued currency’s goods more attractive to the global world of trade as the value of China’s exports will cost less in your respective currency. So a nation’s exports become more competitive globally. It’s not all positives however, as you devalue your currency imports become increasingly expensive as well as debt servicing/repayments if the debt is denominated in a foreign currency like the dollar. So this strategy works great for net exporters of goods & services as supposed to importers.
August 11th 2015, China devalued their domestic currency against the dollar in order to boost exports as recent data showed exports were down 8.3% YoY compared to July 2014. After this the dollar strengthened against the euro.
The effect of devaluing? The increased demand in global trade markets, spurs higher exports for the devalued currency economy which in return boosts economic activity and drives GDP, growth and development. Only issue in Europe’s sovereign bond crisis was, you guessed right, they’re a net importer of goods. Meaning this would have temporarily boosted goods exporter but the pain of importing goods at a higher cost + increased difficulty to refinance debt outweighed the pros of devaluing the Euro.
Austerity Measure Implemented
The bailouts provided by the EU and IMF, weren’t free checks. With the lifeline came strict rules, known as austerity measures. Meaning government policies aimed at reducing public sector debt; these policies restricted the fiscal policy actions taken by nations across the EU.
Things such as:
amount the government could spend on public debt
public sector wages
were reduced/restricted and income taxes were raised to try and shift the current account to positive.
The effect?
high unemployment rate, greater income inequality and lower standard of living, all which some up the building blocks of fragmentation risk within the euro.
Thanks for getting to the end of this note, it was an in-depth piece so make sure you took your time reading through!
This piece definitely took it out of me but I know you’ll gain some knowledge from this!
A favour to ask, can you share this newsletter on your social media, with your friends and whoever may find value! I’m just about finishing something that’ll really help boost your knowledge so stay tuned!
Until next time