The Sovereign Debt Crises In Euro Zone Economics Essay

The sovereign debt crises in Euro-zone have posed serious threat to the main economies of the Europe, the future of the currency Euro, and the global as a whole. The European Central Bank and other banks within the Euro-zone play significant roles in causing the problems, as well as solving the problems. This paper is attempting to study on the relationship between banks failure to the crisis and the remedy actions that have been taken to solve the crisis. The paper shows that the crisis is not entirely related to sovereign debt but also rooted in the bank financials. The manners in which the European Central Bank deals with the crisis will results in significance changes to Europe and the rest of the world. There are changes in current stage that the European Central Bank and other banks in the Euro-zone will need to manage its monetary, fiscal and financial system properly.

1.0 INTRODUCTION

On 1st January 1999, 11 European countries decided to denominate their home country currencies into a single currency, known as the Euro. The European Monetary Union (EMU) was considered as a committee consisting mostly of central bankers which led to the Maastricht Treaty in year 1991. The Maastricht Treaty was established to set budgetary and monetary rules which called as “convergence criteria” for countries wishing to join the EMU. The criterion set was pertaining to the size of national debt, budget deficits, interest rates, inflation rates, and exchange rates. Denmark, Sweden, and the United Kingdom were qualified but chose not to join the union. (Anand, M. R., Gupta, G. L., & Dash, R., 2012)

The “Euro system” comprised the European Central Bank (ECB), with 11 central banks of the participating countries entrusted with the responsibility for managing monetary policy. These countries are using the same currency but each country has their own tax system. From year 1999 to 2011, the Euro-zone have increase its members into 17 countries, which included Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.

Banking system is the backbone of a country. It can affect the whole economic sectors of the country including the inflation rate, unemployment rate, GDP, living standard and et cetera. While EMU countries were facilitating the adoption of a single currency, a European Central Bank (ECB) was established and took the responsibility in setting a cingle monetary policy on 1st January 1999. The new created European Central Bank (ECB) plays the most significant role among all banking systems within the European countries. The European Central Bank had decided to implement a price stability oriented monetary policy, and use this policy to influence the price level within the European countries. However, the policy cannot affect other countries outside from the Euro-zone. (Franziska, R. & Peter, W., 2011)

In European Central Bank (ECB), the ultimate decision-making body is the Governing Council, which consists of an Executive Board and central bank governors of the EMU countries. The Governing Council has the power to formulate and implement monetary policy. There are three tools used by ECB in conducting the monetary policy: the reserve requirements known as “minimum reserves”, open market operations, and the provision of standing facilities. (Jeffrey, M. W., 1999)

The minimum reserves are the reserve requirements imposed to all financial intermediaries within Euro areas, by requiring each intermediary to hold reserves equal to or exceed by 2% of its total liabilities (consists of overnight deposits, deposits redeemable at notice of up to 2 years, deposits with maturity ties of up to 2 years, debt securities issued with agreed maturities of up to 2 years, and money market paper). (Jeffrey, M. W., 1999)

The open market operations are the purchase and sale of securities commenced by ECB and executed by the EMU national central banks. The open market operations of ECB are different with the Federal Reserve, in the sense that ECB accepts wide range of assets in the operations of monetary policy, and it does not trade on any government securities. The reasons behind this action were to inject more reserves into or extract reserves from the banking system, and also to keep the average interbank interest rate (EONIA). (Jeffrey, M. W., 1999)

Lastly, the standing facilities are the outlets for eligible banks to lend or borrow from the national central banks overnight. It serves the purpose of absorbing or providing reserves. The standing facilities are divided into marginal lending facility and deposit facility. The first is used to obtain overnight loans from the national central bank, while the second is used to make overnight deposits with national central bank. (Jeffrey, M. W., 1999)

2.0 EURO CRISIS

Over the last two years, the Euro-zone has been going through a distressing dispute over the management of its own home grown crisis, which is now know to us as the ‘Euro-zone crisis’. The crisis started from Greece, Ireland, Portugal, Spain, and more recently has spread to Italy. These Euro-zone countries have experienced a downgrade of their sovereign debt rating, the fears of financial default, and a significant increase in the borrowing costs. The developments of these problems are continuing to threaten the other Euro-zone countries’ economies, and ultimately the future of the Euro.

Under the stress of the crisis, the Euro-zone may be forced to do what it takes, and the situation will not return to business on its own as usual in a short term. It has to be made clear that the Euro crisis is not a classic currency crisis. Instead, it is the problems which arise from the mismanagement of the varying economic patterns of the Euro-zone. Countries within Euro-zone are tied together by using a single currency. However, the facts that its components are moving at varying speed, having different debt profiles and fiscal capacities have put enormous tensions on the economic and politic.

Given the name of “Euro crisis” does not means that the current crisis within Euro-zone is only limited to the Euro. The Euro-zone has played a large economic weight in the globe, and the regularity that the crisis will spread from one Euro country to another have shown the importance of the manner in dealing with the problem. The crisis is not merely the results of sovereign debt and bank financial problems, but it is also entrenched in the real economy with structural problems. The Euro-zone will have to change its manner in managing its monetary and fiscal policy, and also its financial systems.

To better understand the Euro crisis, we have provided a timeline showing how the Euro crisis began and it evolved to a global crisis.

Taken from: Bankrate.com

http://www.brimg.net/images/economics/euro-crisis-timeline-1999.jpg

The Euro is first introduced in year 1999 with 11 founding countries. These countries are Belgium, Germany, Ireland, France, Spain, Luxembourg, Italy, Austria, the Netherlands, Portugal and Finland. In year 2001, Greece joined the union. Five other countries joined the union later since 2007, including Cyprus, Slovenia, Slovakia, Malta and Estonia. There are total 17 countries in Euro-zone.

In 2007, the United State economy had officially entered into a recession. The situation became worse in year 2008, when the collapses of Lehman Brothers triggered the global financial crisis into a high gear. Due to the incident, the Standard & Poor’s 500 index closed at 1,251.70 on 12th Sept 2008. On 12th Sept, Lehman Brothers were officially filed for bankruptcy. The Standard & Poor’s 500 index continue to lose nearly half of its value, closing at 676.53.

The crisis was soon spread to the Federal Reserve, government regulators, mortgage lenders, rating agencies, and also over millions of American homeowners. The housing bubble was pop and everyone fallout from the pop. The crisis was later spread to Europe within few days, where Russia and Pakistan suffered from the contraction of their economies. Governments from England to Germany have to step in to bail out the banks. Unfortunately, Iceland went bankrupt in such a hit.

In year 2009, Greece had faced a budget deficit of 12.7% of GDP, which was nearly four times higher than the convergence criteria. Some of the criteria stated are government deficits no more than 3% of GDP and debt-to-GDP ratio cannot be more than 60% of GDP. In addition, its debt-to-GDP ratio was also twice the limit stated in the Maastricht Treaty, which have surpassed the widest wiggle room allowed. In the same year, Spain had reported its budget deficit totaled 11.2% of GDP.

In year 2010, Spain’s economic problems have worsened which caused the Prime Minister Jose Luis Rodriguez Zapatero to announce the cut of public employees’ salaries. Pension and government funding were also been slashed, as reported by BBC in May 2010. On the other hand, Portugal government made similar announcement about plans which aimed to reduce the budget deficit in March. The resulting action was the implementation of an austerity budget which cut down public spending and increase taxes, as reported by BBC in November 2010.

During the same year, Greek Prime Minister George Papandreou announced that a totaled 45 billion Euros loan will be taken by Greece from other Euro-zone countries and International Monetary Fund (IMF). Such request was successful and Greece was bailed out from the default. In addition, Greece had passed some plans which included the frozen of state pensions, cutting of civil service bonuses and government spending, increase taxes, and slashed public sector payrolls. Ireland was also applied for a bailout, with totaled loan amount of 85 billion Euros from IMF, the European Commission, and European Financial Stability Facility (EFSF). Such attempt was also successful and Ireland was bailout from default.

Nonetheless, actions have been taken by European Central Bank (ECB) like the creations of European Financial Stability Facility (EFSF) and European Financial Stabilization Mechanism (EFSM). These actions taken will be explained in section 5.0 of the report.

On 7th April 2011, Portugal became the third countries in Euro-zone that was requested for a bailout. A totaled loan up to 78 billion Euros was taken from the European Financial Stabilization Mechanism (EFSM), EFSF, and the IMF. Hungary had also made an official request for bailout from the IMF, but such request was still not been resolved as at October 2012 due to the economic conditions attached to the loan.

In the efforts of fighting the crisis, the ECB had raised the interest rates on 7th April and July to fight the inflation rate from 2.6% to below 2%. During this period the interest rate was raised from 1% to 1.25% in April, and raised again in July to 1.5%. In 11th July, the European Stability Mechanism was established, and it acts as the permanent bailout fund which was designed to replace the EFSF and EFSM. The maximum capacity that was allowed to lend as the bailout fund was 500 billion Euros, and it was funded by the Euro-area countries.

On 27th October 2011, Greek debt was sliced by slightly more than 50% under the agreement signed by the leaders from 17 Euro-area countries. Another effort made was the adjustments on the dollar liquidity swap (reduction in price) by the U.S. Federal Reserve, in association with the Bank of Canada, the Bank of England, the Bank of Japan, the ECB, and the Swiss National Bank. On 1st November 2011, Jean-Claude Trichet was replaced by Mario Draghi as the president of the ECB. The interest rate was cut to 1% after such took over.

In year 2012, Italian and Spanish bonds were purchased by ECB under the Securities Markets Program. A second treaty on the ESM was also been signed by the European leaders by moving up the effective date to July 2012. On 27th Feb 2012, Greek was rated to Selective Default by the Standard & Poor’s. On 13th March, Hungary became the first country rebuked for not keeping in line with the convergence criteria set, due to the failure in keeping budget requirements. The payment to Hungary was restored in January after the government announced plans that would reduce its budget deficit to below 3% of GDP.

On 9th June 2012, Spain requested for a bailout for its financial sector by taking 100 billion Euros loan. Nonetheless, the fifth Euro-zone country, Cyprus also requested for a bailout on 25th June, by taking loans up to 10 billion Euros representing more than half of its 17 billion Euros economy. ECB cut the interest rate again to 0.75% on 5th July, to allow banks to borrow at a lower cost. The rate paid on deposits was also cut to zero to allow banks to keep surplus funds for loans to other banks or businesses.

On 6th September 2012, ECB announced the launch of an unlimited but sterilized bond-buying program. Under such plan, ECB would offset bond purchases to avoid the excessive money supply. The Securities Markets Program was replaced by an Outright Monetary Transactions program, under which ECB would buy sovereign debt from those countries request for bailouts. In March, EFSF and ESM were combined to a capital base of 700 billion Euros. ECB was announced to be the leading supervision of 6,000 Euro-zone’s banks.

3.0 CAUSES OF EURO CRISIS

Although the intensification of global financial crisis after the collapse of Lehman Brothers between years 2007 and 2008 were said to be the reasons that triggered Euro crisis, there are some responsibilities that must be held by the banking institutions. The European Central Bank (ECB) is one of the most important players in the financial crisis and sovereign debt crisis faced by the Euro-zone. It is the main authoritative body that is allowed to implement monetary policy in influencing the countries’ economy situation.

The ECB has been subjected to extensive criticism since its creation in 1998. Main reason behind this was its narrow focus on price stability and its monetarist bias. Before the Euro crisis happened, ECB was operating strictly based on monetarist concept of central banking. The central banks were reduced to become the guardian of consumer price inflation. The inflation of financial asset prices was ignored, as well as the economic growth, systemic financial stability, and employment. Henceforth, the ECB was blamed for not seeing the crisis coming.

In early July 2008, the collapse of Lehman had ravaged the U.S. subprime crisis and some European banks such as the German IKB had collapsed by such hit. However, the ECB made a blindness decision to increase the interest rate to the historic high of 4.25%. Other surprising turn made by the ECB was acting as the lender of last resort to those European banks in trouble, being very generous in issuing the loans and allowing premium profits. Some of the rules set by ECB were also been broken, when the ECB inject money to the governments under stress, indirectly through the purchase of government bonds in secondary market.

There are two most significant defaults in designing the European Central Bank, which included the monetarist obsession of ECB with consumer price inflation, and the completely undemocratic, unaccountable status, and non-transparent operations in the institutional arrangement of the European Union (EU). By looking at the increase of interest rate from 4% to 4.25% in July 2008, the ECB has clearly shown its misunderstanding on the dimension and depth of the financial crisis until summer 2008. It had strictly followed what theory teaches about the principle of inflation targeting. After the collapse of Lehman Brothers later, the ECB only come to the sense and understood that an exceptional crisis existed and began to change its policies. As the results, it decreases the interest rate gradually until a historic low of 1% in May 2009.

The failure of the ECB in crisis management has transformed the financial crisis into a sovereign debt crisis. Under such crisis, Greece, Portugal, Ireland, Spain and Cyprus were threaten and experienced near default. The chain of this crisis will also put the future of the common currency of 17 Euro-zone countries: Euro at stake, as well as the future of the central banks adopting this currency.

In the case of Greece, the traditional receipts of structural adjustment with agonizing austerity programs for the ordinary people were proven to be useless. Even though future growth perspectives have been sacrificed by the spectacular reductions made on public spending, the debt burden in Euro-zone is still increasing. Till now, the crisis is still spreading and not yet been resolved. From the lessons, the ECB has to find new and innovative ways in dealing with the crisis management, and traditional business of the ECB has to be aborted. Failing to do so will make the collapse of the Euro-zone inevitable.

Nonetheless, the ECB cannot be blamed entirely for causing the crisis but the other banks in Euro-zone countries were also at fault. The German banks were first came into problems when the banks were flush with capital, and began to lend these excess capital to other banks in the rest of the Euro-zone. Such lending activities were not taking into the minimum precaution of ensuring the recoverability of those loans. The borrower banks were then used these funds to finance private sectors investors without considered the financial viability of the investments. Excessive lending to public during the periods has made immense profits for banks, but when the mortgage bubble burst the entire financial systems collapsed. Consequences of this had caused those banks to request for bailout.

In short, the Euro crisis was triggered by the intensification of global financial crisis in 2008. However, the European Central Bank was to be blamed for causing the crisis due to its failure in crisis management and implementation of monetary policies. Nonetheless, other banks had contributed partially to the crisis through excessive and uncontrolled public lending activities. The impact of these banks failure and how they resolve the crisis will be discussed in later sections.

4.0 IMPACTS OF EURO CRISIS

In the year 2008, one of the worst financial crises unprecedentedly hit the global economy in human history which was triggered by the sub-prime crisis happened in the United States. The crisis has made an influential impact in the world order. Several countries such as Greece, Spain, Portugal, Italy and Ireland have the unsustainably huge fiscal deficits and significant debt-to-GDP ratios. The Euro-zone crisis has hit the global economy before the world could recover completely. No one really knows how long the crisis will take and the damage it will do to global economies continually. It would have a great impact on the global economy as Europe is a major trade partner with China and North America. The Euro-zone would get into a great depression as governments cut their budgets and reduce their spending which would lead to the unemployment (Gupta, 2012).

On that period of time, countries were facing high-leverage in every phase. There was not only one problem Europe facing but three which are all self-perpetuating on one another. First, the problem is the banking system as many banks had bad loans on their books which result in a collapsed real estate markets. That’s not all, countries such as Germany and France which has a stronger banking system owns lot of bonds from struggling European countries such as Spain, Greece, and Ireland.

The second problem was some governments are not affordable to pay their bonds’ interest any longer as they are too indebted such as Italy, Spain and Greece. These governments were not certainty about how to solve the problem and their finances as the cost of borrowing was high. Third, the European economy was in a recession even decidedly not booming as compared to no growth at first quarter, the seventeen countries in Euro-zone had GDP contracted by 0.2% in the second quarter of 2012 announced in early September from the office of statistics for the European Union, Eurostat (Steiner, 2012).

In late March 2012, a 14.5 billion Euros of bond redemptions fall made Greece risk in bankruptcy. Greece has under pressures growingly to secure an agreement with its private creditors to accept voluntary losses on their holdings of Greek bonds. After Greece’s deals with creditors broke down, analysts have warned that Greece’s default was on the cards. In the case, Greece could fall apart without a bond swap from private sector involving a voluntary write-down even with a 130 billion Euro second international bail-out (Gupta, 2012).

Furthermore, the Euro-zone debt crisis and recession has a significant impact on American stock market and exports. There are consequences for American financial system and global trade as well. It is because exports are major source of the American economy. If Europe breakdown, the fewer exports to Europe will hurt American manufacturing. United States has an indirect effect from the Europe prolonged recession result in the term of unemployment problems (Steiner, 2012).

Nonetheless, developing countries were affected by the European debt crisis as experience cuts in aid and stalled growth. A financial contagion came out that European banks has the problem on balance sheet which result in the investor confidence reducing and stock markets volatile in developing world. The effects prompt investments cancelled or delayed and credit lines cut. European governments introduced austerity packages which lead to aid spending cuts and weaken the demand for developing country exports.

In addition, fewer remittances transferred into the developing countries as high unemployment rates occurred in the developed countries due to the weak economic activity. The weak Euro diminished purchasing power on remittances and put further pressure on developing countries’ dollar-based exports (Massa, 2011).

Moreover, China represented the biggest trading partner with developed countries in 2010. The economy in China slowed down, its overheated property market was weakening and exports are falling. Some countries heavily dependent on European economies most at risk as own a limited fiscal policy room such as Uganda and Tanzania. Kenya and Mozambique were in a similar position because they were particularly vulnerable given their financial links, narrow fiscal policy room and strong trade with Europe (Massa, 2011). There are not only 322 million people in Euro-zone which depend on their currency, the 150 million people whose currencies are pegged to value the Euro in African countries. These African countries will see the value of currency crash if the Euro-zone fragments and the value of the Euro collapse.

5.0 SOLUTIONS OF EURO CRISIS

For the Euro crisis, Euro Central Bank (ECB) might play a larger role in battling with solving problems through the reaction for the latest signals. There are many types of solution that provide by the ECB when the Euro economy is extremely weak in the moment. For example, the additional money supply is not used in the transactions, but it is saved mainly in central bank accounts. In such a situation, there is a little danger of higher price increases due to the bond purchases. In addition, this would have also given a sufficient time to sell bonds again and thus mop up liquidity by the ECB, should the crisis submerge and the Euro area economy recovered. (Maylis & Henri, 2012)

During a banking panic, the main purpose of a deposit guarantee fund is to reduce the risk of a massive withdrawal of deposits. The European financed this fund through contributions by the European banks which guaranteed by the fund. Such a fund among the risk of contagion would have little credibility during the banking crisis. Additionally, the guarantee of deposits would continue to depend on the States and on the policy of Euro Stability Mechanism (ESM) which would have to provide support funds, ultimately by requiring additional contributions from the banks in order to solve the banking crisis. (Dullien, 2012)

The ESM which is an international organization located in Luxembourg to provide financial assistance for members of the Euro-zone in financial difficulty. It was established on 27th September 2012 and issued by the ECB. A much cleaner solution would thus be to grant a banking license to the ESM and controlled by democratically elected national governments for setting conditions under which it guarantees low interest rates to crisis countries. Such low interest rates could easily be enforced if the firepower of the ESM were increased by allowing it to borrow from the ECB against its holdings of government bonds. (Dullien, 2012)

On the other hand, the excessive public spending or insufficient taxation was element which contributed to the current crisis in some of the countries of the Euro area such as Greece and to a certain extent Italy. ECB decided conditions in terms of fiscal and structural reforms to the Italian government before it started buying Italian bonds. It has been given independence for a closely defined field of maintaining price stability. Giving it the additional power to control economic and fiscal policy across Europe would turn the democratic principle on its head. (Maylis & Henri, 2012)

A banking union can help break the correlation between a sovereign debt crisis and a banking crisis. In this case, ECB has done its part by lowering interest rates and providing cheap loans of more than one trillion Euros to maintain money flows between European banks. The ECB also calmed financial markets by announcing free unlimited support for all Euro-zone countries involved in a sovereign state prevent program from European Financial Stability Facility (EFSF) and ESM through some yield lowering Outright Monetary Transactions (OMT) On 6th September 2012. (Stephen, 2012)

Moreover, most of the economists agree that renewed economic growth is essential for saving the Euro. Currently, Euro-zone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. The most preferred solution to recover competitiveness in the Euro-zone which is “internal deflation.” In practical terms, it means simplicity in the form of less government spending, cuts in pensions and wages, and higher taxes. The economic pain supposedly puts downward pressure on wages and prices thus making a country’s exports cheaper relative to its healthier neighbors. (Aris, 2012)

The Euro Commission has developed a common framework for resolving the banking crisis by adopting the proposal of Michael Barrier which involve 3 components. Firstly, banks have required to set up will for improving prevention as so to provide recovery strategies and even disposal plans in case of a serious crisis. Secondary, the European banking authorities is given the power to get involved in implementing the recovery plans and changing the leadership of a bank if it fails to meet the capital requirements. Thirdly, if a bank fails, the national governments must take control of the establishment and use resolution tools such as seizure like the creation of a extinction bank, or “bad” bank or an internal urgent. (Carol, 2012)

Additionally, the Euro Commission also published the plan to present legislative proposals aimed by improving provisions in the light of experience, especially of crisis, providing it with more effective enforcement instruments and complementing with provisions on national fiscal frameworks. National budgetary framework can be understood as the set of elements with the basis of national fiscal governance which includes public accounting systems, statistics, forecasting practices, numerical fiscal rules, independent national budget offices, budgetary procedures governing all stages of the budget process and medium term budgetary frameworks in particular, and fiscal relations across government layers. (Carol, 2012)

Besides that, Germany central bank provided a more pessimistic assessment of the Euro-zone’s crisis than the European central bank, saying the warning of negative side effects from record low official interest rates and the threat to financial stability is as great as it was a year ago. From the annual report of 2011 to 2012, the official data show on growth in the 17 European Union countries that use the Euro, which could confirm that the region is in recession. In the report, they provided another example of how best the Bundesbank and Europe’s central bank fight it and how the diverged in their views of the state of the crisis.

The risks to the German financial system are no lower in 2012 than they were in 2011. The European sovereign debt crisis actually came to a head at several points this year. Spain and Italy is the two major economies have been drawn into the crisis. Monetary and fiscal policy measures on a massive scale were therefore needed to stabilise the financial system. But monetary policy cannot eliminate the causes of the crisis, “this has entailed an ever greater transfer of risk to the public sector and has caused the low-interest rate environment to become entrenched” (Bundesbank Executive Board Member Dr Andreas Dombret).

However, this is a good news regarding German banks because they have lower down their leverage ratios, increased their tier 1 capital ratios and increasingly tapped more stable sources of funding such as customer deposits. In addition, German banks have significantly reduced their claims on the countries hit by the sovereign debt crisis. The German banking system still had substantial exposures to Italy and Spain alone in mid-2012 of which just under €59 billion were to government debtors of both countries. “A substantial escalation of the sovereign debt crisis would, of course, have an adverse impact on the German financial system too (Ms Lautenschläger).” The Bundesbank also sees other structural developments that will weigh on banks profitability in the medium term, including a looming rise in competition for customer deposits and lending business and regulatory costs.

Although the countries like Spain suffer a severe credit squeeze, money has transferred into Germany because it is perceived as a haven from European turmoil. That has pushed down borrowing costs for German consumers and business, producing some worrying consequences, including a sharp rise in real estate prices in urban areas, the Bundesbank warned. A member of the Bundesbank’s executive board said it was too early to speculate about a real estate bubble. But at a news conference, he added: “The experiences of other countries show that precisely such an environment of low interest rates and high liquidity can encourage exaggerations on the real estate markets.” (Andreas Dombret).

The current crisis that happens is largely a banking crisis. European banks had served financial bubbles and housing bubbles especially in Spain and Ireland, and they had invested in hedge funds and mutual funds in the United States. The Member states came to their rescue, which was particularly costly for Germany, the UK, Spain and above all Ireland after major losses during the crisis of 2007-2010. The sovereign debt that they hold has become a risky asset and the dominant debt crisis in the Euro-zone has compounded their despairs. The problem of regulating the banks has been raised at the international level new Basel III standards, in the United States Volkers rule and Dodd-Frank law and in Britain Vickers report.

The worries about the reliability of Europe’s banks surfaced yet again in June 2012. The measures taken since 2008 to stabilize the financial system have proved insufficient. In response to these dangers, the proposal for a European ba