Impacts of the European Debt Crisis

Introduction

Small and developing countries have triggered a wide impact in financial markets. These countries are heavily indebted because they borrow many loans, both internally and externally to finance their development policies. This creates more liabilities to the small developing countries because they must repay the debts with additional interests. Repaying the debts becomes a heavy burden for these countries, and this creates a vicious circle of poverty (Klare & Thomas, 1994).

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With the growth of economic integration, developed countries have established trade partnerships with developing countries. These trade treaties have caused poverty spillover from the developing countries to the developing countries. It is a fact that much international trade has allowed countries to remove barriers of movement within borders. This has been created to facilitate the trade of goods and services. There has been an increasing need for developed countries to support developing countries. This has caused the developing countries to suffer from poor economic policies of the developing countries. In this situation, when developing countries suffer from an economic crisis, the developed countries are affected because they exchange goods and services. This results in the importation of inflation by the developed countries. Economic integration has also encouraged both developed and developing countries to develop economic policies together. This has caused the developed countries to inherit poor economic policies from the developing countries (Klare & Thomas, 1994).

Spillover effects of global trade also cause financial crises. Small and developing countries trade with other countries globally, with the import and export of goods and services, it is has become inevitable to import goods at high prices. International trade has been the major cause of the international financial crisis. Therefore, small and developing countries have caused financial crises in the global economies through trade with other countries. In this paper, the author discusses how the European Sovereign debt crisis affected other larger economies. The debt crisis emanated from small economies and spread to other countries globally (Klare & Thomas, 1994).

Case Study of European Sovereign Debt Crisis

The European Sovereign debt crisis refers to a time when European countries experienced failure of financial institutions, increasing government debt and an increased bond yield. This situation started to be experienced in 2008 when the banking system of Iceland collapsed, and this affected other countries such as Greece, Ireland and Portugal. During the crisis, many investors lost confidence in the businesses and economies in European region. Greece was the worst-hit country by the crisis. The situation was controlled and regulated by financial guarantees provided by some European countries. The intervention by the International Monetary Fund (IMF) was of great importance when regulating the debt crisis in the European zone. The IMF provided bailout funds to the affected countries, and this served as a measure to reduce public debt (Wignall & Slovik, 2011).

Causes of the debt crisis in the European Union

Several factors triggered the debt crisis to escalate beyond control.The European sovereign debt had an impact locally and internationally. This was caused by the fact that capital markets in the world are interrelated and countries interact in transacting capital goods and services. International trade facilitated the widespread debt crisis in other countries. Through trade, countries involved import or export products with the affected countries. The inflation rates of the affected countries cause the products exported to have high prices. This causes the importing countries to sell the products at high prices to cover up the cost. This leads to inflation in the other countries (Silvia, J. (2011).

According to Obstfeld and Taylor (2011), countries have liberalized capital markets, and this has increased foreign investment in many countries. International trade agreements have encouraged governments to remove barriers to trade so that many investors in the global markets can exchange their products. The capital market has been increasing with the opening up of trade boundaries in many countries. However, the free trade in capital markets caused the debt crisis to increase at a higher rate. Capital markets also cause inflation to spread among the transacting countries. In the European Union, investors bought bonds and other capital assets at high prices hoping that the prices would reduce shortly. Foreign investors would bring in more money to the EU regions. With the experience of debt crisis, the investors suffered losses due to the poor performance of the EU economies. This affected the economies of the home countries of the investors (Batten, Szilagyi & Szilagyi, 2011).

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In Ireland and Spain, the banking institutions were blamed for the crisis. The banks offered many loans to subprime borrowers in the housing and property industry. This led to a boom and this caused a widespread financial crisis when the people who had borrowed the debts started to default. A fiscal problem was experienced in the economy, and this caused a high inflation rate to be experienced. The problems encountered by the banking industry were experienced by other industries in the economy due to spillover effects. Other countries in the European region trading with Ireland and Spain experienced the same problem because they had to import and export products at higher prices. With the increase in inflation rates, prices and other fiscal measures, the GDP of the countries affected declined. The European countries started to experience the debt crisis in the year 2009, but the situation worsened in 2010. Consolidating the budget for the countries involved became difficult (Elliott, Stewart & Hooper, 2011).

Greece was the worst hit by the European sovereign debt crisis. The country suffered the highest amount of sovereign credit default swaps compared to any other countries in the region. From the diagram below, it is evident that the curve representing the economy of Greece is the tallest.

Sovereign credit default swaps

After realizing the problem facing European Union, the member countries established the Maastricht Treaty. The members resolved to limit the number of deficit expenditures and levels of debts for each member country. Greece and Italy evaded the rules and used complicated structures to sustain their currencies and credit derivatives. However, better financial reforms were required to improve the performance of the economies of the countries in the EU (Harrington & Moses, 2011).

The different opinions adopted by the various countries were almost to collapse the EU. According to Elliott, Stewart and Hooper (2011), “reports emerging from Brussels said that Germany and France had begun preliminary talks on a break-up of the Eurozone, amid fears that Italy would be too big to rescue” (p.1). Italy started to take some precautions to rescue its economy from collapsing. The Prime Minister, Silvio Berlusconi, announced that he would step down as a measure to control the economy of the country. This was proposed to be a strategy to win investor confidence and to increase foreign investment (Elliott, Stewart & Hooper, 2011).

The government of Greece resolved to apply different strategies to solve the financial problems. The prime minister had been blamed for making poor decisions. The need for the prime to resign could not solve the problems the country was facing (Afonso, Furceri & Gomes, 2011). Prudent fiscal and monetary decisions were required to salvage the economy of the country. Winning investors’ confidence was important because they would bring more currencies to the country. Eliminating the prime minister worsened the situation because the investors withdrew their investments from the country, and this led to a bad economic situation. The decision did not only affect the country’s economic and financial performance, but also caused other countries to suffer. Most of the countries which traded with Greece were affected negatively because the performance of their capital markets was reduced (Elliott, Stewart & Hooper, 2011).

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Greece and other Eurozone countries experienced bankruptcy and were provided US$146 billion by IMF as a bailout. This was aimed at improving the fiscal deficit that the countries were experiencing. However, the bailout had a negative effect on the countries because they were supposed to cut down their expenditure. This means that they had to carry out mass retrenchment in the public sector. Taxes had to fix higher taxes. In addition, wages were frozen and other fiscal measures were applied to reduce the government expenditure. The conditions put in place by the IMF would affect the ability of the Greece government to access more bailout money (Nelson, Belkin & Mix, 2011).

Budget surplus or deficit

From the diagram above, it is evident that the crisis has affected the GDP of the countries in the EU. All countries had their GDP decreasing at a very high rate, with Ireland experiencing the highest rate of decline. The GDP in Ireland dropped from a high of 5% in 2000 to as low as -33% in 2010. Other countries also experienced declining GDP but a low rate. Greece was also adversely affected by the crisis compared to other countries in the region (Liu, 2011).

Long-term Interest Rates

It is evident from the above diagram that the interest rates in the European Union have been increasing. This has affected the economies of the countries in the region. Greece is worst affected because it indicates the highest increase in the interest rates. The interest rates of Greece skyrocketed as high as 18%, and this is an indication that the country has been the worst hit. The other countries had maximum interest rates of 13%. However, Ireland is the second affected in the region (Liu, 2011).

The capital market was affected by the sovereign debt crisis, and this reduced investors’ confidence. It was not normal for developed countries to experience a debt crisis, and investors had confidence in the EU capital markets before the crisis occurred. A slower response to government bonds was experienced during the debt crisis because the securities had lower ratings. The announcements made by financial agencies negatively affected the performance of capital markets in the European Union (Arezki, Candelon & Amadou, 2011).

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The impact of the European debt crisis on Germany

Germany has been affected by the European debt crisis. The market has been turbulent and the country has been experiencing challenges in exporting its products to some of its trade partners in the European region. In addition, the European Central Bank has increased its lending rate to control the inflation effects which have been experienced in the economy due to a spillover effect from the European trade partners. Germany has established strategies to salvage the euro from collapse. Angela Merkel, the Chancellor of Germany has complained that the European Central Bank has barred the country from bailing out the nations in the region. He also opined that the ECB has set up rules to prevent Germany from containing the crisis. The Germans fear that the government may exhaust its gold reserves to contain the crisis (Faiola & Birnbaum, 2011).

The effect of the crisis on the Euro currency

The European debt crisis has affected the euro currency, and this has placed the need to have a rescue package to make the currency operational in the future. According to Saraiva and Theunissen (2011), “the euro fell to a three-week low against the dollar and slid versus the yen as speculation the Greek debt crisis is deteriorating damped demand for the region’s assets” (p. 1). The Euro continues to fall in value as the crisis worsens. This has created the need for the emergency fund for the region to be doubled to salvage the currency. The currency dropped by 0.6 percent in June 2011 to a value of $1.4094. The euro continued to fall in value to as low as $1.4074, which is the lowest level ever since the currency was introduced in the region. On the other hand, the Euro dropped to 0.7 percent during the same month to 113.92 Yen. The Euro dropped by 1.1 percent as compared to 1.19567 Swiss francs during the same period. It also fell by 0.1 percent when compared to 80.87 Yen in the month of July (Saraiva & Theunissen, 2011). The dollar index indicated an increase of 0.5 percent and reached a value of 75.983. This was the highest level since May, 2011. Many investors have lost their confidence of investors on the strength of the Euro currency (Saraiva & Theunissen (2011).

Conclusion

The European sovereign debt crisis has affected all the countries in the region and globally. However, Greece and Italy have been affected to a larger extent. The capital markets in these two countries were affected such that investors lost their confidence and withdrew their investments. In the EU, many countries had tried to conserve the situation spillover effects from the international trade caused poor performance in both economic and financial markets. This has resulted in inflation, increasing interest rates, the poor performance of the country’s GDP and high government expenditure. Investors’ confidence has declined because the economies are not performing well. In addition, the bond prices have been affected by the declining economies. Spillover effects have been experienced in Latin America and other global economies. To solve this problem, IMF has issued bailout to the affected countries. This has helped reduce the adverse economic effects of the crisis.

List of references

Afonso, A., Furceri, D. & Gomes, P., 2011. Sovereign credit ratings and financial markets linkages application to European data. European Central Bank Euro system.

Arezki, R., Candelon, B. & Amadou, N. R., 2011. Sovereign Rating News and Financial Markets Spillovers: Evidence from the European Debt Crisis, IMF Working Paper.

Batten, J. A., Szilagyi, P. G. & Szilagyi, P. G., 2011. The Impact of the Global Financial Crisis on Emerging Financial Markets. Bingley: Emerald Group Publishing.

Faiola, A. & Birnbaum,M. 2011, European financial crisis: A growing gap between France and Germany, The Washington Post.

Harrington, S. D. & Moses, A., 2011. Credit Swap Disclosure Obscures True Financial Risk. Blomberg.

Liu, H. C., 2011. The Eurozone Sovereign Debt Crisis – Part I. The Global Realm.

Nelson, R. M., Belkin, P., & Mix, D. E., 2011. Greece’s Debt Crisis: Overview, Policy Responses, and Implications. Congressional Research Service.

Obstfeld, M. & Taylor, A. M., 2011. Global capital markets: integration, crisis, and growth. New York: Cambridge University Press.

Silvia, J. 2011. Dynamic Economic Decision Making: Strategies for Financial Risk, Capital Markets, and Monetary Policy. New Jersey: John Wiley & Sons.

Elliott, L., Stewart, H. & Hooper, J., 2011. European debt crisis spiralling out of control. The Guardian.

Klare, M. & Thomas, D. (1994). World Security: Challenges for a New Century. New York: St. Martin’s Press, 1994), pp. 332-355.

Saraiva, C. & Theunissen, G., 2011, Euro Declines to Three-Week Low on Concern Europe Debt Crisis Is Worsening. Web.

Wignall, A. B. & Slovik, P., 2011. A Market Perspective on the European Sovereign Debt and Banking Crisis, OECD Journal, 2.

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