The Sovereign Debt crisis
An analysis of the main facts that have characterized the Sovereign Debt crisis in Europe.
The sovereign debt crisis (part 1)
In the wake of the subprime crisis, many European banks experienced severe difficulties and were bailed out by public intervention. These interventions amplified the structural imbalances in public finance in the most vulnerable countries.
On the eve of the sovereign debt crisis, the countries of the Eurozone showed significant differences in public finance conditions and growth rates. The so-called core countries, such as Germany, were characterized by low levels of public debt and a more solid economic activity, while the so-called GIPSI countries (Greece, Ireland, Portugal, Spain, and Italy) were characterized by greater vulnerability due to unsustainable public debt dynamics, due to the debt accumulated over the years, the uncontrolled increase in the deficit and low growth rates of GDP and the cost of rescue operations for banks in crisis.
Despite these differences, in 2010 the Eurozone benefited from the economic recovery that affected the main advanced economies, albeit with heterogeneous rhythms and modes between countries and geographical areas. The Greek public accounts bankruptcy, announced in October 2009, interrupted the economic recovery and caused a new hardening of the perception of credit risk by international investors that involved sovereign debt securities. The quotations of government bonds of many countries, due to the widening of the spreads, have suffered a collapse, drastically reducing the market value of the trading book held by the major banks.
The major rating agencies have lowered the credit rating of several European countries and, consequently, of several banks based in those countries or with significant exposures in public securities of countries in difficulty, amplifying the turbulence on the markets.
The banking securities sector, due to its deep ties with the public sector, proved to be the most exposed to contagion, so as to record, in 2011, a decline higher than that of the other sectors in all advanced economies. The effects of the crisis then found in the dynamics related to bank credit concessions a fast transmission channel to the real economy: in fact, strong signs of tightening of credit granting standards by the banking system have been recorded since the beginning of 2009, both in Europe and in the US.
The data showed evidence of both the so-called strong rationing, consisting of a real refusal to grant new financing, and the so-called weak rationing, consisting of the granting of financing at such onerous conditions as to induce the debtor to refuse the credit offer. Given that banks typically hold significant shares of public securities in their portfolios for investment reasons and as a primary source of guarantee in the forward markets, the tensions on the secondary market for government bonds have generated, on the one hand, a deterioration in the quality of bank assets and, on the other hand, an increase in the cost of raising funds. The credit rating of banks is also determined by the implicit public guarantee that suffers from the credit standing of the home state.
For the countries involved, the increase in interest rates has increased the burden of debt service, making it more difficult to sustain in the long term and reducing the possibility of using fiscal stimulus to revive the economy in recession. The dynamics of the government bond market has triggered a vicious circle between sovereign risk and bank crisis, which, having massively increased their trading book, have found themselves exposed to market risk, resulting in the reduction of the fair value of the securities held and therefore losses that have reduced the capital.
The increase in market risk has added to the growing credit risk due to the negative recessionary trend in the economy. At the beginning of 2008, the yields of 10-year government bonds of the member countries of the Eurozone were aligned, with the highest difference between the 4.4% of the Italian BTP and the Greek Bond and the 4% of the German Bund, equal to 40 basis points.
In the course of 2009 and 2010, significant differences in interest rates between the different countries began to manifest themselves. In January 2010, the spread between the Greek rate (6%) and the German one (3.3%) was equal to 2.7%, or 270 basis points.
The sovereign debt crisis (part 2)
The sovereign debt crisis in the eurozone was finally unleashed in 2011 when the interest rates of Greece and Ireland reached unsustainable levels, speculation spread to Portugal and subsequently attacked Spain and Italy. The three states, in the presence of very high interest rates, found themselves unable to finance their deficits and to renew the maturing securities by resorting to the financial markets. They were forced to ask for the joint intervention of the International Monetary Fund, the European Commission and the ECB, which imposed very heavy conditions and drastic measures to bring the public budget into balance.
In Greece and Portugal, the heavy restrictive fiscal policy, based on tax increases and cuts in public spending, prolonged the economic crisis to 2012 and 2013 with the fall of GDP and a sharp increase in unemployment. Ireland, on the other hand, showed a greater capacity to react and anticipated the recovery to 2011. In December 2013, the country left the international aid program and returned to turning to the financial markets for its own needs.
Italy and Spain did not have to declare default and resort to loans from the International Monetary Fund, but they nevertheless had to implement a series of restrictive fiscal policies that led them to a new recession in the 2012–2013 biennium, after the brief recovery of 2010 and 2011.
The attack on the Italian public debt began in the summer of 2011 with strong sales of securities, especially from abroad. In November 2011, the interest rate on BTPs exceeded 7%, a threshold beyond which it is believed that a state is unlikely to be able to meet its obligations to pay interest and repay the debt. The severity of the crisis experienced by the country in that circumstance was demonstrated by the resignation of the Berlusconi government and the advent of the technical government of Mario Monti, called by the President of the Republic to the task of launching a drastic austerity policy aimed at bringing the budget deficit of the state within the limit sanctioned by the Maastricht Treaty of 3%.
The sovereign debt crisis in the eurozone has been gradually easing in the second half of 2012 and by the end of 2013 it appeared to be largely overcome, although not completely resolved. In 2013, the interest rates of Italy, Spain and Ireland returned to the starting levels of 2008. Those of France and Germany, on the other hand, remained at much lower levels, even negative in real terms, taking inflation into account according to the Fisher formula. This occurred to demonstrate the fact that international investors considered the securities of those countries as safe haven assets. The rates of Portugal and Greece, although they had fallen sharply from the peaks reached at the height of the crisis, were still very high and, in the case of Greece, out of the market. The situation at the end of 2013 was characterized by spreads that were still quite high and by a strong state of uncertainty about the future prospects of the eurozone.
The sovereign debt crisis (pt.3)
The sovereign debt crisis has highlighted how a rift has arisen in the euro area between financially strong countries and weak countries or countries considered as such by the international community. Among the former we can place Germany and other central-northern European countries; among the latter, the so-called GIPSI and other countries belonging to the southern and eastern belts of the Eurozone. France occupies an intermediate position, closer to the first group. Weak countries run the risk of entering a vicious circle. The increase in interest rates increases government spending and forces it into excessively restrictive economic manoeuvres; induces banks to ration credit to the private sector by realizing a credit crunch condition; depresses investment; it damages exports as it increases production costs and lowers the competitiveness of businesses; it decreases national income and tax revenues; as a result, it makes the parameters of Maastricht worse and forces new restrictive maneuvers.
Strong countries benefit symmetrically from the regime of low interest rates. The cause of the weakness of European countries, such as Italy and Greece, lies in the compliant fiscal policy of governments that have allowed public debt to rise. But this element could not explain the crisis in Spain and Ireland which have always had, until the 2008–2009 recession, particularly low public debts.
Outside Europe, the USA has a public debt of more than 100% of GDP, Japan has a debt-to-GDP ratio of more than 200%. In these two countries the rates should be very high and instead are among the lowest in the world. The sovereign debt crisis of some Eurozone economies may originate from two other causes: the excessive public and private external debt that these economies have begun to accumulate since the early 1990s; the failed completion of the European integration process and the insufficient policy to defend the sovereign debts of the EMU member states.
Greece, Portugal, Spain and Ireland have run large current account deficits since joining EMU. These countries have increasingly borrowed from abroad to pay for excess imports. The balance for Italy shows a negative sign starting from the first years of the new century, but to a lesser extent than that of the other GIPSI. At the beginning of the crisis, a large part of Italy’s external debt was concentrated in the public sector; in the summer of 2011, when the speculative attack on Italian sovereign debt began, about 60% of the latter was in foreign hands; in the course of a few months, following a real sales campaign, the foreign share dropped to around 40%.
Symmetrically, some strong countries such as Germany, the Netherlands, Austria and Finland have recorded, after entering the EMU, large and lasting surpluses in the current account of their balance, accumulating foreign credits and this explains the solidity of the government bonds of those countries. The countries whose public debt rates reached the highest average values in the three-year period 2010–2012 are those that had accumulated the most external debt since the mid-1990s.
EU rules and institutions have proven to be very suitable for some countries with advanced political, social and economic structures, but problematic for others. The second cause of the sovereign debt crisis can be traced back to the lack of a real defense shield for national public securities and the related interest rates by the European institutions. In a state with full monetary sovereignty and standard fiscal policy tools, the competent authorities are able to influence the main economic variables on the basis of the objectives they set for themselves. In an economic system with flexible exchange rates, as the EMU should be considered as a whole, there should be a federal budget with its own revenues and expenditures and a Treasury Ministry authorized to finance any deficits with the issue of federal public debt securities.
The ECB would then have the possibility of intervening on the open market by buying or selling these securities, influencing the interest rate and, through it, the other variables of the economic system: investments, exchange rates, exports and GDP, employment, prices. The problem with EMU is that there is no federal public budget: EU expenditure amounts to about 1% of the total GDP of the countries in the area and is entirely financed by contributions from the member states. Deficits are not permitted, nor is the creation of a European public debt. There is not even a federal interest rate on which the ECB can intervene.
There are only public debts of individual member states on which the ECB can intervene in a very limited way, not only due to the constraints imposed by the Bank’s Statute and by the various Treaties from Maastricht onwards, but also because there is political opposition to such interventions from part of some States, in particular Germany.
This hostility to an interventionist monetary policy is dictated by the fear that individual states, faced with the possibility of support from the central bank, are induced to borrow beyond the limits of the Maastricht Treaty.
The lack of federal public expenditure that reaches levels similar to those of other large states prevents the EMU from carrying out a policy of cohesion and support for the weaker regions and countries of the Union; moreover, the limits placed on the action of the ECB prevent it from carrying out an action of real contrast to the attacks against the public debts of the individual states.
