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The Spread of the European Sovereign Debt Crisis
By Lia Menndez
April 2012
In this section of the E-book, we look at how the debt crisis
that began in Greece in 2010
spread to other countries in the Eurozone. Investors questioned
Greeces ability to pay its debts
and soon doubted other countries abilities to pay their debts.
Investors believed that these
countries shared similar financial features with Greece,
especially high deficits and debts.
Part A first discusses how a sovereign debt crisis begins. It
considers how high debt and
low economic growth can create a financial crisis when a country
cannot afford to pay its debt,
as was the case with Greece. It also describes the loss of
investor confidence that arises when
investors fear taking losses because a country lacks the funds
to pay its debt.
Part B explains how the sovereign debt crisis that began in
Greece migrated to other
countries in the Eurozone as investors also lost confidence in
these countries. Economists agree
that the European sovereign debt crisis has multiple,
inter-related causes. Although investors
believed that some countries in the Eurozone (e.g., Greece)
posed risks of financial loss, other
affected countries (e.g., Ireland, Portugal, Spain, and Italy)
were financially healthy by
comparison. Nonetheless, the crisis has affected these economies
as well. Housing-market and
banking crises greatly impacted Ireland and Spain causing
government deficits to rise when their
governments intervened to rescue their banking sectors that were
heavily invested in failing
housing-markets. In Portugal and Italy, high public debts
adversely affected each countrys
financial health and ability to pay investors.
Part C concludes by describing the impact the financial crisis
might have on other
countries in the Eurozone, especially France, if investors lose
confidence and stop investing in
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them. It summarizes investors concern that the financial crisis
is far from over and will continue
to spread to other vulnerable economies. The next section of
this part of the E-Book will discuss
the measures the EU and Eurozone countries have taken to slow
the spread of the crisis.
A. How Does a Sovereign Debt Crisis Begin?
To finance governmental operations, countries often sell bonds.
When a bond matures,
the country must pay bondholders the face value of the bond,
plus interest. If the countrys tax
revenues or cash reserves are low, the country may have to pay
investors more than it can afford.
A country with low economic growth (like Greece) will have
greater difficulty raising funds to
make bond payments as government tax revenues decline along with
businesses and
individuals income. Moreover, during a financial crisis,
investors may demand higher interest
rates on bonds to guard against the risk of loss that they would
realize if a country defaults on its
debt. If investors lose confidence in a countrys ability to pay
its debt altogether, they will stop
purchasing that countrys bonds.
If interest rates reach levels so high that a country cannot
repay its debt or afford to
borrow more money to pay existing debt, a countrys options
include renegotiating its debt,
monetizing its debt (financing debt by generating more money),
or defaulting on its debt.
Renegotiating sovereign debt involves restructuring and reducing
a countrys debt. Bondholders,
for example, may have to take haircuts on the value of their
bondsthat is, the government
may unilaterally reduce the face value of the bond, and
consequently, the amount it must pay
bondholders decreases. As discussed in the following section of
the E-Book, Greece recently
used this option to lower its debt burden. A country can
monetize sovereign debt by printing
more currency. A larger supply of money leads to increased
spending, stimulating economic
growth and allowing a country to pay its debt with the increased
government revenues. Countries
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can also default on their debts (refuse to repay), which would
result in losses for investors and
make it impossible for that country to borrow money by issuing
bonds for a substantial period of
time until investors no longer fear that the country will
default again.
Countries in a financial crisis can also devalue their currency,
making their exports
cheaper and, therefore, more attractive globally. The government
can use the increased revenue
from exports to reduce the size of its deficit and debt (the
term deficit refers to the amount that
government spending exceeds revenue in a given year, while debt
is the accumulated total of
annual deficits). Individual Eurozone countries, however, do not
have the option of devaluing
their currency because they share a common currency and monetary
policy as described in the
previous section.
1. Excessive Spending and a Lack of Competitiveness Led to Low
Economic Growth
in Greece and Increased Debt
In 1979, Greeces government began implementing a new fiscal
policy aimed at
promoting economic growth through increased household
consumption. Consumption was
financed through heavy consumer borrowing. The government also
borrowed to increase its
spending to stimulate growth. This pattern of borrowing
continued when Greece joined the EU in
1981. The government benefitted from access to EU funds for
agricultural subsidies and
infrastructure financing. The government also obtained other
international loans that it used in
ineffective ways that did not improve economic performance.
Instead, government officials often
used money for the benefit of political allies. They also used
funds to expand social welfare
programs, such as providing pensions for workers to retire at
age fifty-eight. Although social
welfare can promote economic growth by increasing consumers
disposable income, in Greeces
case, it was so excessive (social welfare spending counted for
more than half of all government
spending) that it added to the debt burden.
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Greeces economy has also suffered because of a lack of
competitiveness. It has failed to
attract investors and had low levels of foreign direct
investment because of low entrepreneurship,
a small manufacturing sector, and government corruption.
Excessive government regulations and
bureaucracy made Greece the worst country in the EU to do
business. Greeces competitiveness
decreased after its entry into the EMU when it had to compete
with Eastern European countries
that exported goods at lower prices.
2. High Debt and Low Economic Growth in Greece Spurred the
Beginning of the
European Sovereign Debt Crisis
Despite its history of excessive spending, between 1997 and
2007, Greece had an average
of 4% GDP growth annually (almost twice the EU average). Greeces
significant economic
growth resulted from its membership in the EU and its adoption
of the euro in January 2002. It
continued to enjoy access to EU and international funds at low
interest rates because Eurozone
member countries were considered financially and politically
stable, regardless of their actual,
individual financial circumstances. Greeces economic growth,
however, masked some of the
problems with the Greek economy that contributed to the
financial crisis in 2010. In 2008, the
global financial crisis negatively affected the Greek economy
and growth decreased to 2% of
GDP. By 2009, Greece was in the midst of a recession. As a
result, it could no longer rely on the
sources that had previously fueled its economic growthaccess to
international loans, trade, and
consumer spending.
The government spent about half of the countrys GDP every year
between 1995 and
2008. To stimulate the economy during the global financial
crisis in 2008 and 2009, the
government increased spending even further, which increased the
debt to more than half of GDP
by 2009. In 2009, Greece had the highest debt in the EU at
126.8% of GDP. Economists predict
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that Greeces debt will continue rising through at least 2014. As
of April 2012, Greeces debt
was approximately 127.8% of GDP (about 286 billion).
Compounding the problem, the government falsely reported data
and gave the impression
that its debt situation was not dire. The government originally
reported its 2009 deficit at 3.7%,
but later revised it to 13.6% of GDP. The government also lost
large amounts of potential tax
revenues from the shadow or underground economy, comprised of
legal and illegal operations
that go unreported and untaxed each year. Between 1996 and 2006,
the size of Greeces shadow
economy was 20% to 25% of GDP. Furthermore, revenue losses due
to tax evasion amounted to
3.4% of GDP in 2006.
Greeces fiscal deficit has been above 3% of GDP almost every
year for ten years, in
violation of the Stability and Growth Pact (SGP) (revised data
from 2010 shows that it was at
5.1% in 2007 and 13.6% in 2009). Under the SGP, EU member states
agreed to limit their
budget deficits to 3% of GDP, but the SGPs enforcement
mechanisms were not sufficiently
effective to force countries to comply. As discussed above, the
influx of EU funds and
international loans made it easy and cheap for Eurozone
governments to borrow and build large
deficits and debts over time.
Government inefficiency also provoked the crisis in Greece. The
inability of the
government to take control of Greeces debt by raising taxes or
cutting spending led to a loss of
investor confidence in Greece. Greece implemented few fiscal
reforms to stimulate growth and
reduce its debt after joining the EU. Since it was unwilling to
raise taxes to pay for social welfare
programs (or cut those programs), the governments only option
was to borrow to finance its
operations, which increased its debt.
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To refinance its deficit, Greece began issuing bonds with short
maturity periods, meaning
that it would have to repay the bonds in relatively short
periods of time. As bond payments
became due, Greece had to pay investors more than it could
afford because of its low revenue
due to slow economic growth. Concerned that Greece would be
unable to pay them in full,
investors began requiring higher interest rates to purchase
Greek bonds. As those concerns grew
along with Greeces debt, borrowing became prohibitively
expensive and investors stopped
investing in Greek bonds because of the associated risks. As a
result, Greece eventually required
two bailout packages to secure the funds needed to pay
investors.
B. The Sovereign Debt Crisis Spread from Greece to Other
Countries in the Eurozone as Investors Perceived that these Other
Countries Shared
Economic Characteristics with Greece that Caused Greece to
Experience a
Financial Crisis in the First Place
Contagion resulted in the spread of the sovereign debt crisis
from Greece to Ireland,
Portugal, Spain, and Italy. Contagion occurs when investors
believe that other countries, in
addition to the original country facing economic crisis, pose a
risk of financial loss and act
accordingly. In the Eurozone, investors began to worry about
other countries with high debts,
despite no other country having debt as high as Greece.
Investors began demanding higher
interest rates on governments bonds to compensate for the
perceived increased risk, whether
justified or not. Some investors withdrew from these markets
altogether.
1. The Greek Financial Crisis First Spread to Ireland
Ireland was the first country after Greece to face the impact of
the European financial
crisis. Unlike other countries that the crisis affected,
Irelands financial markets were not
strongly linked to Greece. For example, Ireland did not hold a
significant amount of Greek debt.
Irelands financial situation was also significantly different
from Greece. Unlike Greece, Ireland
did not have a tax evasion problem, suffer from a lack of
competitiveness, or falsify its fiscal
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data. Furthermore, it began making spending cuts fairly quickly
after its debt began to rise
rapidly in the aftermath of the global financial crisis and
before it was forced to seek a bailout in
November 2010 to help cover the cost of rescuing its banking
sector. In 2009, the government
announced a goal of cutting 4 billion from the 2010 budget.
Despite these differences, Irelands
economy did have vulnerabilities that investors believed made it
a risky investment. At the time
Ireland received a bailout in 2010, its deficit was 32% of GDP
and its budget cuts did not
reassure investors that its debt was sustainable. Interest rates
on bonds soared in the month prior
to the bailout. As of April 2012, Irelands debt was
approximately 112 billion or 75.3% of
GDP.
a. Housing and Banking Crises Led to an Increase in Irelands
Deficit
Ireland experienced outstanding economic growth from the mid- to
late-1990s, largely
due to a construction and housing boom. Immigration increased
along with the growth of the
construction sector and the economy in general as the Irish
economy created approximately
90,000 new jobs annually and attracted over 200,000 foreign
workers, many of whom were
employed in the construction sector. The higher population and
number of income earners
increased the demand for housing, which led to an increase in
housing prices.
To meet this growing demand, Irish banks financed mortgage loans
by borrowing from
international lenders. However, the banks did not always ensure
the creditworthiness of
mortgage applicants due, in part, to aggressive lending
practices meant to help them compete
with foreign financial institutions that were operating in
Ireland, particularly U.K. banks that also
financed mortgages. Because Ireland was a member of the
Eurozone, international lenders
presumed Ireland was stable and posed little financial risk.
Irelands continued economic growth
also convinced foreign lenders to extend credit to Irish banks.
Lenders, therefore, provided
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inexpensive loans to Irish banks at low interest rates. In 2008,
Irish banks combined debt from
making loans for property purchases had reached over 60% of GDP.
The banks could only afford
to repay funds they had borrowed from international lenders as
long as they continued to receive
interest payments from their own borrowers.
By 2008, however, the housing demand in Ireland had fallen,
which slowed the
construction sector and eventually the entire Irish economy.
Unemployment increased as
construction jobs disappeared. Consequently, many
newly-unemployed property owners began
falling behind on loan payments and defaulting on loans, leaving
Irish banks unable to repay
their lenders. Government revenue also fell due to losses in
property taxes.
By the start of 2008, it was also clear that Irish banks lacked
the funds necessary to
finance their daily operations. The government intervened by
providing investors with
guarantees for the banks bonds (encouraging investors to
purchase those bonds) and taking large
ownership stakes in banks to prevent them from collapsing. The
government also created the
National Asset Management Agency (NAMA) to purchase bad loans
from banks at discounted
prices. NAMA was intended to stabilize the financial system by
removing banks riskiest loans
from their balance sheets. By doing this, the banks could make
more loans because they no
longer needed to hold as much money in reserve to cover the
potential losses on bad loans.
The government borrowed to finance its rescue of the banking
sector, which caused its
debt to rise from 24.4% of GDP in 2007 to 59.4% of GDP in 2009.
By 2010, it was clear that the
Irish government could not cover the losses in the banking
sector. As the economic situation
worsened in Ireland, investors lost confidence in Irelands
ability to repay its debts, and the
government was no longer able to issue bonds on the
international market to raise funds. Ireland,
therefore, sought a bailout package from the EU and IMF in
November 2010. It accepted a three-
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year bailout package of 85 billion to help with government
funding and the rescue of failing
banks. In return, Ireland committed to reducing its deficit to
3% of GDP in four years by cutting
at least 15 billion from its budget.
b. The Bailout Failed to Restore Investor Confidence in Ireland
or Other
Financially Vulnerable Countries in the Eurozone
European Union finance ministers hoped that the Irish bailout
package would stabilize
Irelands economy and encourage investment in Ireland. However,
as news of the bailout spread,
interest rates on Irish bonds increased, indicating a lack of
investor confidence about whether
Ireland could meet its debt obligations, even with the bailout,
and whether investors would
experience losses if Ireland were forced to restructure its
debt. The credit rating agencies
Standard & Poors and Moodys decisions to downgrade Irelands
credit rating following the
bailout reflected the lack of reassurance the global market
felt.
The Irish bailout was also supposed to calm investors fears that
the financial crisis would
spread to other countries in the Eurozone, particularly Portugal
and Spain. Investors were
concerned that like Ireland, Portugal and Spain would need
bailouts as well. Although Portugals
banks were healthier than Irelands, investors lost confidence in
Portuguese bonds after the Irish
bailout because they worried that Portugals slow growth and
large budget deficit would lead
Portugal to seek a bailout. Despite Spanish protests that Spain
was not like Greece, Ireland, or
Portugal, investors were not convinced that Spain was
financially healthy either. Spain was
heavily exposed to Portuguese debt, so as the Portuguese crisis
worsened, Spain faced an
increasing risk of financial loss. Furthermore, like Ireland, it
experienced a housing-market crisis
and had high levels of unemployment.
In 2011, Irelands successful efforts to meet budget deficit
targets reassured some
investors. Ireland reduced its deficit from 22.3 billion in the
third quarter of 2010 to 21.4
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billion in the third quarter of 2011. Its commitment to fiscal
responsibility set it apart from
Greece and Portugal. Unlike these countries, Irelands economy is
forecasted to grow in 2012
due, in part, to an increase in exports, especially manufactured
goods. Even before the crisis,
Irish exports were attractive to international customers,
especially pharmaceuticals, chemicals,
and software-related products. Ireland has also facilitated
trade by removing barriers and Irish
exports are more affordable because the euros value against the
dollar has decreased because of
the crisis.
Not all investors, however, are convinced that Ireland is on the
mend. Moodys, for
example, lowered Irelands credit rating further to below
investment grade in July 2011, stating
that even with the bailout, Ireland does not have sufficient
funds to meet its obligations. Moodys
also expressed concern that investors would have to take
haircuts on the their bonds if Ireland
were to restructure its debt. As a result of Moodys actions and
a continued lack of investor
confidence in Irelands recovery efforts, Ireland will probably
not be able to reenter the
international bond market in 2013 as it hoped.
2. The Crisis Spread Next from Ireland to Portugal
It is not difficult to see why the financial crisis spread next
from Ireland to Portugal,
although Portugal did not experience the same financial problems
as Ireland. Since it joined the
euro in 1999, Portugal has had the lowest growth in the Eurozone
and suffered from low
productivity and competitiveness. Between 2001 and 2007,
Portugal experienced only 1.1%
average annual growth. Meanwhile, increased government spending
and decreasing tax revenue
caused the deficit to rise. As the countrys deficit grew, it did
not have sufficient funds to pay its
increasing debt. Nevertheless, other aspects of Portugals
financial situation seemed comparable
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to countries in the Eurozone that investors did not think posed
substantial financial risks. For
example, Portugals debt was 77% of GDP in 2010, as compared to
83.2% of GDP in France.
a. Portugals Slow-Growing Economy, Increasing Deficit, Low
Productivity, and Lack of Economic Competitiveness Made the Country
Vulnerable to the
Sovereign Debt Crisis
Portugal joined the EU in 1986 hoping that EU membership would
lead to greater
economic and political stability after decades of authoritarian
rule. Joining the EU was supposed
to provide Portugal with the incentive to enact reforms that
would lead to economic growth.
Portugal hoped to benefit from access to cheaper credit
available either from the EU or
international lenders that believed all Eurozone countries were
safe investments. At first,
Portugal enacted some economic reforms that stimulated economic
growth and attracted
investors, such as removing some barriers to trade like high
tariffs.
Between 1986 and the late 1990s, Portugal experienced relatively
high GDP growth due,
in part, to an increase in trade. Portugals low labor costs and
an influx of EU funds contributed
to the development of its infrastructure. As a result of joining
the EMU and adopting the euro,
Portugals exchange rate stabilized and inflation decreased.
However, the government did not
use newly-available funds to increase production and promote
entrepreneurship, which would, in
turn, promote economic growth. Instead, it channeled the funds
into sectors that government
officials and their supporters favored. From the mid-1990s
onwards, Portugal lacked the
incentive to continue implementing economic reforms and scaled
back reform measures because
it had easy access to EU and international funds despite
whatever flaws its economy may have
had. These developments contributed to very low economic growth
in the 2000s. In the late
1990s, Portugals growth rate was an average of 3.9% of GDP, but
had fallen to an average of
0.4% of GDP by the late 2000s.
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Portugals lack of competitiveness also contributed to low
economic growth. Portugal
mainly exports low-tech, inexpensive goods that have lost market
share to cheaper producers
in emerging markets. Although Portugal was once competitive in
the service industry because of
low labor costs, Eastern European countries with even lower
labor costs decreased Portugals
competitiveness in this area when they joined the EU.
While Portugals deficit was under 3% between 2002 and 2004, it
rose to 5.9% in 2005.
The government then unsuccessfully attempted to reduce the
deficit, which reached a high of
10.1% of GDP in 2009. This increase resulted from an 11% drop in
tax revenue due to the
economic slowdown resulting from the global financial crisis.
With less revenue, the government
had to rely on borrowed funds to finance spending on its
generous social programs. In 2010,
Portugals debt was 93% of GDP and was projected to increase to
97.3% of GDP in 2011.
To finance the growing debt, the government issued new bonds.
However, investors
demanded higher interest rates as incentives to buy, causing the
debt to increase further. The
government relied on domestic banks to buy government bonds,
which left the banks holding
risky debt. As Portugals debt continued to grow, investors
became increasingly unwilling to
lend to the country. By the spring of 2011, it became clear that
the Portuguese government would
not be able to repay its debt. In the beginning of the year, it
had 2 billion in cash reserves and
was due to repay investors 4.2 billion on government bonds in
April and another 4.9 billion in
June. The Portuguese parliament complicated matters by rejecting
proposed austerity measures.
Portugal became the third Eurozone country to request a bailout
from the EU. Portugal received
a bailout package of 78 billion on the condition that it reduce
its deficit. In 2011, Portugal was
supposed to reduce its deficit to 5.9% of GDP from 9.1% in 2010,
but failed to do so. Under the
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terms of the bailout agreement, Portugal has until 2014 to lower
its deficit to below 3% of GDP
as mandated by the SGP.
b. The Portuguese Bailout Failed to Restore Investor
Confidence
The credit rating agencies were not optimistic upon hearing the
news of the Portuguese
bailout. Moodys downgraded Portugal to junk status due to its
belief that the bailout would not
be enough to stabilize Portugals economy. Standard & Poors
and Fitch Ratings have since done
the same. In October 2011, Moodys downgraded nine individual
Portuguese banks because it
doubted that these banks could be recapitalized since they have
a number of loans on their books
that are either already non-performing or are at risk of
becoming so. Although international
lenders have been unwilling to lend to Portuguese banks for over
a year, credit rating agencies
attitudes could lead to a greater loss of investor confidence
that could continue to shut Portugal
out of financial lending markets.
The region of Madeira has complicated Portugals efforts to
comply with the bailouts
terms and has shaken investors confidence further. After
agreeing to the bailout in 2011,
Portugals government discovered that Madeiras regional
government had underreported its
debt since 2004, which increased Portugals public debt by 1.668
billion. Although Madeira is
an autonomous state, its debt counts as part of Portugals total
public debt. Thus, this revelation
has made it harder for Portugal to meet the budget deficit
targets the EU and IMF set as a
condition of the bailout. Madeira does not want to impose
austerity measures on its population
and wants to continue spending on public projects, which will
likely continue increasing
Portugals debt. As of April 2012, Portugals debt is 131 billion
or 82.4% of GDP.
As Portugal implemented austerity measures to try to bring its
deficit under control, the
economy contracted further. As a result, many workers left
Portugal in search of jobs after the
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government cut wages and benefits for public sector employees
and raised taxes throughout the
country. Portugal is largely dependent on its exports for
revenue, but most of its trading partners
have been affected by the crisis70% of its exports go to the EU,
including 24% to Spain. As a
result of reduced trade, Portugal cannot rely on exports to
generate the revenue necessary to pay
its debts. The crisis in Portugal poses financial risks for
countries that have significant exposure
to Portuguese debt, especially Spainthe next country to face the
effects of the crisis.
3. From Portugal, the Crisis Moved to Spain
Similar to Ireland, housing-market and banking crises provoked a
sovereign debt crisis in
Spain. Spain enjoyed substantial economic growth prior to 2007,
but with the end of a housing
boom in 2007 and the recession in 2008 resulting from the global
financial crisis, Spains deficit
increased. Despite the high level of private debt Spanish
citizens held prior to the crisis, the
countrys deficit was relatively low when compared to the rest of
the Eurozone. In 2007, Spains
deficit was 1.132% of GDP compared to the Eurozone average of
1.83%. By 2008, however,
Spains deficit had risen to 4.9% of GDP compared to the Eurozone
average of 2.58% of GDP.
By 2010, Spains deficit had risen to 9.7% of GDP. As the
fourth-largest economy in the
Eurozone, Spain has been characterized as too big to fail, but
the EU and the IMF do not have
enough money to bail out an economy the size of Spains.
a. Housing-Market and Banking Crises Led to Increased Deficit
and Debt in
Spain
Between 1995 and 2007, a construction boom fueled remarkable
economic growth as
housing prices rose 220%. The demand for housing soared as
homeownership became a goal for
the majority of Spaniards due to the unavailability of
affordable rental options in the mid-
twentieth century and a tax policy introduced in the 1980s that
made mortgage principal and
interest tax-deductible. Increased immigration to Spain due to
the availability of construction
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jobs also increased demand for housing. Unemployment fell from
23% in 1986 to 8% in mid-
2007.
The availability of cheap credit from international lenders to
banks and other lending
institutions like the cajas de ahorros (Spains savings and loan
banks) allowed Spanish
households and businesses to borrow heavily to finance real
estate purchases. Like other
countries in the Eurozone, Spain benefitted from the low
interest rates available to Eurozone
members. As a result, Spain turned from a country relying on
virtually no external funding in
1996 to one that relied heavily on international lenders in the
2000s. By 2008, Spain had
borrowed the equivalent of 9.1% of GDP.
In 2007, housing prices began to drop because property was
overvalued. Unemployment
subsequently rose as jobs in construction disappeared. As the
housing market slowed, lenders
issued loans to homebuyers that posed risks of default. As a
result of growing unemployment
(which rose to over 20%), many people could not afford to make
their mortgage payments.
Developers also began to default on their loans as the demand
for new construction dropped, so
banks ended up holding bad loans from both individuals and
businesses. As bad loans increased,
Spanish lenders revenue fell to the point that they lacked the
funds to pay their own foreign
lenders.
The government eventually stepped in to rescue the banking
sector. It first selectively
targeted the most indebted banks, but it soon provided funds to
the entire banking sector,
including 99 billion to recapitalize the cajas. It feared that
without more robust stimulus
measures to help the banking sector, the country risked a
financial collapse and recession. As
government spending increased, so too did the deficit. The
government had a budget surplus of
1.9% of GDP in 2007, but by 2009 it had a deficit of 11.2% of
GDP. Consequently, its debt rose
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from 26.52% of GDP in 2007 to 43.73% of GDP by 2009. As of April
2012, Spain owes
approximately 614 billion or 61.1% of GDP.
b. Spains Attempts to Impose Fiscal Discipline Have Not
Reassured
Investors
The major credit rating agencies have downgraded Spains credit
rating. They argue that
Spain faces great difficulty in significantly reducing its debt
because reforms will not restore
market confidence and economic growth quickly enough to avoid a
debt default. The
government has imposed a number of austerity measures that have
burdened citizens already
facing the challenges of a recession. A new government has
recently taken charge because of
citizens dissatisfaction with the effects of the crisis.
Interest rates on Spanish bonds were dropping in early 2012
after the European Central
Bank (ECB) helped stabilize Eurozone banking sectors by making
low-interest loans to
Eurozone banks. In March 2012, however, the government announced
that it would not meet the
4.4% of GDP budget deficit target set by the European Commission
for 2012. Instead, it aims to
cut the deficit to 5.3% of GDP from the 2011 deficit of 8.5%
through a proposed deficit-
reduction package of 27 billion. The government stated that the
2011 deficit was greater than
what had been forecast by the previous administration, meaning
that it would have to make much
larger cuts than previously thought to meet the original
targetsomething it was unwilling to do.
Following this announcement, interest rates on Spanish ten-year
bonds rose, reaching 5.81% in
April 2012their highest level since the beginning of December
2011. The increase reflected
investors concern that more austerity would cause the economy to
contract further, leading to
more unemployment, loss of tax revenue, and increased social
welfare costs.
4. The Crisis Advanced to Italy Next
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Italy did not experience a banking crisis like Ireland and
Spain. Although it had the fourth
highest sovereign debt in the world (119% of GDP as of November
2011), its budget deficit
(4.6% of GDP as of November 2011) was low compared to the
Eurozone average of 6% of GDP.
Nevertheless, Italy was the next country after Spain to
experience the threat of a sovereign debt
crisis. Despite having the third-largest economy in Europe and
one of the largest in the world in
terms of GDP, Italy had a slow-growing economy and high debt,
much like Greece and Portugal.
Investors, therefore, began to question whether Italy would be
able to repay its debts.
a. Italys Slow-Growth Following the Global Financial Crisis
Strained Its
Ability to Pay Its Debt
In the late 1980s and early 1990s, Italys strong manufacturing
and export sectors,
especially in areas such as automobiles, clothing, and chemicals
propelled strong economic
growth. Reduced public spending, a declining deficit, and lower
inflation also fueled growth.
Italys economic growth eventually stagnated, however. Investors
often found Italy unattractive
because of its high level of corruption and strong labor
regulations that increased labor costs. A
lack of investment in infrastructure and research, particularly
in southern Italy, also hampered
economic growth. More recently, Italy struggled to compete with
China in industrial
manufacturing due to Chinas lower labor costs. Between 2001 and
2008, Italy had an average
growth of only 0.8% of GDP.
The global financial crisis caused the economy to contract
further as domestic and global
demand for Italian goods fell. In 2008, the economy shrank by
1.3% followed by a 5.2%
contraction in 2009. The government increased spending in an
effort to stimulate the economy,
but Italys debt increased to over 1.88 trillion in 2011 (120% of
GDPthe second-highest in
Europe behind Greece) as a result. As Italys economy slowed,
investors became concerned that
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Italy could not generate sufficient revenue for the government
to repay its debts (the IMF expects
it to grow only 0.3% in 2012).
b. The Slow Pace of Italian Reforms Has Failed to Restore
Investor
Confidence
The Italian governments delay in passing austerity measures due
to political
disagreements decreased market confidence as investors feared
that Italy would fail to take
action. In June 2011, Parliament approved an austerity package
to cut the nations budget deficit
by 70 billion over three years by, among other things, cutting
spending on many social services.
The EU, however, did not consider these measures sufficient to
substantially decrease the debt,
so Parliament passed another austerity law in November 2011.
Parliament intended this law to
prevent the crisis from spreading to France, which holds a large
amount of Italian debt and
would, therefore, experience significant financial losses if
Italy could not repay its debt.
The slow-moving pace of Italys government in dealing with the
crisis and failure to
calm investors fears resulted in the prime minister stepping
down. The new Italian government
proposed an austerity package in November 2011 that aimed to
eliminate the deficit by 2013, but
had to scale back many of its proposals under heavy protests
from political opponents, especially
labor unions. Like Spain, the latest austerity package failed to
reassure investors immediately,
and long-term borrowing costs neared 7% in late 2011 (which most
economists regard as too
high to sustain), though they have since fallen.
Standard & Poors downgraded Italys credit rating in May
2011, and Moodys and Fitch
Ratings soon followed, citing Italys high public debt and slow
pace in implementing reforms.
They also announced that further downgrades are possible given
Italys high risk of default. Such
downgrades would make it harder and more expensive for Italy to
continue borrowing from
international lenders. Like Spain, the size of Italys economy
makes it too big to fail. The EU
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and IMF do not have the funds necessary to bailout such a large
economy. Nevertheless, in the
first few months of 2012, investors seemed optimistic that the
Eurozone was stabilizing. As a
result, interest rates on ten-year bonds dropped to 5.24%the
lowest they had been in seven
months. By the beginning of April 2012, however, the yield on
ten-year bonds rose to 5.41%.
Experts believe that the increased interest rates reflected
investor concern over Italys high debt
and low economic growth.
c. The Size of Italys Bond Market Puts Investors at Risk of
Financial Loss
Italy has the largest bond market in Europe and third-largest in
the world behind the
United States and Japan. Therefore, if Italy were to default on
its debt obligations, it would cause
massive repercussions globally, but particularly throughout the
Eurozone and especially in
France and Germany. Many French and German banks own a
significant amount of Italian
bonds, meaning that an Italian default would result in major
losses for these banks. The United
States also owns more Italian bonds than any other Eurozone
countrys bonds. Investors took
note of the potential danger of financial loss when Fitch
Ratings issued a warning on the United
States Eurozone exposure in November 2011, which resulted in a
drop in shares in U.S. banks.
While Italy issues the most bonds in the Eurozone, Italians own
about half of those bonds.
C. The Future of the European Sovereign Debt Crisis
France, the EUs second-largest economy, is the next country that
may feel the effects of
the European sovereign debt crisis. Standard & Poors
downgraded Frances sovereign bond
rating in early 2012. Unlike Spain and Italy, however, interest
rates on French bonds had not
substantially increased as of April 2012. If Frances economic
situation were to deteriorate, the
EU and IMF would not be able to afford to bail it out.. French
banks have loaned heavily to
Eurozone countries in crisis, including Italy and Spain.
Therefore, if those countries were to
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default, French banks would suffer considerable losses. The U.K.
and Germany, in turn, hold
significant amounts of French debt. Thus, if France becomes the
next domino to fall in this crisis,
they too may be vulnerable. Furthermore, France and Germany are
providing much of the
funding to help other countries in crisis, so the continued
availability of bailout funds for smaller
economies would come into question if France succumbs its own
financial crisis.
Although Europes situation seemed to be improving in early 2012
as interest rates on
Spanish and Italian bonds fell following the injection of ECB
loans into their banking sectors, by
late March of 2012 interest rates were on the rise. Escalating
interest rates reflected investors
concern over whether the ECB and the EUs central banks would
continue their financial support
of markets facing the effects of the crisis. Investors were also
cautious over countries abilities to
meet deficit reduction targets, especially after Spains
inability to do so.
Some experts believe that the Eurozones current focus on cutting
as much spending as
possible will not solve the crisis. Austerity measures have
brought on recessions in many
countries, meaning that those countries are losing revenue as
they cut spending, thereby
preventing them from reducing their debts. Data for the
countries most affected by the crisis
showed that unemployment was on the rise and manufacturing was
on the decline in 2012.
Relatively healthy Eurozone countries, like Germany and France,
have also had decreases in
manufacturing, although unemployment has not increased as of
April 2012. Experts especially
criticize the European Commissions support of austerity programs
to reduce deficits in countries
like the Netherlands and France that have lower interest rates.
Instead, experts believe that such
countries should focus on boosting economic growth. In countries
that import more than they
export, like France, Italy, Spain, and the United Kingdom, they
suggest increasing investment
and exports to generate revenue. For countries that have
surpluses in export revenue, like
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Germany and the Netherlands, experts advocate increasing
domestic consumption to stimulate
economic growth. Though experts disagree on methods, all agree
that Europe must stop the crisis
from spreading to other countries as the consequences of failing
to do so may be dire.