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The continuing euro zone sovereign debt crisis

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In Brief

The financial troubles in the euro zone are an on-going series of sovereign debt crises that originated in countries within the zone that were already or became heavily indebted following the global financial crisis of 2008–09.

The debt crisis is exacerbated by a debt cycle in that the banking sector needs to recapitalise, the public sector must undertake fiscal consolidation, and households and firms need to reduce their level of indebtedness.

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Yet simultaneous action by all three groups makes the individual task of each more difficult. Central banks have thus been taking up the task of providing monetary stimulus to assist households and firms while providing financial support to both governments and the financial sector.

There have been multiple ‘solutions’ to the on-going debt crisis. These include a write-down of Greek sovereign debt in October 2011 and a substantial increase in the size of the bail-out funds to indebted countries — about one trillion euros — held by the European Financial Stability Facility (EFSF). In addition, the European Fiscal Compact (EFC), which should come into force on 1 January 2013 (except in the UK and the Czech Republic), seeks to re-enforce ‘convergence criteria’, which state that the structural deficit of an EFC member country should not exceed 0.5 per cent of its GDP annually unless it has a GDP-to-debt ratio significantly below 60 per cent and long-term financial sustainability risks are low. A permanent financial facility has also been established called the European Stability Mechanism (ESM), whose ratification took a step forward after the German Constitutional Court approved Germany’s contribution on 12 September 2012 — with some conditions.

The spreads between the debt crisis countries and Germany dropped substantially in early 2012 following interventions by the European Central Bank (ECB) in December 2011 and February 2012. These interventions involved long-term refinancing operations in which the ECB loaned about half a trillion euros to more than 500 banks for a three-year period at an interest rate of 1 per cent. This lowered interest rates, especially in the PIIGS (Portugal, Ireland, Italy, Greece and Spain), and along with the completion of the restructuring of Greek debt in March 2012 helped to restore confidence in the European financial system. Long-term refinancing operations have encouraged banks, assisted by the ECB, to buy the sovereign debt issued by their governments, and that paid an interest rate much higher than the 1 per cent the commercial banks are obliged to pay to the ECB. The ECB interventions temporarily lowered the interest rate spread, but have also linked to an even greater extent the fortunes of domestic commercial banks to the PIIGS sovereign debt crises.

Since May 2012 the euro zone crisis has returned in the form of a banking crisis in Spain. The unfolding drama has further encouraged capital outflows and deposit withdrawals from euro zone countries perceived to be most at risk. Despite a 100 billion euros rescue package agreed to on 20 July 2012 for Spanish banks, Spanish government borrowing costs rose substantially. Concerns about Spanish debt have also spilled over to Italy. In 2011 Spain and Italy had combined debts of about 2.7 trillion euros. By the end of July 2012 their long-term borrowing costs were, respectively, around 7 per cent and 6 per cent.

There are also increasing concerns that Greece’s austerity plans are unlikely to be achieved. In turn, this suggests another Greek bail-out may be required, but this will need support from Germany, which is becoming increasingly reluctant to pay the bills of the PIIGS. Should a Greek exit from the euro zone occur because of this, it could be contagious and would test the confidence and liquidity of the European and the global banking sectors.

To provide further monetary support and reduce risks to the European banking system, the ECB announced on 6 September 2012 its Outright Monetary Transactions (OMT) program. The OMT program, opposed by the German central bank, requires euro zone governments to first apply for assistance from either the EFSF or the ESM. Subsequent to an agreement on the country meeting agreed-to conditions, the ECB would undertake market operations to purchase sovereign bonds in secondary markets of up to three-years’ maturity with the explicit objective of reducing bond yields. As part of its announcement the ECB waived its right as the senior or preferred creditor status in case of a default and did not announce any quantitative limits to the size of the bond purchases.

To maintain a viable euro zone, countries such as Germany will be required to make much larger fiscal transfers to the highly indebted and low-growth countries. To restore confidence in the financial sector the larger, solvent economies in the euro zone will also need to accept a collective responsibility for the national debts of insolvent countries. A much more unified banking system will be needed with a common deposit insurance scheme to protect against bank runs and to ensure private borrowing costs are similar across the euro zone. However, support from Germany for such changes is highly unlikely without much greater political union and a strict observance of the EFC’s convergence criteria.

Quentin Grafton is Executive Director and Chief Economist at the Bureau of Resources and Energy Economics, Australia, and Professor of Economics at the Crawford School of Public Policy, the Australian National University.

One response to “The continuing euro zone sovereign debt crisis”

  1. If no default and exit of members from the euro zone is allowed at all costs, then the issue of moral hazard and fairness will arise and continue into the indefinite future.
    The costs associated with that are likely to be much higher in the long run than the costs arising from a default and exit of a member or two.
    It is a matter of choices of trade-off for all euro members, especially the more weighty ones, such as Germany.

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