The Sovereign Debt Crisis


28 Οκτ 2013 (πριν από 4 χρόνια και 7 μήνες)

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Prof. Juan Gabriel Rodríguez

The Sovereign Debt Crisis

A paradox

In 2011 as a percent of GDP the UK government debt
stood 17% higher than the Spanish government debt

The yield on Spanish government bonds has increased
strongly relative to the UK (
in 2011, a difference of 200
basis points!


The banking sector in the UK is not better than the
banking sector in Spain so…

Spain belongs to a monetary union!!!

Sovereign Debt in a Monetary Union

The “UK Scenario”

Assume investors were to fear that the UK government might be
defaulting on its debt…

They would sell their UK bonds, driving up i.

They would sell their “new” pounds in the foreign exchange

The price of pounds would drop, but pounds would be
bottled in the UK money market to be invested in UK assets
(the UK money market would remain unchanged).

If the government cannot find the funds to roll over its debt
at reasonable interest rates, it would force the Bank of
England to buy government securities.

Investor cannot precipitate a liquidity crisis in the UK!

Sovereign Debt in a Monetary Union

The “Spanish Scenario”

Assume investors were to fear that the Spanish government might be
defaulting on its debt…

They would sell their Spanish bonds, driving up i.

They would invest their Euros, say in German bonds so the Euros
leave the Spanish banking system.

Because no foreign exchange market, nor a flexible exchange rate
can stop this, liquidity (money supply) in Spain shrinks.

The Spanish government cannot obtain funds at reasonable
interest rates. Moreover, the Bank of Spain cannot buy
government bonds. The ECB could do it, but the Spanish
government does not control it.

The liquidity crisis, if strong enough, can force the Spanish
government into default! Financial markets acquire power to…

Sovereign Debt in a Monetary Union

The “Spanish Scenario”

Furthermore, because the national currency does not depreciates (see the
case of UK) the Spanish economy is not given a boost and prices do
not change…

Since 2010:

Inflation: 2.9% Vs 1.6%

Growth: 2% Vs 0.2%

The pound has depreciated by 25% against Euro.


Primary budget surplus must be at least as high as the difference
between the interest rate and growth rate times the debt ratio for
solvency (stabilization of the debt to GDP ratio)…

Sovereign Debt in a Monetary Union

The “UK Scenario”

The “Spanish Scenario”
: 2.30

Spain is forced to apply much more austerity than the UK to satisfy
the solvency condition, despite the fact that it has a substantially
lower debt level!!!

Dynamics in a monetary union

when investors fear some payment difficulty (triggered by a recession that
leads to an increase in the government budget deficit) liquidity is
withdrawn from the national market.

Once a member country gets entangled in a liquidity crisis, interest rates
are pushed up, and in this manner, the liquidity crisis turns into a
solvency crisis.

A self
fulfilling prophecy: the country has become insolvent because
investors fear insolvency

Sovereign Debt in a Monetary Union

Further considerations

Financial markets acquire great power in a monetary union,
will this power be a
discipline force on bad governments?

The problem is that financial markets are driven by
extreme sentiments
: during periods of
euphoria investors cheered by rating agencies, fail to see the risks and take too much;
after, fear dominates and investors prodded by rating agencies detect risks everywhere.

When a bad equilibrium is forced on some member countries, financial markets and
banking sectors in others countries are also affected (for many Eurozone member countries
more than half of government bonds are held outside the country of issue).

Because the interest rate on government bonds increases, the domestic banks which are
usually the main investors in the domestic sovereign bond market, will suffer losses on their
balance sheets. Moreover, because liquidity has dried up, domestic banks have difficulties
to rollover their deposits. Thus the sovereign crisis spills over into a domestic bank crisis
and credit to the economy disappears.

A recession leads to higher government budget deficits which trigger a liquidity and
solvency crisis. The latter forces to institute austerity programs in the midst of a recession.

Sovereign Debt in a Monetary Union


European Financial Stability Mechanism

that will be the
Stability Mechanism

(ESM) from 2013 on. This organism will obtain
funding from the participating countries and will provide loans to
countries in difficulties.

Interest rate too high

Austerity package spelled out over a sufficiently long period of time, so that
economic growth gets a chance.


Collective actions clauses: private bondholders know that their bonds will
automatically lose value when a country turns to the ESM…but this will make it
more likely that the country need support from the ESM!

Joint issue of Eurobonds
: internalizing the externalities. Problems:
moral hazard (issue too much debt), less favourable credit ratings.

Coordination of Economic Policies
: control bank credit (reserve
requirements, capital ratios)