Critically Analyse How the Government Debt Problems Essay

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Introduction

Since the Greeces debt crisis happened, the Euro zone has to confront with a huge sovereign debt crisis, like governments debt increased, bond yield spreads widened, Euro exchange rate fell as well, which caused that the whole international financial markets gradually lost the confidence. The purpose of this essay is to discuss the impact of this crisis both on foreign exchange and derivative markets. And the rest words is to analyse several possible reasons why this small economy could trigger such a wide impact on global financial markets, in which contagion can be considered as the fundamental and identifiable cause during the whole spread of crisis.

The Impacts of European sovereign debt crisis

Foreign exchange

Foreign exchange market, as the largest and the most liquid financial market, with an average daily trading volume of nearly $1.5 trillion changing hands where statistically it is superior to all US equity and Treasure markets combined (Michelle Chan, 2011), was expectedly deteriorated as well as fluctuated by the ongoing European debt sovereign crisis since 2008.

On one hand, the foreign exchange market reflected considerable stress under the lingering European debt crisis. On the basis of the Financial markets Stability Map(Graph1), apparently, financial markets, particularly the foreign exchange market continued to be weaker and experienced the heightened volatility. This weakness is shown in the graph1 that risks successively increase as the movement gradually moves away from the map center. Dissimilarly, risks in the rest of three components of the financial markets stability map, banking sector funding, debt and equity markets remained largely stable as well as unchanged, compared with the foreign exchange market. Generally to say, as indicated by the trends in the Financial Stability Map, the overall stability of the financial system kept in a robust development.

Graph1 Financial Stability Map
[pic]
Source: Bloomberg

On another hand, the foreign exchange rate was deeply influenced as well, particularly the depreciation of the Euro was more prominent against non-European currencies, such as yen, the USD and the GBP, as non-European currencies was coinstantaneously affected by spillover effects from the euro-zone.

According to the graph2, the euro has depreciated against the USD and Japanese yen by around 25 percent since the late 2011, but by approximately 4 to 8 percent against the UK pound. Overall, the euro has depreciated by 8 percent on a trade-weighted basis (TWI) since the mid 2011, fluctuating around its average index.

Graph 2 Euro against Selected Currencies
[pic]
Source: Bloomberg; RBA

On the contrary, according to the Graph3, the Japanese yen had been depreciated slightly and modestly against the USD from its nearest highest rate in late November 2011. Generally to say, the yen was smoothly unchanged against the US dollar during the time period of six mouths. Nevertheless, the yen has appreciated by 7 percent against the euro since late 2011, reaching a highest level during past 11 years at the beginning of 2012. Reflecting this in the graph2, Japans nominal trade-weighted index (TWI) has recovered to historically high levels, though it remains only above its long-run average in real term (Reserve Bank of Australia, 2012).

Graph 3 Japanese Effective Exchange Rates
[pic]
Source: BIS; RBA

As for the USD, it was appreciated extremely strongly against the euro since late November 2011, seen in the Graph4, but depreciated against other foreign currencies. Concerning the trade-weighted index (TWI), the USD was mostly unchanged since 2011.

Graph 4 US Dollar against Selected Currencies
[pic]
Source: Bloomberg

Oppositely, after fluctuational depreciating during the past few months, several emerging market currencies have appreciated since the beginning of 2012(Graph5). However, as the continuous concerns about spillover effects from the euro area debt crisis, emerging European currencies remained relatively weak nowadays.

Graph5 Emerging Market Currencies
[pic]
Sources: Bloomberg; IMF; RBA

Derivative Market

In 2001, in order to enter European Union, Greece referred the U.S. Goldman Sachs to design the currency swaps, which facilitated Greece join the European union. Nevertheless after predicting the prospects of the Greek economy, Goldman bought German CDS credit default swap insurance and gambled that Greek could not afford such a large sum of payment of insurance that purchased the cheap CDS. When Greece debt broke out, distribute the bad news of the Greeces pay ability to increase the price of CDS and earn the price differences.

With the emergence of European debt crisis, the credit rating of some countries like Greece, Portugal, Ireland and Spain had been downgraded in term of there sovereign credit, which means the international markets would no longer trust these economical situation and credit rating levels. As a result,most of potential buyers and sellers of bonds in the sovereign debt market began to suspect the governments ability to repay its debt, and then they will require a higher bond discount rate in the potential risk of default about sovereign bond as the part of the compensation of risk premium. When the discount rate significantly exceeds the risk-free rate, the national debt will be in a rather high discount rate. In addition, the CDS price of the European countries increased rapidly. As we saw from the graph6, the Greece five years CDS price had reached to almost 1500, which reflects the buyer of the CDS have to cost a relatively higher fix rate to buy the Greeces credit risk call option.

Graph 6 5 years Sovereign CDS risk premium and Sovereign credit rating in different countries. [pic]
Source: Bloomberg

Another impact on derivation market is the Futures and Options. Traders and hedge funds had bet nearly $8bn (£5.1bn) to against the euro, amassing the biggest ever short position in the single currency on fears of a euro-zone debt crisis. Figures from CME(Chicago Mercantile Exchange) illustrates that investors had enhanced their positions against the euro to record levels. This phenomena demonstrates that investors were losing confidence in the single currencys ability to withstand any contagion from Greeces budget problems affecting other European countries(Financial Time, 2010). Additionally, European debt crisis aggravated as the Moody turn 17 German banks rating outlook to negative on the 25th of July. The bear have the advantage in the Futures and Options market.

How does the European debt crisis transmission

Since the Greece was downgraded by credit rating companies, European sovereign debt crisis broke out and then intensified across the euro-zone. Other European countries like Belgium, Portugal, Spain and Italy. Germany and other primary euro-zone countries had begun to be impacted by such an unavoidable crisis(Graph 7), simultaneously the euro fell sharply. With European stock markets at rock bottom, the euro area was experiencing the most severe difficulty since its inauguration. Whist the debt crisis was unexpected expanded. As to how and why this small economies could trigger such a wide impact in financial markets, it must be the financial contagion.

Graph 7 How sovereign debit crisis could spread through the Euro-zone [pic]

The inter-contagion within a country could be considered as an essential cause that triggered such a wide impact in financial markets. The interconnectedness means that a crisis in one can cripple the other (Daniel and Harold, 2012). As European banks are much more deeply connected to their individual governments, euro-zone banks naturally hold large shares of their governments debt, like in Greece and Germany, domestic banks hold nearly 20 percent of domestic government debt, and Spanish banks hold around 30 percent (Silvia and John, 2012). So look, other financial domestic institutions may hold much domestic debt as well, such as insurance companies. Government. Spain exemplifies contagion spreading from banks to government. Spains banks were loaded with mortgages that went bad when the countrys housing bubble popped. Despite modest debt and budget surpluses in six of the seven years preceding the crisis (World Bank, 2007), the band crisis caused the government to lose control of its financing. Generally to say, government risk could affect banks, otherwise, if banks fail, the governments bond market customers are bankrupt (The Heritage Foundation, 2012).

And moreover, with the momentum of the globalization, the world economy is becoming tightly linked, like non-euro countries governments or banks hold the European bonds. It means that problems in one part of the world can reverberate almost everywhere else-risking a cascade of default contagion, contracting credit and collapsing economic activity. For example, in October 2011, Italian borrowers owed French banks $366 billion (net). Should Italy be unable to finance itself, the French banking system and economy could come under significant pressure, which in turn would affect Frances creditors(Seth et al., 2011). Greece, for instance, its debt is held by a host of other EU members. Once it defaults, the ripple effect for the economy as a whole would be devastating across the region, probably the world. The statistics from the IMF illustrated that the German banks held Greek government bonds up to totaling $ 14.1 billion and $ 13.4 billion was held by French banking industry.

And also the China holds nearly 600 billion Euros of the European bonds. So if the debtor countries cannot pay the money on time ,not only itself but also these creditor will under a huge financial pressure. This is simply showed by the MF Global who is the biggest victims in the European debt crisis that Global voted to file for bankruptcy. The main reason why MF Global got into financial trouble is because it bought over 6 billion U.S. dollars in European sovereign debt, mainly related to the national debt of countries like Italy, Spain, Portugal, Ireland and Belgium. Finally, European debt crisis have the first victims outside the region of the Europe. Thus,the connection each economic system makes the risk contagious simply.

Apart from those mentioned above, an alternative way for this crisis transmission is the relation among correlation coefficients in the conditional correlation model (DCC),which may be related to herding behaviour, specially the rating agency continually reduced euro-zone counties grades and as well as influences formed the short-selling speculators.Some studies estimated a dynamic conditional correlation model (DCC) in order to analyse the correlation structure of Greek, Portuguese, Spanish, Italian, Dutch, Belgian and Austrian bond yield spreads over the German yield to study contagion in the Euro Area. In particular, Portuguese, Spanish, Italian and Belgian yield spreads do increase along with their Greek counterpart. Thus it seems that Greek financial problems could spread via contagion to other Euro Area countries.

As European counties are related, if it is more likely for similarly bad rated countries to sustain a rating cut once Greek was downgraded, then for such countries the control variable should have a positive impact on the correlation coefficients(Sebastian and Sebastian, 2011). Therefore in terms of European debt crisis, contagion occurs when investors believe that other countries, in addition to the original country facing economic crisis, pose a risk of finance loss and act accordingly(Lia Mennde, 2012). And according to the Herd Instinct,other European countries, to some extend, would be influenced,particularly for those counties who had been facing such problems.

Due to the European sovereign debt crisis not only impacted the bond market, the equity market, money market and foreign exchange market, even the whole world was also affected. As all the country has International Reserves, Gold Reserves and Foreign Exchange Reserves, it can be evidently reflected that a bigger concern would be jitters over if sovereign debt become less focused on euro-zone and more global. As the stock price declined, and the euro devaluated, Europes crisis will no longer be Europe s along. It would affect the global trade balances even.

Conclusion

Since the early 2010, the Euro Area faced a severe sovereign debt crisis, resulting from government deficits and debt levels which triggered rating agencies subsequently to downgrade the credit ratings of nine euro area sovereigns, thereby creating a loss of confidence in financial markets. Learning from this crisis, bank should increase their capital to counteract the loss and passive influences of the crisis. And meanwhile, governments need to broaden revenue and strengthen the budget management, as well as control the government debt reasonably, particularly, investors confidence should be reactuated urgently.

Reference

[1] Chan, M. (2011) Robin Hood Meets Wall Street (online). Poole: Friends of the Earth. Available from: http://www.foe.org/news/archives/2011-02-robin-hood-meets-wall-street (Accessed 22 Feb 2011).

[2] Reserve Bank Of Australia(2012). Statement on Monetary Police (online). Available from: http://www.rba.gov.au/publications/smp/2012/feb/html/intl-fx-mkts.html (Assessed 9 August 2012).

[3] Financial Time,2010:raders in record bet against the euro (online)Available from:http://www.ft.com/cms/s/0/9203f08c-151a-11df-ad58-00144feab49a.html#axzz2BOITU3eG

[4] Daniel, W. and Harold, H. (2012). Spains Banks, Government Co-Dependent on Debt . Associated Press. June 25, 2012. Available from:http://www.sfgate.com/business/article/Spain-s-banks-government-co-dependent-on-debt-3660227.php (Accessed June 26, 2012)

[5] Silvia Merler and John Pisani-Ferry (2012), Whos Afraid of Sovereign Bonds?Bruegel Policy Contribution. No. 2012/02, February 2012. Available from: http://docs.jean-jaures.net/NL470/21.pdf (Accessed June 26, 2012).

[6] World Bank, World Development Indicators. Cash Surplus/Deficit as % of GDP 20012007.

[7] Furth, S. and Ligon, J. L. (2012) How Contagious Is Europes Economic Crisis? Backgrounder (online), No.2726. Available from: http://report.heritage.org/bg2726 (Accessed 18 Sep. 2012).

[8] Seth W. Feaster; Nelson D. Schwartz; Tom Kuntz (2011-10-22). NYT-Its All Connected-A Spectators Guide to the Euro Crisis. New York Times Available from: http://www.nytimes.com/imagepages/2011/10/22/opinion/20111023_DATAPOINTS.html?ref=sunday-review. Retrieved 2012-05-14.

[9] Sebastian Missio;Sebastian Watzka,(2011-08-31).Financial Contagion and the European Debt CrisisJournal of Economic Literature, E43, E44, E63. p2.

[10] Menndez, L.(2012). The spread of the European Sovereign Debt Crisis(online). Available from: https://docs.google.com/viewer?a=v&q=cache:IaD0olBUZ2kJ:ebook.law.uiowa.edu/ebook/sites/default/files/Spread%2520of%2520the%2520European%2520Sovereign%2520Debt%2520Crisis.pdf+The+spread+of+the+European+Sovereign+Debt+Crisis&hl=zh-CN&

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