This document summarizes the key events and factors that led to the European sovereign debt crisis. It explains that the creation of the euro enabled countries like Greece and Ireland to borrow at lower interest rates, fueling private sector borrowing and housing bubbles. When the global financial crisis hit in 2008, it exposed weaknesses in heavily indebted countries and dried up capital flows. This caused banking crises, rising bond yields, and eventual bailouts for Greece, Ireland, Portugal and others as investors grew concerned about their ability to repay debts. Reforms were implemented around fiscal rules and banking regulation, but the crisis highlighted the need for greater fiscal integration or risk of further crises.

1. European Sovereign Debt Crisis
By
pvishwarathreddy@gmail.com

2. • Japan 2012 Debt/GDP – 200%
• Mexico default 1980s – Debt/GDP - 50%
• Ability to Repay? Or Willingness to Repay?
• Willingness is a cultural problem.
• Fiscal Austerity Measures
– Higher Taxes
– Cutting
European Sovereign Government Debt
Crisis
Social Services
Public Spending
Civil Servant Jobs

3. More Fundamental Problem
Common Scenario among PIIGS

4. Pre Euro Scenario – Risk Factors
• Process of Convergence – key macroeconomic variables inflation, interest
rates should be same.
Stability and the growth pact
*Limits Budget Deficits – 3% (GDP),
*Public Debts – 60%(GDP)
*No Bailout Clause – Sovereign Default

5. Due to common currency, Financial Markets
Looked at countries like Greece, Ireland with
same risk of default as Germany.
Free rider problems: Easy Credit
Pre Euro Scenario – Risk Factors

6. Evolution of Debt/GDP Post 1999-2000

7. Public Debt Swells – 2000 to 2010

8. Financial Imbalances
2003-2007 - Housing Bubbles
booms In Ireland & Spain
Euro Zone Meant  Banks could raise from
International sources in their own currency
(euro) - Lower interest rates & easy credit 
consumption related & property related
borrowings
Easy credit: ↑Private Sector Borrowings

9. External Imbalances
Current Account Balance in Euro
Area is close to zero due to
sheer size of German Economy
* Capital inflows fueled property bubbles which have little effect on future productivity growth.
• Delayed Structural Shocks – Competition from Eastern Europe & emerging Asian markets in
the production of low margin goods  Significant Macroeconomic Risks
• CAD is harmful if increased expenditure on nontradables squeezes tradable sector by bidding
up wages and drawing resources away from high productivity growth.
• Sudden shocks  external capital flow reversals  output contractions, asset price declines,
rising unemployment

10. Failure to Tighten Fiscal Policy
Private Sector taking risks
* Increased Tax revenues
* Capital gains taxes
* Asset transaction taxes
* Instead of reducing external debt
Governments cut taxes & increased
Public spending
* Just contained regular fiscal deficits.

11. Global Financial Crisis
• High Exposure of European banks to US market in asset – backed
securities.
• Investors reassessed their international exposure levels and
withdrew funds to home markets.
ECB Actions
• Slashed short term interest rates
• Provided euro-denominated liquidity
• Currency swap arrangements
• Facilitated access by European banks to dollar-denominated
liquidity
• Cross Border financial flows dried up in late 2008.

12. Implications of Drying up of Cross Border
Financial Flows
• Asymmetric effects across Euro Area
• High Dependency on external
funding; reliance of banking system
on international short term funding
• Squeeze on External funding --> End
of Credit boom, property bubble
bursts
• Falling asset prices, abandoned
projects.
• Huge losses to banks that made
property-backed loans.
• Banking Crisis
Euro Area Sovereign Debt
Markets (bonds)
remained stable – danger
lurking in the dark!
Asymmetric Effects on Ireland, Portugal & Greece
Within Euro Area.

13. Lets get back to Greece!
*Change in Government in 2009
*New Government Revised Budget
deficit forecast from 6% to 12.7%
*Shocks
* No more rollover debt
* Imminent bailout talks
*Social unrest ,High Unemployment

14. No more Rollover DebtWhy bother?
*Monetary Union lead to highly
intertwined European economies.
*Cross border project financing
Wakeup call, rollover
problem hit larger
economies like Italy
and Spain

15. What happens when Greece Defaults?

16. Rising bond Yields
Self-fulfilling – Speculations!
↑ Perception of default risk
↑ Rate of borrowing & investors
demand higher yields
Perception of default risk turns a
reality.
Rising bond yields indicates
higher risks

17. Reforms to Address Sovereign debt
Concerns
• Stability and growth pact: pre-crisis focused on containing budget deficit
to 3% of GDP, but left out Debt/GDP levels.  New systems focuses on
structural budget balance. Governments bank on cyclical revenue gains in
exchange for a greater slippage during recessions.
• Banking Union: diabolic loop between national banking systems and
national governments was central to fiscal crisis.
• Introduction of “euro bonds” to counter the self fulfilling speculative
attacks – European Financial Stability Facility
• Problem: Weaker states might over borrow using euro bonds.
• Solution: limit these bonds to short maturities, thereby denying access to
ill-disciplined countries.

18. Response to Sovereign Debt Crisis
• Joint bailouts in 2010-2011 by EU & IMF
• Fiscal Austerity packages & structural reforms to boost growth.
• Repayment period in general was 3 years.
Problems
• Macroeconomic adjustments were longer in high income countries (Debt/GDP
ratios are stickier).
• Very difficult for real growth rates to exceed long term growth rates of 2% in
advanced economies.
• Adding to that – erosion in human capital due to prolonged unemployment.
• So repayment period was increased to 15-30 years.
• IMF principle : if sovereign debt level is not sustainable, private sector creditors
take a beating by reduced PV of debt owed to them.
• March 2012, Second bailout package of Greece required 50% cut in PV.

19. Need for Fiscal Union
Surrendering National
Sovereignty?
Fiscal rules written into
domestic legislation
giving greater political
legitimacy
External Sanctions,
remain as
“second line of
defense”
- United States of Europe?
Or
Euro Break up?

20. Recent Phenomena
• S&P Downgrades Greece’s credit rating from B to B- (Feb 6,2015)