The European Sovereign Debt Crisis originated from the rapid growth in government debt in Europe, particularly the Eurozone. Sovereign debt in the Eurozone is denominated in euros, an international currency. Eurozone countries cannot get out of their debt problems by means of currency devaluation.
• Growing fiscal deficits and rising debt levels of several European governments in 2000s.
• Deficits and debt levels were made worse by Global Financial Crisis.
• Banks are major investors in government bonds in some Eurozone countries.
• Financial health of banks therefore linked to state of government finances, since rising bond yields mean falling bond prices.
• Loss of investor confidence in Greece, threat of default by Greece.
• Contagion effect: investor concerns spread to Ireland, Portugal, Spain, Italy, Belgium.
• EU/IMF rescue packages for Greece, Ireland, Portugal, Cyprus.
• Governments impose fiscal austerity measures. Economic recession or low growth.
When the Greek government announced a revision of its budget deficit in November 2009, from 6 per cent to 12.7 per cent of GDP, the three major global credit rating agencies responded soon after by downgrading Greece’s credit rating
A number of EU members became very vulnerable to financial shocks. The high debt levels and high budget deficits meant that a sudden increase in interest costs would place significant additional burden on those countries, and loss of access to reasonably priced debt would expose governments to bankruptcy risk (i.e. an inability to meet their payment obligations). This is what happened to Greece and a number of other countries in the eurozone.
In Spain and Ireland, the financial problems of the government were compounded by a property market crash, causing large defaults of property loans and large losses for banks.
Contagion is defined as some or all of the following effects that a country may experience as a result of a financial crisis in another country:
• increase in the perceived likelihood of a financial crisis
• correlated increase in asset-price volatility
• correlations in asset-price movements not driven by fundamentals, but rather by perception of risk and changes in risk.
Missio and Watzka (2011) found that Portugal, Spain, Italy and Belgium have been particularly affected by the contagious effects of the Greek sovereign debt crisis, as evidenced by movements in bond yields
The build-up of high debt levels was caused by consistent budget deficits (the difference between a government’s tax receipts and its spending). This meant that should a government lose access to cheap debt, it would need to take drastic measures to cut its expenditure, or increase taxes, to be able to balance its budget.