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“Ovidius” University Annals, Economic Science Series Volume XII, Issue 1 /2012 Eurozone Sovereign Debt Crisis: Causes and Solutions Maria Pascal (Andriescu) “Alexandru Ioan Cuza” University of Iasi [email protected] Abstract Debt issue is a highly debated topic today since many of the world economies, especially the Eurozone, hit by global financial and economic crisis, faces with high levels of deficits and debt. Credit rating agencies, due to the problems related deficits and public debt have downgraded the credit ratings of these countries, with the immediate impact on financial markets. This paper aims to develop an analysis of the Eurozone sovereign debt crisis and of the measures taken by European leaders to reduce excessive levels of budget deficits and debt. Keywords: sovereign debt, Eurozone debt crisis, European Fiscal Pact, excessive deficit procedure J.E.L. Classification: F34, H63, H68 1. Introduction The global economy is currently facing with a sovereign debt crisis that is spreading rapidly across the euro region. The sovereign debt crisis triggering proved the ineffective of the surveillance systems within EMU and of the framework for coordinating economic policies in general. Accumulation of the macroeconomic imbalances in pre-crisis year was not checked sufficiently and their unwinding has since proven very costly for some Eurozone countries and has also contributed to the ongoing sovereign debt crisis, with serious implications for the functioning of the Eurozone as a whole. This paper provides a clear image regarding the Eurozone sovereign debt crisis by analyzing the causes that led to this situation, the evolution of public indebtedness starting with the year prior to triggering crisis up to the present and, also, the measures taken to reduce budget deficits and excessive levels of public indebtedness. The rest of paper is organized as follows: Next section presents the analysis of the causes that led to the Eurozone sovereign debt sharp increase. The dynamics of public debt in the period 2006-2012 is described in Section 3 of this paper followed, in Section 4, by an analysis of measures taken by European leaders in order to overcome the current sovereign debt crisis. Section 5 concludes. 2. Causes of indebtedness of Eurozone countries The global economic crisis has increased the debt in all Eurozone countries due a combination of high fiscal deficits and support measures for the banking sector. While the magnitude of debt varies considerably among states, it is high enough overall to bring the issue of medium and long term sustainability [16]. Massive accumulation of budgetary deficits and unsustainable debt in the Eurozone countries endangers not only the monetary union or the European Union, but also the entire global economy. In order to expand rapidly Euro Zone, the European Economic Community leaders have allowed the economically less prepared countries to adopt the euro. The new entrants have brought with them many elements of failure, affecting monetary union as a whole, including [6]: Inefficient restructuring of the economy; Existence of oversized public sectors; High social transfers; Industries oriented to produce goods with low added value; High consumption of raw materials, which make the cost structure to be extremely rigid, almost inflexible; Low sustainability of pension systems and public finances;

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“Ovidius” University Annals, Economic Science SeriesVolume XII, Issue 1 /2012

Eurozone Sovereign Debt Crisis: Causes and Solutions

Maria Pascal (Andriescu)“Alexandru Ioan Cuza” University of Iasi

[email protected]

Abstract

Debt issue is a highly debated topic todaysince many of the world economies,especially the Eurozone, hit by globalfinancial and economic crisis, faces withhigh levels of deficits and debt. Credit ratingagencies, due to the problems related deficitsand public debt have downgraded the creditratings of these countries, with the immediateimpact on financial markets. This paper aimsto develop an analysis of the Eurozonesovereign debt crisis and of the measurestaken by European leaders to reduceexcessive levels of budget deficits and debt.

Keywords: sovereign debt, Eurozonedebt crisis, European Fiscal Pact,excessive deficit procedure

J.E.L. Classification: F34, H63, H68

1. Introduction

The global economy is currently facingwith a sovereign debt crisis that is spreadingrapidly across the euro region.

The sovereign debt crisis triggeringproved the ineffective of the surveillancesystems within EMU and of the frameworkfor coordinating economic policies ingeneral. Accumulation of the macroeconomicimbalances in pre-crisis year was not checkedsufficiently and their unwinding has sinceproven very costly for some Eurozonecountries and has also contributed to theongoing sovereign debt crisis, with seriousimplications for the functioning of theEurozone as a whole.

This paper provides a clear imageregarding the Eurozone sovereign debt crisisby analyzing the causes that led to thissituation, the evolution of publicindebtedness starting with the year prior totriggering crisis up to the present and, also,

the measures taken to reduce budget deficitsand excessive levels of public indebtedness.

The rest of paper is organized as follows:Next section presents the analysis of thecauses that led to the Eurozone sovereigndebt sharp increase. The dynamics of publicdebt in the period 2006-2012 is described inSection 3 of this paper followed, in Section 4,by an analysis of measures taken byEuropean leaders in order to overcome thecurrent sovereign debt crisis. Section 5concludes.

2. Causes of indebtedness of Eurozonecountries

The global economic crisis has increasedthe debt in all Eurozone countries due acombination of high fiscal deficits andsupport measures for the banking sector.While the magnitude of debt variesconsiderably among states, it is high enoughoverall to bring the issue of medium and longterm sustainability [16].

Massive accumulation of budgetarydeficits and unsustainable debt in theEurozone countries endangers not only themonetary union or the European Union, butalso the entire global economy.

In order to expand rapidly Euro Zone, theEuropean Economic Community leadershave allowed the economically less preparedcountries to adopt the euro. The new entrantshave brought with them many elements offailure, affecting monetary union as a whole,including [6]: Inefficient restructuring of the economy; Existence of oversized public sectors; High social transfers; Industries oriented to produce goods with

low added value; High consumption of raw materials, which

make the cost structure to be extremelyrigid, almost inflexible;

Low sustainability of pension systems andpublic finances;

“Ovidius” University Annals, Economic Science SeriesVolume XII, Issue 1 /2012

Poor developed infrastructure, whichshows an increase in transport costs and areduction in trade;

Large discrepancies between current andfuture economic competitiveness betweenthe developed states and new members,due to inefficient labor policies promotedby the authorities.In order to fit the parameters set by the

Maastricht Treaty, countries such as Italy,Spain and Greece have implemented toughfiscal measures without making acomprehensive restructuring. These countrieshave resisted more than five years in theEurozone, stimulated by the huge infusionsof cash and by an unprecedented access tocredit from other member states. At the sametime, their productivity was limited due torigid labor markets and a reduced economiccompetitiveness.

After the American crisis in the early2000s that led debt again on an upward trend,Eurozone member states have succeeded, dueto the expansion period in the years 2005-2007, to reduce government debt to aminimum of 66.2% in 2007. After this year,however, as a consequence of the economicand financial crisis that led to economiccontraction and to the need of governmentaid for banking system, public indebtednessrecorded a worrying trend, reaching 88.5% in2012, according to the latest forecasts ofEuropean Commission.

Table 1. The amounts allocated by Europeangovernments to support the banking system

Guarantees Liquidityinjections Total

UK 460 bil. € 47 bil. € 507 bil. €DE 400 bil. € 100 bil. € 500 bil. €FR 320 bil. € 40 bil. € 360 bil. €DK 200 bil. € 200 bil. €NO 55.4 bil. € 55.4 bil. €PT 20 bil. € 20 bil. €

Source: Wehinger, G. (2008), “Lessons fromthe Financial Market Turmoil: Challengesahead for the Financial Industry and PolicyMakers”, Financial Market Trends, OECD,p. 9;

To combat the credit market crisis,European governments have made availableto financial system players around 1,870billion euros in 2008.

Germany has allocated the sum of 400billion euros for interbank market loans. Thegovernment also created a reserve fund of100 billion euros to make infusions ofliquidity into institutions in difficulty and topurchase illiquid assets.

The Paris Executive guaranteed interbankloans of 320 billion euros and provideliquidity reserves of 40 billion to financialinstitutions in order to increase liquidityindex to 9% so that it can compete from thesame level with the similar Britishinstitutions.

In the same time, the Netherlands, Spain,Italy, Austria, Portugal and Norway havejoined this effort, paying 501 billion euros asguarantees and reserve funds. Britishgovernment made available to three localbanks liquidity worth 37 billion pounds (47billion euros), as part of a financial systemrescue plan worth 400 billion pounds (507billion euros). Norway has offered to thedomestic commercial banks credit linestotaling 55.4 billion euros, acceptingmortgages hold by them as collateral. ThePortuguese authorities have also allocatedguarantees worth 20 billion euros for theinterbank market operations.

These measures taken to save severalEuropean banks from bankruptcy representsone of the main factors that contributed to thecurrent difficult situation in which are theEuropean economies. Although the financialinstitutions support was necessary, avoiding abankruptcies series that would have ruinedeconomies, the way it was done has onlymove the debt from one place to another,leading to an EU countries public over-indebtedness.

3. Sovereign debt evolution

Analyzing data on sovereign debt, weobserve that, in Eurozone, the most heavilyindebted states, Greece and Italy, recordedeven before the global financial andeconomic crisis high levels of public debt.Not the same thing we can say about Irelandand Portugal which, after the outbreak of thecrisis, have experienced a sharp rise in debtlevels. Thus, Irish presented in 2007, aindebtedness level of 25.9% and today itstands at about 108.1%. The global crisis hasalso hit the Portugal which recorded a rise ofdebt from 68.3% in 2007 to 101.6% in 2011.

“Ovidius” University Annals, Economic Science SeriesVolume XII, Issue 1 /2012

Table 2. The Eurozone government debt evolution in the period 2006-2012 (% in GDP)2006 2007 2008 2009 2010 2011* 2012**

Estonia 4.4 3.7 4.6 7.2 6.6 5.8 6.1Luxemburg 6.7 6.7 13.6 14.6 18.4 19.5 20.2Slovenia 26.4 23.1 21.9 35.2 38.0 45.5 50.1Slovakia 30.5 29.6 27.8 35.4 41.0 44.5 47.5Finland 39.7 35.2 34.1 43.8 48.4 49.1 51.8Netherlands 47.4 45.3 58.2 60.8 62.7 64.2 64.9Cyprus 64.6 58.3 48.3 58.0 60.8 64.9 68.4Malta 64.2 62.0 61.5 67.6 68.0 69.6 70.8Spain 39.6 36.1 39.8 53.3 60.1 69.6 73.8Austria 62.1 60.7 63.8 69.6 72.3 72.2 73.3Germany 67.6 64.9 66.3 73.5 83.2 81.7 81.2France 63.7 63.9 67.7 78.3 81.7 85.4 89.2Belgium 88.1 84.2 89.6 96.2 96.8 97.2 99.2Portugal 63.9 68.3 71.6 83.0 93.0 101.6 111.0Ireland 24.8 25.0 44.4 65.6 96.2 108.1 117.5Italy 106.6 103.6 106.3 116.1 119.0 120.5 120.5Greece 106.1 105.4 110.7 127.1 142.8 162.8 198.3Eurozone 68.4 66.2 69.9 79.3 85.4 88.0 90.4*= estimation; ** = forecast; Source: “European Commission (2011), “European economicforecast – Autumn 2011”, European Economy, Vol. 6, p. 225;

The Eurozone is not the only faced with largeincreases in debt levels, as a result of theglobal crisis. Thus, the United States, with adebt level of 62.3% of GDP in 2007, isexpected to arrive in 2012 at a indebtednesslevel of 102.4% of GDP. In a similarsituation of an excessive increase of debtfrom the outbreak of the global crisis, is alsoJapan, for this being expected an increasefrom 167.0% of GDP in 2007 to 215.9% in2012. The strong growth of public debt inboth advanced economies, measured inpercentage points of GDP indicates that thedebt problem is not just an issue of the euroarea.

Figure 1. Debt level in Eurozone countries in2007 and 2012

Source: European Commission (2011),“Quarterly Report on the Euro Area”,Volume 10 No. 3;

As shown in Figure 1, there is a widevariation in the evolution of the debt in theEurozone countries. While in countries likeEstonia, Cyprus and Malta debt is estimatedto have modest increases, in Spain andPortugal are expected increases of over 30percentage points from 2007 and in Greeceand Ireland, over 60 and, respectively, 90percentage points.

Increasing debt represents a real problemfor policy makers. The high levels of debtbrings into question the sustainability of aneconomy, given that the sustainability refersto the ability of government to meet, on longterm, its financial obligations related debtcontracted. Here we do not refer only to thecosts of an increasing debt but also to its sideeffects that create difficulties. Once exceededa certain threshold, there is evidence that thedebt has a negative effect on growth, whilethe perceived risk associated with high levelsof debt may lead to an increased interest ratefor the new debt. Thus, the interest paymentsincrease not only because of the increasingdebt levels but also due to higher loan costs.Moreover, higher taxes, required for debtservice payment will act as a brake ongrowth.

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4. Emergency measures for sovereign debtcrisis resolving

On May 9, 2010, in order to assistcountries with financial problems, theEurozone member states have agreed tocreate the European Financial StabilityFacility (EFSF). EFSF can issue bonds orother debt instruments on market, supportedby the German Office of Debt Managementin order to raise the necessary funds forproviding loans to Eurozone countries infinancial difficulty, to recapitalize banks or toredeem sovereign debt. Bond issues aresupported by guarantees granted by Eurozonemember states, proportional with their sharein paid-up capital of the European CentralBank. Borrowing capacity of 440 billion isguaranteed by the Eurozone governments andcan be combined with loans up to 60 billioneuros from the European FinancialStabilization Mechanism (EFSM) and up to250 billion euros from the IMF, to obtain afinancial safety net up to 750 billion euros.

On November 29, 2011, Finance Ministersof the Member States agreed to extend EFSFby creating certificates that could guaranteeup to 30% of Eurozone government newissues and to create investment tools thatwould increase the power of EFSF tointervene on primary and secondary bondmarkets.

Fund is scheduled to expire in 2013,running a year in parallel with fundingprogram called the European StabilityMechanism (ESM), which will be launchedmost likely in July 2012.

On January 5, 2011, European Unioncreated the European Financial StabilizationMechanism (EFSM), an emergency fundingprogram based in funds obtained fromfinancial markets and guaranteed by theEuropean Commission, using, as guarantee,EU budget. It works under the Commissionsupervision and aims to maintain stability inEurope by providing financial assistance toEU member states in economic difficulty.EFSM is rated AAA by rating agencies Fitch,Moody’s and S&P.

By the EFSM, the EU has successfullyplaced on the capital markets bonds worth 5billions euros as part of financial supportpackage agreed for Ireland, at a EFSMborrowing cost of 2.59%.

As European Financial Stability Fund, theEuropean Financial Stabilization Mechanismwill be replaced with a permanent programfunding named European StabilityMechanism (ESM), which will be launchedin July 2012.

To assist states in financial difficulty, theESM may provide loans, preventive financialassistance, purchase member states bonds onprimary and secondary markets and credit inorder to recapitalize financial institutions.Loans will be conditioned andreimbursement will be a priority. Volumeadequacy of ESM maxim loans will berevised periodically. Current ceiling ofcommon borrowing capacity EFSF/ESM is500 billion euro.

A key element in the strategy of Euro zonedebt crisis overcome is the new Treaty onstability, coordination and governance in theeconomic and monetary union, called alsothe European Fiscal Pact, signed on March2, 2012 by the all member states, exceptUnited Kingdom and the Czech Republic.

The main objective of the Treaty isdefined in its first Article as being promotingfiscal discipline, strengthening economicpolicy coordination and improvinggovernance in the Eurozone, in order toachieve EU objective of sustained economicgrowth, employment, competitiveness andsocial cohesion.

The Fiscal Pact will come into force onJanuary 1, 2013, subject to ratification by 12Eurozone member states or on the first day ofthe month following storage of the lastratification instrument from the 12th eurozone member, first of two dates beingchosen.

According to Article 3(1), the budgetaryposition should be balanced or in surplus.This rule is considered met if the annualstructural balance meet medium-termbudgetary objective and does not exceed0.5% of GDP.

Also in the same article it is mentionedthat, structural deficit may have a higherthan specified value, up to maxim 1% ofGDP, at market prices, if public debt issignificantly below 60% of GDP and risks forlong term public finances sustainability arelow. Budget rules are introduced throughnational provisions with binding legal forceand permanent character, preferablyconstitutional or otherwise guaranteeing the

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full respect and adherence to themthroughout the national budgetary processes.Rules must be specified in national lawwithin one year after entry into force of theTreaty.

Article 8 provides that, if the state doesnot include the two rules into national law,the Court of Justice of the European Unionmust be apprised. If the court decision is notrespected, it may entail a lump sum paymentor an appropriate situation penalty, whichmay not exceed 0.1% of Gross DomesticProduct. Amounts imposed to a contractingparty whose currency is euro are paid toEuropean Stability Mechanism. In othercases, payments are paid to the generalbudget of the European Union.

States that are the subject of an excessivedeficit procedure establish the bindingbudgetary and economic partnershipprograms, monitored by the EuropeanCommission and European Union.

International Monetary Fund, through thechief economist Olivier Blanchard proclaimsthat the new agreement is a step in the rightdirection but not a complete solution to thesovereign debt crisis [2]. British PrimeMinister, David Cameron, shares the sameview, believing that the change of treatiesdoes not solve current problems. In hisconception, Eurozone member states mustbecome more competitive and EuropeanCentral Bank should support the eurocurrency and none of these things involvetreaties changing.

By signing the European Fiscal Pact,Romania is committed to a fiscal disciplineprogram, a program that imposes rules onbudgetary deficit. It does not fit perfectly tothe Romanian economy needs which wouldneed major investments in the coming yearsin order to increase production capacity andinfrastructure, but it is difficult to find aunified way to reduce debt. Fiscal adjustmentmeasures are more appropriate for the UErich countries than for the developingcountries, as Romania. However, we can saythat the Pact is, for Romania, a warranty thatprovides access to international capitalmarkets in order to attract funds for financingbudget deficit at reasonable prices.

5. Conclusions

The global economic crisis triggered in2007 affected especially advancedeconomies, this situation representing amajor change since the last decades emergingmarkets were in the central concerns relatingsovereign debt crisis.

Three of the Eurozone countries (Greece,Ireland and Portugal) have receivedemergency loans in order to prevent entryinto default but public debt crisis persistscausing a domino effect in the country ratingfor most nations affected.

The gravity of the Eurozone current debtcrisis is that it has potential to cause amassive banking crisis in center of Europesince much of the sovereign debt of thecountries in financial difficulty is contractedfrom the banks of France and Germany.

Undoubtedly, the approximately threeyears of financial and economic crisis hadserious consequences for the Eurozonecountries. To assist, the EU has created twotemporary instruments that will be replacedin 2012 with the permanent EuropeanStability Mechanism. The first of these, theEuropean Financial Stabilization Mechanism,was established in order to provide financialassistance from the Union with guaranteesfrom the EU budget. The second instrument,the European Financial Stability Fund isdesigned to assist Eurozone member stateswith an amount of funds up to 440 billion.

In the strategy of Eurozone sovereign debtcrisis overcoming, an important stage is thesigning, in March 2012, of the Treaty onstability, coordination and governance in theeconomic and monetary union (EuropeanFiscal Pact). It provides primarily tax rulesfor balancing budget and economic policycoordination at European level. EuropeanFiscal Pact requires a commitment from theparticipating states to a strong fiscalgovernance, introduction of budget balancingprovision in the Constitution, strengtheningregulations on the excessive deficit procedureby automating sanctions and submission ofthe budget projects for EuropeanCommission verification.

Through these measures taken to resolvethe debt crisis, European economies haveexceeded the immediate danger but are in thefront of a long period af convalescence.Europe must make further efforts to restart

“Ovidius” University Annals, Economic Science SeriesVolume XII, Issue 1 /2012

economic growth while reducing debt incountries with problems. If the end of 2011there were concerns about the disappearanceof the Eurozone and the unique currency,major events in the early 2012 had a greatcontribution to reassure financial markets.

By signing the European Fiscal Pact,Romania is committed to a fiscal disciplineprogram, a program that imposes rules onbudgetary deficit. It is not perfectly fits to theneeds of the Romanian economy, whichwould need major investments in the comingyears in order to increase production capacityand infrastructure, but it is difficult to find aunified way to reduce debt. However, we cansay that the Pact is, for Romania, a warrantythat provides access to international capitalmarkets in order to attract funds to financethe budget deficit at reasonable prices.

Acknowledgment

This paper had benefit by the financialsupport within POSDRU/88/1.5/S/47646project co-financed from European SocialFund, by the Sectorial Operational Program –Human Resources Development 2007-2013.

References

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