International Financial Market
The European sovereign debt crisis was a major focus for international financial markets during 2010-2015. Economies fell into recession and financial market volatility was high. Critically analyse how the government debt problems initially faced by a few relatively small economies could trigger such a wide impact in financial markets. Your essay must be strongly focused on the impact on financial markets, not on other aspects of the European sovereign debt crisis, (i.e. there should be no discussion of banks, politics or macroeconomics). You can consider the impact of the crisis on any one or two of the following: equity markets, bond markets, money markets, derivatives markets and foreign exchange. Contagion (or spillover) across markets is an important theme to be included. The essay must include some theoretical content as well as practical considerations. You must demonstrate reading and research far beyond the material discussed in lectures. A minimum of ten references from academic journals is expected. Your essay will benefit significantly from the inclusion of insights from academic and practitioner research. Support your arguments with exampleswhen appropriate. You should ensure careful citation of all paper and electronic sources of information, and include a list of references. (The references are not included in the word count).
In response to some student questions:
The focus should be on contagion/spillover and the channels through which such effects operate.
Your initial objective should be to collect a group of recent journal articles that provide evidence on these spillovers in financial markets.
It is not true to state that sovereign rating actions started the crisis. Have a careful look at what happened in Greece in late 2009, and you will come to a different view.
The essay is not directly concerned with sovereign rating actions. They are relevant, but should not be the only focus.
These are the key steps in addressing the question:
The crisis started in small countries (Greece, Portugal, Ireland) which had to receive bailout funds in 2010-11. Your essay can begin with a very short discussion of this background.
The main question is: why did this crisis become a Europe-wide and global financial market problem rather than only affecting those small countries’ financial markets?
What is the process of contagion / spillover / transmission of the crisis across different countries’ financial markets?
To answer these questions satisfactorily, you need to review relevant academic research articles (at least 10 of these). You should study the articles’ research questions, literature reviews and findings, but the articles’ methodological approach is not a central aspect of my expectations for this particular assignment.
Based on this, you should structure the essay as a literature review based on this reading from journals (i.e. present their findings in relation to contagion across the financial markets you have chosen).
Please all information has to be latest articles and must provide graphs, histograms, and charts and all calculations must be included as well as all data and formulas (in appendix).
Word limit: 2,000 words +/- 10% (approximately 6 pages A4 1.5 spacing).
And this is an example of a previous work which I would like to be better than it and change the style for Figure 3. Cross-Border Exposures: Greece’s Interconnections
The European sovereign debt crisis was to a great extent transmitted from the global financial crisis which initially started from the USA mainly from under estimating the risk associated with the structured financial products or what so called Sub-prime mortgage. However, the signs of the crisis started years ago initially with the formation of the Eurozone. Andreas Dombret, 2013, Member of the Executive board of the Deutsche Bundesbank, explained that following the Eurozone, the small economies like Portugal, Spain, Greece, Ireland and Cyprus received huge capital inflow from the developed economies such as, Germany, UK and France. However, the problem has substantially increased after the announcement of the Greek Prime Minister about the real deficit of the Greek accounts in October 2009. The PIIGS (Portugal, Ireland, Italy, Greece and Spain) are the centre of the European debt crisis although Italy is slightly in better shape than the others. During the global financial crisis, advanced European countries had to commit bailout plans to rescue the effected local organisations and therefore worsened their levels of sovereign debts (Lucarelli, 2011).
This essay will critically evaluate the impact of these small economies on the financial markets in Eurozone. The main theme of the study is to find how the effect transmitted to strong economies from the relatively smaller economies. For the purpose of completing the essay and to be specific, we will evaluate only the European sovereign debt crisis effect on the financial markets in Eurozone and precisely address the impacts of the crisis on bond and equity markets. Major focus will be on Greek debt and its effect on other European countries as Greece has contributed largely to the problem. Contagion or spilloverwas blamed to be the main reason for the problem having spread from the small economies to the strong economies (Constáncio, 2012 and De Santis, 2012). The essay discusses three transmission channels of the crisis between the European countries during the sovereign debt crisis and impact. The channels are: credit rating agencies, bailout and economic news related to the effected countries, and interconnectedness and cross-boarder exposure.
Channel One: Credit Rating Agencies
The US subprime crisis caused by non-performing mortgage loans due to high interest rates transmitted through the highly interconnected financial system to Europe. The European crisis started after the New Greek government in 2010 announced the actual budget deficit which was kept hidden before. The below table shows the percentage of government debt to the GDP in the GIIPS countries (Greece, Ireland, Italy, Portugal and Spain) which explains how these countries got quickly effected one after another. From the table we see how the Greek public debt has grown by 12.3% to reach 142.8% of the GDP in 2010 serviced by public deficit of 10.5%, which is notably very high. Beside the non-transparency in disclosing information, the crisis has also revealed the weak monetary policy control on the European Union state members (Trabelsi, 2012).
Figure 1: Public Debt and Deficit (% of GDP)
Source: (Trabelsi, 2012)
In the case of Ireland, the extremely high public deficit of 32.4% in 2010 was supposed to service a public debt of 96.2% of the GDP, which grew up by 46.6% in one year only. This has made Germany to request Ireland to accept an immediate financial aid of 70 billion euros to avoid worsening the situation and prevent contagion to other European countries.
The crisis had a major impact on the bond markets especially in term of the bond yield of the European governments bonds. There was an old belief that investing in the European sovereign debt is safe till the 2009 when the European debt crisis started (Alsakka et al, 2014). European Central Bank revealed in 2012 that the European government’s bond yields has gone through significant pressure during the crisis. Many studies linked the deterioration of the sovereign bonds yield to the spread of news regarding the credit ratings of the country. (Constáncio, 2012) find that the downgrading of Greek sovereign rating be the major credit rating agencies (CRA),
S&P, Moody’s and Fitch, had great effect on other European countries. (Alsakka et al, 2014) also conclude in one research paper that the negative or even positive news from the CRA about one country will lead to spread of the result of the news to another country. Additionally,(Nelson, et al, 2011) find that a negative action by the CRA on a country will have a significant impact on the sovereign credit of another country.
Alsakka and apGwilym, 2011, state that credit rating agencies have negatively contributed to the spread of bad news which did not have an impact on the affected countries only but also did have a negative impact on non-affected countries within the Eurozone and USA as well. They compare the impact of CRA’s news (positive and negative) by using the daily rating observations, outlooks and watch-lists of at least one of the three dominant rating agencies (S&P,
Moody’s and Fitch) in two periods, pre-crisis (2000 to 2006) and during crisis till 2010. It was concluded that the effect of spill over is significant during the crisis and not much evidence of spill over effect prior to the crisis. In another study conducted by Claeys and Vasicek (2012), they suggest that euro debt crisis crossed boarders to other countries not only through the connections between bond markets but also the news about credit rating, which created massive sale of government bonds and increase in spreads. In 10 days after the new rating of PIGS, spread increases by 4 to 20 basis points.
Channel Two: Economy News and Bailout News of Effected Countries
Beetsma and his colleagues, 2013 demonstrate a study to find the effect of news between GIIPS countries and non-GIIPS. They find that the bad news tend to spread from GIIPS to non-GIIPS faster than between GIIPS countries themselves. This shows that a healthy economy can be severely affected by financially instable country especially if the volume of transactions between the two countries is high. Due to this all, investors are more cautious and tempt to take quick reactions to the negative news. However, Stracca, 2013, finds that the bond yield dramatically affected in the less advanced countries within Europe but not the advanced economies like U.K and Germany. The fact that U.K isn’t part in the Eurozone has helped to insulate itself from the deteriorating countries in Europe but to a certain extent there was a link to Ireland. Ludwig, 2014, argue that bail out plans to the affected countries of Greece, Ireland and Portugal could prevent the problem from spreading further.
In addition, the market movements react to new information that is economy-based; and this new announcement has strong impact that might affect the bond market than others. Hence, the financial market policymakers seek to the reaction relationship between the financial markets and release of monetary policy decision in order to implement new financial market policy. For instance, the release of the monetary policy decision that has been released by the American Federal Reserve and the European Central Bank caused strong increasing in bonds price intervalidity. Moreover, the Italian Bond price has reacted to the new economical announcement during long period in order to incorporate into new prices (Paiardini, 2013).
From the other side, examining the impact of Greek bailout on bank stock market in 2010, Mink and Haan (2013) have conducted a study to measure this impact using data for 48 European banks. The study figures out that, stock prices of the selected European banks, except Greek banks, do not respond to the news about Greece but they do so for news about the bail out. This finding is same even for the banks, which do not have any exposure to Greece. This gives indication that investors are sensitive and afraid that government is going to use taxes funds to extend financial support in order to control contagion.
The study throughout the below table shows that news about Greece and about the bailout have large impact on the stock prices of Greek banks. The most important finding in this study is highlighted by the third and fourth rows. Results show that news about Greece economy does not have significant abnormal change in stock prices. However, news about the bailout always has such impact on stock prices even banks that do not have any exposure to Greece have the same response.
Figure 2: Impact of bond-based news and bailout news about Greece on bank equity and sovereign bonds
Source: Mink and Haan (2013)
Examining the event of impact on the returns of sovereign bonds, the study sees a significant impact of news about Greece as well as news about the bailout on Ireland, Portugal and Spain. The impact of bailout news is 10 times more than Greece news impact. The study further suggests that the impact of bailout news on markets of other European countries is surely not surprising. The authors return the reason behind that to the learning effect or the wake-up-call. According to (Bekaert et al., 2011), domestic factors have a notable impact on the transmission of the crisis. As the crisis sparked in Greece, other countries keep an eye to see the impact and
Greece’s ability to recover. In addition to that, revising the credit rating of the GIIPS creates fear among investors on the impact of this step on other countries.
In a study conducted by Stracca (2013), he highlights that the euro debt crisis have reached to countries outside the Eurozone. The study covered 12 global advanced economies and 13 emerging ones from January 2010 to May 2013. The main impact was a considerable increase in the global risk-aversion and diminishing returns on equity in the advanced countries like Germany and US. The study further confirms that the real economy activities played an important role to transmit the contagion, which significantly impacted all assets except exchange rates.
Channel Three: Interconnectedness and Cross-Boarder Exposure
The crisis has spread out to other European countries due to the interconnectedness of financial institutions. In a report issued by IMF (October 4, 2010), it states that the global financial system is interconnected and concentrated in a way that financial activities conducted only by 20 large and complex financial institutions LCFIs. It shows that the mutual connections between economies in 2010 got six times doubled than 1985. The report further illustrates complex are these financial connections between countries. Using funds information from Lipper, the below figure shows how the connections are centred in few countries.
Figure 3. Cross-Border Exposures: Greece’s Interconnections
Source: IMF report: Understanding Financial Interconnectedness, October 4, 2010
The above map demonstrates four main types of clusters each cluster with different colour. These colours represent group of countries, which are financially connected by the financial hubs in order to have access to funds. We see that Greece is in the heart of this network being interconnected with all central nodes, which explains how contagion can spread out across the globe because of this complex network.
As a supporting material to this, a research conducted by Deutsche Bank Research (2010) explains how the cross-boarder exposure and stimulate risk within banking sector of a country.
For instance, Germany’s risk ratios were fine right prior to the US subprime crisis. However, because German banks hold significant claims on US residents, this made these banks very sensitive to the international crisis. Same for the GIIPS countries, German and French banks for instance have heavy credit exposures to Spain and Ireland. Figure 4 illustrates the exposure of banking sector of some European countries to the GIIPS by showing the USD value of claims.
Figure 4. Banks’ exposure to the euro-area periphery
Source: DBR: Monitoring Cross-Border Exposure, November 26, 2010
German banks have credit exposure of about USD 180 billion to Spain and about USD 135 billion to Ireland. For the case of French banks, they are exposed by about USD 165 billion to Spain. However, British banks have high credit exposure to Ireland by USD 130 billion. These notable numbers give clear indication on how creditor countries are relatively impacted by any debt restructuring takes place to the indebted countries. Supporting to this, as per the Bank for International Settlement (BIS), in June 2010 the Eurozone banks had exposure to of $727 billion in Spain, $244 billion in Portugal, $206 billion in Greece and $402 in Ireland (BIS 2010, PP. 1819).
The essay discusses three transmission channels of the European sovereign debt crisis, which are: credit rating agencies, bailout and economic news related to the effected countries, and interconnectedness and cross-boarder exposure. From all of the above, it can be said that the contagion was mainly due to the news related to credit rating agencies, bailout and economybased news and the interconnectedness of financial institutions. The impact of the contagion is highly observed within the GIIPS countries especially on the bond and equity markets. The spread to the developed economies is mainly through the connectedness between the financial institutions but not significantly high.
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