Tuesday, 15 November 2011

Eurozone crisis - Intermezzo

Here's something to keep it interesting while waiting for the next few posts on consequences and the remedies of the eurozone crisis. 

I 'borrow' this figure from the Economist, depicting debt burdens of eurozone economies:

Source: The Economist

The graph serves as a good reminder on importance of debt levels and the sustainability of these debt levels on investor confidence and country bond yields. Greece, Italy, Portugal and Ireland (4 out of 5 countries analyzed previously) are countries with the highest debt burdens in the eurozone and are the countries most exposed to the threat of default. 

In addition to this I would like to stress out the mechanism of outside contagion described excelently by Reinhart and Rogoff (2009) (I summarize their main findings on the spread of contagion throughout the world financial system):
  • "Banking crises in advanced economies decrease growth of these economies. This slowing of growth and economic activity will hit exports thus eliminating availability of hard currency to emerging market countries, making it more difficult for them to service their debts.
  • Weakening global growth will decrease commodity prices which will reduce export earnings to primary commodity producers – the emerging market countries, making it even more difficult for them to service their debt
  • Banking crises in global financial centers will yield a credit squeeze on the international lending market. Since it will become harder for the emerging market economies to obtain credit, their economic activity will contract and the burden of the debt will be harder to service
  • Banking crises will decrease investor confidence and make them withdraw from risk taking and move their money into safe assets (such as low-yield government securities). Again, emerging markets will find it much harder to borrow on the international market as the yields on their bonds will rise and they will become less attractive to investors." 
Reinhart, Rogoff (2009): "This Time is Different: Eight Centuries of Financial Folly" Princeton University Press

There are striking similarities with the case of the eurozone economies described previously. The only difference is that they didn't depend on commodity prices to drive their exports, but the credit squeeze and the dependence on credit from net lenders forced them into a situation where they were unable to service their debts anymore, and their economies contracted. Now, due to a severe decrease in confidence they find it hard to borrow on international markets and are entering into an even higher dependency on foreign aid from either Germany, the ECB or eventually the IMF (in the emerging markets case, it's usually only the IMF who comes to the rescue). 

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