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ABSTRACT
The behaviour of sovereign bond investors stands at the heart of the euro area debt crisis. By pushing upward the yields on the government debts of member states standing in the eurozone's periphery, investors caused, in a self-fulfilling way, the crisis that ultimately threatened the eurozone's integrity and the euro's survival. So how do we explain the behaviour of market investors before, during and after the eurozone's sovereign debt crisis? Why did investors not discriminate in their pricing of eurozone sovereign bonds before the crisis? Why did they abruptly change their minds in 2010? And why have they gradually felt reassured enough from mid-2011, depending on the country, to ask for significantly lower yields on sovereign bonds? To answer these questions, the paper argues that investors’ confidence rests to a large extent on the expectation of the eurozone's solidarity, which is why large-scale multilateral solutions coming from the euro area were more successful in resolving the crisis than unilateral ones coming primarily from the debtor countries. As a result, this paper improves our understanding of the international political economy of financial (currency, bank and debt) crises by looking at the particular case of a monetary union with a single currency.
ACKNOWLEDGEMENTS
We would like to thank David Howarth and Lucia Quaglia for having made this paper possible. We are also very grateful for the excellent comments received from two anonymous reviewers. They really helped sharpen our thinking.
Notes
1. At the time of writing (June 2014), there were still doubts as to whether the crisis was over; however, the continued decline in bond yields in 2013 and 2014, the return of economic growth in the euro area, albeit at very modest levels, and the end of the official bailout programmes in Ireland and Portugal strongly suggest that the crisis has passed. Unfortunately, this does not mean that the difficult task of reforming public finances and the economy is now behind eurozone governments and people.
2. It is important to note that there exists a substantial body of literature that argues that monetary integration would constrain government spending in the euro area (e.g. Bovenberg et al., Citation1991; Glick and Hutchison, Citation1993; Mongelli, Citation1999).
3. These prohibitions are found in Articles 123–125 TFEU (Treaty on the Functioning of the European Union) (Articles 101–103 of the Maastricht Treaty). In a review of the literature on fiscal federalism, Oates (Citation2005) casts doubts on the effectiveness of such bailout prohibitions.
4. This decrease in bond yields is a result of the decrease in inflation and liquidity risk, as well as the elimination of exchange risk, that were expected to result when countries adopted the single currency.
5. There are other criteria for joining the single currency in the Maastricht Treaty, as already mentioned, but the key criterion for deciding which countries would adopt the euro was the one on fiscal deficits (no more than 3 percent of GDP).
6. A similar situation prevailed in 1995–1997 with respect to emerging market bonds, just before the East Asian financial crisis (Eichengreen and Mody, Citation1998).
7. One basis point equals one percent of one percentage point. For example, an increase in the yield from 2.55 percent to 2.80 percent corresponds to an increase of 25 basis points.
8. In Cyprus's case, a bailout became necessary in the winter of 2013.
9. For an excellent study of the domestic politics that take place during currency crises, see Walter and Willett (Citation2012).
10. Aizenman et al. (Citation2013), Arghyrou and Kontonikas (Citation2011), Arghyrou and Tsoukalas (Citation2011), Ghosh et al. (Citation2013), and Gibson et al. (Citation2012) also subscribe to this explanatory model of self-fulfilling multiple equilibria.
11. Irish and Portuguese sovereign bond yields also continued to increase after the November 2010 and May 2011 bailouts, respectively.
12. The speed at which fiscal consolidation must be undertaken depends on the extent and duration of financial assistance (i.e. bailouts) from external sources as long as international bond markets remain unwilling to finance the government's debt at reasonable interest rates. The availability of untapped domestic savings to finance fiscal deficits will also make fiscal consolidation easier.
13. For domestic bondholders, their euro-denominated debt gets converted to the national currency so that it can be inflated away.
14. See Eichengreen and Wyplosz (Citation1998) for an early sceptical view of the SGP's importance.
15. Luxembourg belongs in this group but data on banking claims are not available.
16. The Slovenian government ran a large fiscal deficit in 2013; however, sovereign bond investors did not react negatively to this dismal fiscal performance.
17. In Portugal's case, the banking crisis was less intense but the government's public finances were much weaker than in the other three cases (see ).
18. Gibson et al. (Citation2012: 504) claim instead that it is the request by Dubai World for a six-month debt moratorium that made bond investors more nervous. This seems unlikely, however, since the spreads for the other GIIPS (Greece, Ireland, Italy, Portugal and Spain) countries did not increase in November 2009.
19. According to Featherstone (Citation2011: 199), the governor of the Bank of Greece declared publicly only days after the election that the 2009 deficit was set to be above 10 percent of GDP.
20. In December 2009, Fitch, another major credit-rating agency, downgraded Greece's debt to BBB+, which is two grades above junk status. It was the first time in a decade that Greek sovereign ratings had fallen below the A grade. A week later, Standard & Poor's also lowered its rating of Greek sovereign debt to BBB+. Finally, it was Moody's turn a few days later to lower Greece's debt rating, from A2 to A1.
21. For a study of the effects of political communication on sovereign bond spreads, see Gade et al. (Citation2013).
22. The figure was again revised by Eurostat in November 2010, to 15.4 percent of GDP. The final figure has been established at 15.7 percent of GDP (see ).
23. If a financial asset (e.g. a bond) is rated ‘junk’, then it means that certain investors – most especially conservative institutional investors like insurance companies and pension funds – can no longer buy such an asset. As a result, there is less demand for this asset, which leads to a decrease in its price and an increase in its yield.
24. The same day, not by coincidence, the ECB announced that it was suspending, in the case of Greek government debt, its requirement that debt instruments accepted as collateral in refinancing operations satisfy a minimum credit rating threshold. This measure ensured that eurozone banks would be able to continue offering Greek sovereign debt as collateral against loans from the Eurosystem even if credit ratings on Greek debt were falling below the ECB's minimal requirement. Nevertheless, such a decision was not without controversy in terms of what it entailed for the ECB's independence (see Kirkegaard, Citation2010b).
25. A few days after the Greek bailout, on 9 May 2010, EU (not eurozone) governments delivered a massive rescue package plan of €750 billion, because they were afraid that the Greek crisis was becoming contagious, with Ireland and Portugal increasingly at risk (see below for details). The sum was meant to be at the disposal of any EU member state facing public finance difficulties. It included €60 billion in balance-of-payment help from the European Commission (European Financial Stability Mechanism [EFSM]), €440 billion in eurozone-backed loan guarantees (European Financial Stability Fund [EFSF]) and, finally, €250 billion in loans from the IMF. All funds and guarantees extended were subject to IMF conditionality rules. Furthermore, the ECB contributed to this rescue operation by putting together a ‘securities markets programme’ whereby it would purchase a limited number of government bonds on financial markets in order to maintain (not increase) liquidity in eurozone credit markets.
26. The use of the term ‘restructuring’ should not obscure the fact that it nevertheless amounts to a default, albeit an organized one.
27. The actual deal took place in March 2012.
28. The budget might have been considered tough, but in reality the fiscal deficit was much higher in 2013 than in 2012 (see ); however, sovereign bond investors did not show that they were concerned with such a poor fiscal performance (see ) given the external support and guarantees accorded to the Greek government and economy.
29. It should be noted that in spite of their ratings still being of ‘investment’ grade, Portuguese banks had not tapped private financial markets for funding in more than a year because of unprofitable yields demanded by investors. Instead, the banks preferred to borrow from the ECB as part of the latter's special crisis measures put in place to inject liquidities into the eurozone's banking system in order to keep it functioning.
30. For details on Europe's banking union, see Leblond (Citation2014).
Additional information
Notes on contributors
Michele Chang
Michele Chang is a Professor in the Department of European Political and Administrative Studies at the College of Europe in Bruges, Belgium. She is vice chair of the European Union Studies Association. She has received grants from the Fulbright Program, the Deutscher Akademischer Austausch Dienst, the Institute of Global Conflict and Cooperation and the Picker Foundation. Her research interests include European economic and monetary union, financial crises and economic governance. Her upcoming book, Economic and monetary union, will be published by Palgrave Macmillan in 2015.
Patrick Leblond
Patrick Leblond is an Associate Professor in the Graduate School of Public and International Affairs at the University of Ottawa as well as Research Associate at CIRANO (Montreal). He is also Affiliated Professor of International Business at HEC Montreal and Visiting Professor at the University of Barcelona (LL.M. in International Economic Law and Policy [IELPO]) and the World Trade Institute in Bern, Switzerland. He is a member of Statistics Canada's International Trade Advisory Committee and an advisor to the Canada-Europe Roundtable for Business. Dr. Leblond has published extensively on financial and monetary integration, banking regulation, international trade and business-government relations, with a particular focus on Europe and North America. Prior to moving to Ottawa, he taught international business at HEC Montreal and worked in accounting and auditing (he holds the title of Chartered Accountant) as well as in corporate finance and strategy consulting for major international accounting and consulting firms.