What is a Sovereign Debt Crisis? 

A sovereign debt crisis occurs when a country is unable to pay its public/government debt. Usually, this happens when the country’s economic growth is unable to refinance its critical level of debt. This in turn creates concern among investor that the country will default their debts and they would require higher government bond yields to offset risk of investment. It eventually becomes a vicious cycle since higher yield spreads mean higher costs of refinance. In time, the sovereign debt rolls over till the country’s financial system collapse (Amadeo, 2016).

The Eurozone Crisis 

The Eurozone crisis started in 2008, when the global financial crisis started its avalanche impact on the banking system. Due to a combination of reasons, the relatively fragile banking sector had suffered huge capital losses, and several Eurozone states had to bail out their most affected banks with supporting recapitalization loans since the banks are simply too big to fail (Harrison, 2009). These loans resulted in high government budget deficits in several Eurozone states.

This further invoked public fears of sovereign defaults in other states (Greece, Spain, Ireland, Portugal and Cyprus), causing the rise of government bond yield spreads and further creating refinancing troubles (Investopedia, 2011; SPIEGEL, 2011). The main concern here was the lack of common Eurozone institutions to absorb shocks. As these indebted countries relied strongly on external capital (sovereign debt) to finance internal investments, these countries would face will credit crunch and there were no effective measures to solve these issues (Baldwin and Giavazzi, 2015).

The crisis subsequently created financial turbulence in other Eurozone countries. Even though the countries faced with sovereign debt crisis only accounts for a small portion of Eurozone GDP, the Eurozone states’ government and banks have strong interlinkages between them. Bankruptcy of these countries could set the entire Eurozone into mayhem. Furthermore, investors were worried about the willingness of other stronger member states to support weaker states and the currency union itself (Wijffelaars and Loman, 2015).


When the crisis started to unfold, nearly everyone was blaming the indebted countries (especially Greece) for being fiscally irresponsible, such as increasing government expenditure and budget deficits to fuel for expansionary fiscal policy as to attract public votes. However, it is not completely on the government’s side to blame. Part of the reason that contributed to this high level of debt is the easy access to cheap credit. When the riskier countries with lower creditworthiness such as Greece, Portugal, Ireland and Spain joined Eurozone, they get to borrow at cheaper rates as their memberships in the Eurozone made them less of a credit risk. Investors believed that the more stable nations like France and Germany would help these states to repay their debts in case they defaulted, in which investors referred to as “a sort of implicit Germany guarantee” (The Washington Post, 2016; Lewis, 2011).

Low borrowing costs led to large capital inflows (in form of bank loans) into these riskier countries, resulting in significant increases of not only public, but also private indebtedness. For example, in Ireland and Spain’s case, the government has been fiscally responsible, but the households used the cheap debt to finance housing consumption. Without effective regulation from the government, the real estate bubble slowly inflated. During the 2008 financial crisis outbreak, the whole global economy growth was stunted. Consequently, when the real estate bubble burst, Irish and Spanish banks struggled to stay afloat and needed the government to bail them out. Overtime, these countries which took over huge amounts of debt for the bailout began having trouble in refinancing its debt. The private household debt evolved into sovereign debt crisis (Wijffelaars and Loman, 2015).

The irresponsible fiscal policies by Greece and the financial sector indiscipline in Ireland and Spain leads to the focus on the lack of fiscal union in Eurozone. Eurozone states shared a monetary union (same currency, i.e. Euro) without a fiscal union. Under European Central Bank (ECB), supply of euro is maintained by changing the interest rate, buying/selling Eurobonds or changing the amount of money banks are required to keep in the reserves. Without fiscal union, Eurozone states with the same monetary system have freedom in taxation and expenditure.

So, even with the Maastricht Treaty agreement and regulation through the ECB, countries may not be able to or would simply choose not to follow the limits on monetary policy, for instance Greece. With the aid of Goldman Sachs, Greece masked its true levels and debt (sidestepping the Maastricht Treaty) and involved in irresponsible monetary policy. The loans borrowed were not used for productive investment but used for financed social benefits as to attain votes. Only after the newly elected Socialist government took over, the deficit reports were being revised (Balzli, 2010; Willis, 2010).

Besides that, the international trade imbalances between Eurozone countries has partially contributed to the crisis. The competitiveness of most Southern Eurozone member states had been declining considerably in the years after entering euro as compared to their Northern counterparts, especially relative to Germany. From 1999 to 2007, Germany had a substantially better public debt to GDP ratio than the most affected Eurozone members such as Portugal, Spain and Italy while these weaker countries had far worse balance of payments positions (outflows more than inflows). The lack of competitiveness was partly due to the higher labour costs and lower productivity (Johnson, 2012; The Economist Intelligence Unit Limited, 2011).

Policy Reactions 

During end of 2008, the ECB has relaxed on the terms of its Long-Term Financing Operations (LTRO). LTRO is a tool to provide emergency financing to Eurozone banks to maintain sufficient liquidity for banks, thus prevent interbank lending and other loan organization from seizing up the banks’ assets (Financial Times, no date). After the 2008 global financial crisis, the ECB extended the maximum lending term of LTRO loans from 3 to 12 months. It also removed maximum limit on total lending and relaxed collateral standards required under LTRO loans (Sky, 2014).

Even with LTRO, the crisis persisted till May 2010 when the Troika, referring to ECB, European Commission (EC) and International Monetary Fund (IMF), agreed to bailout Greece, followed by Ireland in November 2010, Portugal in May 2011, Spain in June 2012 and Cyprus in March 2013 (BBC, 2012b). These Economic Adjustment Programmes, or generally referred as the Bailout Programmes, are supported by a few facilities/mechanisms, for example the European Financial Stability Facility (EFSF), European Financial Stabilisation Mechanism (EFSM) and European Stability Mechanism (ESM). The EFSF can issue bonds or other debt instruments which are backed by guarantees given by the euro area member states on the market to raise necessary funds needed for the bailout programmes. On the other hand, EFSM is also another loan facility which raised funds using the EU budget as a collateral. Later on during 2012, ESM was introduced to replaced EFSF and EFSM as a permanent lending facility to those Eurozone states which need financial assistance (Walker, 2015).

However, the loans given came with pricey measures. Eurozone states which took up the bailout programmes had to undertake strict austerity policies such as cutting down government expenditure (plunging social benefits) and raising taxes. Out of sudden, the people in these countries were finding themselves out of jobs. Unemployment, homelessness and suicide rates had hit record high, labour productivity plunged due to job insecurity, and the people lose their access to healthcare services (Reynolds, 2015). The human costs of the austerity measures were extremely high, especially in Greece’s case. Besides, these measures may help to pay off debts in short-term, but it will create a devastating impact on the economic growth on the longer term. As the countries were amid negative growth, these measures would push them further into recession. This led to political upheavals (anti-austerity protests) in all of these countries.

Amidst these events, the Euro Plus Pact or the Competitiveness Pact was enforced in all European Union members (except for a few) to increase the competitiveness of all member states and to stabilise economic growth among the states. It is a first step to structural reform in Eurozone and aims to increase competitiveness, employment, sustainability of public finances, financial stability reinforcement and tax policy coordination. Measures such as reducing labour costs, increasing labour participation/competition by education system improvement and constant monitoring over financials status of country are implemented in hope to resolve the issue of trade deficits (Eurofound, 2014).

Aside from Euro Plus Pact, during 2012, 25 out of 27 EU member states signed a treaty, the European Fiscal Compact, aka the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG), which impose strict regulation on member states’ budget policies. Penalties will be imposed on the “rule-breakers” as to avoid the replication of the 2008-2016 Eurozone crisis where the sovereign debts used to finance budget deficit exceeded the country’s debt capacity (BBC, 2012a).


With all the measures undertaken, Ireland managed to exit the bailout programme by December 2013, followed by Spain in January 2014, Portugal in May 2014, and Cyprus in March 2016 (RTÉ, 2013). Only Greece was still struggling in its economic recovery efforts.


It is true that a monetarist without integration of fiscal policies is the core weakness of the euro system. The Euro Plus Pact and European Fiscal Compact are meant for closer integration of Eurozone states’ fiscal policies. Recently, even the president of ECB, Mario Draghi has stepped up and called for more structural reforms that would spur higher growth potential and create more jobs. However, the plans were being criticised for entrenching the sovereignty of countries, as its authority interferes areas that were previously under national sovereignty.

Then controversies arose when some parties blamed the German-dominated ECB as being a loan-sharking conglomerate and cruelly thrusting Greece into depression (Lee, 2015). But the stronger/more economically stable nations in the Eurozone felt unfair pressure as they need to spend their hard-earned money to bailout countries that had been spending profligately. On the other hand, some parties argued that certain states (especially Germany) has been taking advantage of other Eurozone states by suppressing imports and moderating labour costs to maintain trade surplus. Some other Eurozone states have no competition with Germany, causing the unhealthy trade imbalances within Eurozone persists (Moore, 2015).

It may seem unreasonable to blame countries for being competitive, but compare it with the example of predatory pricing. Setting prices at very low levels may seems favourable, but in longer terms, it may wipe out competitors and create monopoly. In Eurozone’s case, some parties contested that Germany’s policy to maintain trade surplus made the other peripheral Eurozone states to struggle to keep up with Germany’s pace (Bernanke, 2015).

No matter which side wins the argument, Greece was still trapped in the depth of recession with all these reforms. This leads to the discussion whether Greece should exit from the euro system. The proponents of “Grexit” may argue that the adoption of Drachma may help to boost the economy. As a member of euro, it has no other choice but to resort to internal devaluation and austerity measures, i.e. reducing labour costs, at the cost of a further contraction of the economy and higher unemployment. But let’s say, if Greece wasn’t in the euro, it could have boosted its economy by printing more of its currency, the Drachma, or implementing quantitative easing. This would have lowered the Greek currency value, making its exports more competitive. It would also have lowered domestic interest rates and encouraged domestic investment. However, the opponents of Grexit contended that the Grexit would not immediately help to improve its economics but could instantly result in social unrest. The cost of Grexit would be too great for Greece right now (SEPA, 2015).

After United Kingdom had withdrawn from European Union (Brexit), negative signals were sent across Eurozone. It leads to the speculation of the breakup of other countries (especially Grexit and Frexit) from the Eurozone. With all these instabilities, the anticipated period of full recovery from the crisis still remains uncertain.

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Prepared by Kam Kai Xin