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Preet Desai

Professor Fernando Lopez-Alves

International Politics

Sovereign Debt Crisis: Euro Zone’s Place in the World

The Euro Zone Sovereign Debt Crisis started unfolding in late 2008. During the Euro Zone

Sovereign Debt Crisis 17 countries were sharing the euro. Certain member states took upon and

mismanaged unsustainable levels of debt. ‘Core countries’ European countries, which include

and include Germany (5th largest economy in the world), France, UK, Italy and the former

Benelux (the Netherlands, Belgium and Luxembourg), are considered stable. On the other hand

periphery countries are less stable and include the PIIGS (Portugal, Italy, Ireland, Greece, and

Spain). The classification scheme of core and periphery countries is useful in understanding

environment of the Sovereign Debt Crisis.

Since 2008 the GDP of both the EU and Euro Zone countries have dropped proportionally.

Regardless of the fact the Euro Zone is in the EU, the congruency changes in GDP in EU and

Euro Zone show the interconnectedness of economies in within Europe. The countries in Europe

were highly exposed to the regional grievances. In addition to Euro Zone GDP dropping from

$13.6 trillion in 2008 to $12.2 trillion in 20121, there has been a rise in the Euro Zone’s overall

unemployment levels. The average Euro Zone’s unemployment was just above 7 in the first

quarter of 2008, and it increased to 12% by 2014.2. Periphery countries had very high

unemployment while core countries had relatively stable levels. From 2011 to 2012 Germany's

1 "GDP (current US$)." Data. http://data.worldbank.org/indicator/NY.GDP.MKTP.CD/countries/US-XC-DE-EU-JP-CN?display=graph (accessed April 23, 2014).2 "euroindicators." eurostat newsrelease. http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/3-28022014-AP/EN/3-28022014-AP-EN.PDF (accessed April 23, 2014).

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unemployment remained stable between 5.6% and 5.4%. However periphery countries like

Greece and Spain (26.6) had record high unemployment at 26%3.

The reason for this large difference between unemployment rates is because periphery countries

were taking on debt while core countries like Germany became better at exporting goods to parts

of Europe and outside. This behavior contributed to an increased polarization (core v. periphery)

in the economic prosperity of Euro Zone member states. This polarization becomes a significant

factor for foreign investors to consider when deciding how to invest their money within Europe.

The fiscal contraction in Europe shrunk the consumer appetites. Not only did this region’s

imports fall, but the debt crisis endangered the growth of all financially integrated countries.

On April 22, 2014, the World Trade Organization (WTO) released a report4 blaming the

Sovereign Debt Crisis for sluggish world trade growth in 2012. World trade grew only 2% in

2012, as compared to 5.2% recorded the year before. To put things into perspective, the 20-year

average of trade growth is 5.3% and the pre-crisis (1990-2008) growth of world trade is 6% - so

this mediocre growth of trade is abnormal. The sluggish growth in 2012 and the dip in the

average trade growth after the crisis can be attributed in part to the fiscal contraction of

developed economies in the Euro Zone. The contraction affects other economies because of EU’s

reduced imports and constrained financial system.

This paper explores the crisis from the perspective of emerging Asian markets, China, and the

US investor. Such market fluctuations redistribute influence and play a long term stabilizing role

by establishing best practices.

3 Sedghi, Ami, and John Burn-Murdoch. "Unemployment in Europe: get the figures for every country." theguardian.com. http://www.theguardian.com/news/datablog/2012/oct/31/europe-unemployment-rate-by-country-Euro Zone (accessed April 23, 2014).4 Elliott, Larry. "Eurozone crisis to trim global trade, World Trade Organisation warns." The Guardian. http://www.theguardian.com/business/2012/apr/12/uk-trade-deficit-rose-february (accessed April 20, 2014).

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U.S. Investment in Europe (2007-2011)5

In 2008 the European Union’s economy was around $3.5 trillion larger than that of the

America’s. Data from 2012 notes the EU’s GDP as $16.668 trillion, while the United States is

16.224 trillion. The narrowing of the difference in GDPs of these large economies can be

attributed to two crises, the Global Financial Crisis and the Sovereign Debt Crisis.

The EU banks had an unhealthy exposure to US subprime assets. This exposure contributed to

the start of the Euro Zone Sovereign Debt Crisis. It will be illustrated: the limited exposure of US

banks to risky periphery government bonds lead to the crisis in Europe to be largely contained on

a financial level to the region. Had the US been more heavily invested in the risky Euro Zone’s

assets, there would have been a different global outlook right now.

It is safe to say the America’s response to foreign investment has been framed by the global

financial crisis. Using data from 2007 to 2011, the following section outlines U.S. investment

behavior into the Euro Zone during Sovereign Debt Crisis.

An analysis conducted by the Federal Reserve using security-level data shows US investors have

not pulled back from Euro Zone debt securities during the Soverign Debt Crisis. In fact US

investors have continued investing in European government debt, but have made little new

investment in the financial sector. The stability of American investment in the Euro Zone goes to

show that rather than having exposed outstanding investments in periphery countries, most of the

US investor government debt is held as bonds from stable core areas. The American investor

5 "Did U.S. Investors Play it Safer in the European Debt Crisis? Did U.S. Investors Play it Safer in the European Debt Crisis?." Federal Reserve. http://www.federalreserve.gov/pubs/ifdp/2013/1088/ifdp1088.pdf (accessed April 21, 2014).

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balances risk with return. The investor is knowledgeable that the business cycle is constantly

shifting and there are opportunities to profit.

a) Equity

Throughout the European Sovereign Debt Crisis (2009-2011) the level of U.S. holdings in

European securities has remained relatively stable. Had U.S. investors divested, then the crisis in

Europe would have be exacerbated. However there are logical reasons why investors did not.

In 2011: U.S. held a total of $4.5 trillion in foreign equity. $2 trillion of this $4.5 trillion was

being held in European equity. The $2 trillion in European equity accounts two thirds American

investors' total European monetary holdings (roughly 3 trillion). While investors lost $269 billion

in 2011, they neither bought nor sold equity in the financial sector. The net investment was very

close to zero.

US Investors were comfortable retaining a 14% loss, because it was on par with the performance

of the European stock index MSCI. The similarity of American investment with the composition

of MSCI shows, rather than investing in volatile financial sector equity American investment

was a part the economy’ natural contraction – so the loss is acceptable.

Although in this year, 2011, Americans did not did not further invest in the financial sector in

2011, they did invest $77 billion in non-financial sector equity. This example highlights how

American investors are hedging their portfolio to focus new equity investment towards the

(relatively) stronger performing nonfinancial sector.

b) Debt

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On average (using the years 2007 – 2011), half of U.S. foreign holdings are in Europe. In 2011,

of the $36 trillion Americans had invested in Europe, almost $1 trillion was in long term debt. A

knee-jerk reaction given the Euro Zone crisis would be to think that Americans are exposed,

because of their investments in volatile assets. Data from the Treasury International Capital

(TIC) shows American investors are not at risk.

Most holdings of European debt are in the core Euro Zone countries, which represents about

three fourths of total European debt held (76% in 2011). Compared to this debt holdings in the

perceived to be more volatile periphery countries only account for 9% of that trillion (in 2011).

This goes to show that U.S. holds very little debt from vulnerable European countries.

New Investment

In order to understand how U.S. investors allocate their new investment, we decompose net

investment flows into European debt by sectors (government, financial, non-financial cooperate).

In 2008 the global financial crisis prompted U.S. investors to exhibit a high home bias or

preference for domestic asset classes. However in the ensuing years, U.S. investors started

investing in foreign or in this case European debt.

a. Financial debt

In 2011, U.S. net investment in the financial long term debt sector was zero. Rather than an

unreasonably high risk for this asset class, U.S. investors likely had no new investment because

the European banks had been redeeming increasing quantities European Financial Debt in an

effort to deleverage. 7

6 ibid7 ibid

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b. Government

During 2011 there was $40 billion new investment in the government debt (Core and peripheral).

As opposed to very low levels or sales in peripheral country government debt, investment into

peripheral government debt went from net negative to about $13 billion us dollars. This

surprising increase in debt issued by ‘risky’ countries can be attributed to low treasury yields in

2011. U.S. (and also core Euro Zone) yields are especially low, it is good to see how U.S.

investors seek higher returns through different avenues. This investor mindset helps explain why

investors seemed to prefer high yielding eastern European and peripheral sovereign debt in 2011.

c. Non-financial corporate

In 2011, American’s invested $20 billion in non-financial corporate long term debt. The steady

flow of U.S. investment (2007 – 2011) in the European non-financial sector indicates much of

these holdings are in dollar-denominated bonds issued by multinational corporations who happen

to be headquartered in Europe. Therefore, because of their business structure, they are less

directly affected by the current European crisis than firms in the financial sector.

Wrap Up

Analyzing U.S. investor behavior during the Euro Zone crisis shows they are being conscientious

of the market and are considering risk and return in their capital flows. U.S. investors exhibit

preference higher security credit ratings and the larger issuing banks. Their concern for safety is

likely molded by 2008’s global financial crisis. As evidence of this preference to mitigate loss,

U.S. investments in the Euro Zone have, to a large majority, been in relatively stable core

countries.

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During this crisis U.S. investors avoided the Euro financial sector, and invested in other sectors.

While their return on Euro government debt declined, it would have been worse had they kept

their original portfolios.

The way U.S. investors have continued to re-balanced their holdings from 2007-2008 reflects

diversification and different investment objectives. While investors wanted to realize higher

return in government debt, they shifted towards safer investments in the financial sector. Their

propensity safety and investment awareness reflects lessons learned from losses during the global

financial crisis.

Impact of Euro Zone Sovereign Debt Crisis on Developing Asia

The European Union (EU) and developing Asia have long since been economic partners. As

opposed to an extensive financial relationship like America and the EU have, Developing Asia

and Europe have a well-established trade relationship. The higher-income countries in Western

Europe historically have played an outsized role in importing final goods from the developing

Asia. Asia’s recent rapid growth has repositioned it to be an import market, the focus of foreign

direct investment and other cash flows. Despite Asia’s increased economic independence over

the years, the region still is still affected by external shocks from large economies outside the

region. In this regard the ongoing Euro Zone Sovereign Debt Crisis is one such external shock.

Trade

Given the economic partnership between EU and Asia, the Sovereign Debt Crisis is undoubtedly

affecting developing Asia’s short term macro-economic growth. The contracting Euro Zone

economy leads to a smaller demand for elastic goods (or goods necessary for basic functions).

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The type and level of exposure of developing Asia to Europe varies greatly across sub regions

and countries. Some parts are much more vulnerable to change in EU demand than others are.

Between 1995 and 2011, Central Asia has reoriented its exports to go EU instead of Eastern

Europe and the Russian Federation. For example in 2011, the Europe swallowed 56% of Central

Asia’s exports. Of this EU absorbed 37% and the rest of Europe took the rest.8 From the raw

numbers one would expect Central Asia’s economy to suffer a great deal during the Sovereign

Debt Crisis, given their established export dependence on Europe. However, this sub region is

perfectly capable of weathering the storm because 90% its exports to the EU are in the form of

inelastic commodities. When looking at how the Euro Zone affects different countries, one needs

to look at the elasticity of certain goods.

Commodities are less sensitive to the business cycle than manufactured goods. On this note,

Southeast, South, and East Asia are very vulnerable to the EU recession. A very high percentage

of their exports are strictly in the form of manufactured goods. East Asia exports 95%

manufactured goods, South Asia exports 86% manufactured goods, and Southeast Asia exports

82% manufactured goods. 9

However, more so than expected, the weakened level of Asia’s exports to Europe will not have a

pronounced effect on Asia’s growth. While one cannot deny the EU plays a disproportionate role

as a consumer of final goods in this relationship and is an important export market, it needs to be

mentioned: their role as such has been diminishing since the 2008 global financial crisis.

8 " Economic Impact of Euro Zone Sovereign Debt Crisis on Developing Asia." Asian Development Bank. http://www.adb.org/sites/default/files/pub/2013/economics-wp336-economic-impact-Euro Zone-debt-crisis.pdf (accessed April 21, 2014).9 Ibid.

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Beyond the short term where developing Asia will be affected, the Euro Crisis is just another

reason why Asia needs to rebalance its economy. As the Europeans and Americans already had

diminished import needs in 2008, developing Asia had begun building towards domestic sources

of growth, by simulating south – south trade rather than north – south.

Finance

Asia’s lack of financial integration insulated them during the global financial crisis, and in much

the same way, they are sheltered from the relatively smaller Euro Zone Sovereign Debt Crisis.

Euro Zone banks provide 12-17% of total foreign bank borrowings in East, South, and Southeast

Asia regions. The five Asian economies: the People’s Republic of China PRC; Hong Kong,

China; the Republic of Korea; India; and Singapore took in about three-fourths of Asia’s total

borrowing from Euro Zone banks.10

In order to understand the financial vulnerability of Asia, one must analyze the effect of credit

tightening would in the region. In India, Indonesia, the Republic of Korea, Malaysia, the

Philippines, and Viet Nam Euro Zone borrowings carry into to 4-8% of domestic credit. The

relatively low share of Euro Zone borrowing being used as domestic credit means that said

countries are not vulnerable to credit tightening. The proportion of foreign credit used as

domestic credit is higher in Asia’s two major financial centers, Hong Kong, China and Singapore

– but in these cases the high domestic credit represents the region’s role as a financial center

(inelastic) and not a dependence on foreign credit.

Modeling done by the Asian Development Bank shows that a reversal of Euro Zone bank loans

to Asia could financial intermediation in the region but the impact such an would be relatively

10 Ibid.

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minimal.11 Though differences exist across countries in the region, developing Asia does not

seem at high risk of a credit crunch from a pullback of Euro Zone bank lending.

Fiscal Prudence

In addition to everything just said about developing Asia, the region has built in a lot of policy

options to serve as a cushion from the sovereign debt crisis. They have monetary tool, a lot of

fiscal space to unleash a forceful stimulus, and financial policy at their disposal. Part of the

reason the region is fiscally responsible is because it faces medium-term issues associated with

an aging population, and the need to foster inclusive growth (by product of external shocks).

Developing Asia serves as an example of how prudence can be extremely beneficial in times of

crisis.

Global Shift

Asian exports to the European Union have been diminishing since the onset of the global

financial crisis in 2008. The Euro Zone Sovereign Debt Crisis is speeding up an inevitable shift

of power from North to the South. Europe was already weakened by the Global Financial Crisis

and now the Sovereign Debt Crisis represents medium-term obstacle to recovery from still the

first issue. As they are recovering, developing countries will be catching up. The Euro Zone

Sovereign Debt Crisis reinforces, “a two-speed world economy which combines robust,

sustained growth in the South with feeble, sputtering recovery in the North”.12

Because of Euro Zone crisis, the PIIGS were forced into take austerity measures. Large

economies used to be considered pillars of stability, but recent developments have shown that

they themselves are sources of instability. 11 Ibid.12 Ibid.

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The developing Asian economy has grown and is responsible enough to make a contribution to

global financial stability. Regardless of whether they invest financial resources or not, the region

should participate in discussions regarding strengthening the global financial architecture. They

are able to be a part of this conversation because the world’s leading economies have crashed in

the recent years. One specific avenue developing Asia can contribute towards this endeavor is

through the International Monetary Fund. Here, an expanded Asian advisory role would go hand

in hand with increased Asian contributions (if they choose to do so). 13

CHINA: Motivated by self-interest

The debt crisis is changing global power relations: like developing Asian countries, Chinese

leaders are in the position to lecture European policy makers on their economic and fiscal

policies; and have done so.

Though the Euro Zone Sovereign Debt Crisis is affecting China’s export-driven economy,

Chinese leaders are turning elements of the crisis into advantages for them. China has the

world’s largest federal reserves (around $3.3 trillion at the end of March 2012). Their financial

resources are courted to contribute to solving the Euro Zone’s debt problem.

In 2011, EU-China trade amounted to $600 billion14, yet the economic downturn in Europe is

seriously affecting the Chinese manufacturing sector. A strong euro would benefit China’s

export-driven economy. If the euro appreciates with respect to renminbi, then Chinese prices

points would be more competitive. This in turn acts as a stimulating mechanism for Chinese

exports.

13 Ibid.14 Is China the real reason for the euro’s strength?." CNBC.com. http://www.cnbc.com/id/101495433 (accessed April 22, 2014).

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China’s strategy is multifaceted. Another part of the reason China is interested in helping the

Euro Zone is to combat America’s primacy. Chinese leaders are diversifying their economy,

political interests, and connections to more parts of the world. This type of behavior includes

China’s sale of $48 billion dollars’ worth of treasury in December 2013, the most in two years15.

Furthermore, Chinese Premier Wen Jiabao’s declared the euro as the prime target of China’s

purchases. The euro now accounts for roughly a third of China’s foreign reserves, up 6% since

summer 2011.16

Chinese officials are intervening in Euro Zone crisis to reassure markets. They were a significant

buyer of the Portuguese bail-out bonds which were being auctioned by the Euro Zone’s €440

billion rescue fund. However, it is their great preference to only invest in safe assets with reliable

returns. To this Beijing has also showed an interest in investing in fully guaranteed and safe

Eurobonds when they become a reality. Like in America, risk in the Euro Zone has been offset

by reallocating Chinese away from the PIIGS and towards core Euro Zone members (Germany,

France, Austria and the Netherlands).

Grisons Peak Merchant Bank analysts have seen Chinese foreign direct investment reach $2.13

billion, increasing a nearly 300% from 2009 to 2010. China likely views Europe as good

investment, because the recent crisis has made Europeans more willing to cut deals they

previously would not have.

As a general practice China has made a shift towards by growing investments in industrial assets

and infrastructure projects across Europe, rather than bailing out countries. To this end, in March

2012 the Chinese government injected $30 billion into the China Investment Corporation (CIC),

15 ibid.16 ibid.

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a now $480 billion Chinese sovereign wealth fund to be used specifically for acquiring industrial

and strategic assets in Europe. Mid-201217 CIC stopped buying European government debt

because of increased concerns regarding the Euro Zone financial crisis. Instead state-owned CIC

too began focusing more on private equity and infrastructure projects to boost returns. In October

2012 CIC bought is a 10% stake in UK's largest airport, Heathrow. Spain's Ferrovial sold CIC a

5.7% stake and the other 4.3% stake came from investors in Heathrow's holding company.

Spain's Ferrovial now owns a 34% stake18.

One of China’s most high profile investments is in the Greek pier Piraeus. Piraeus is Greece's

largest port, just six miles from Athens. Last June China Ocean Shipping Co. (Cosco), a state-

run shipping company, signed a 35 year lease to the container terminal for almost $5 billion.

Such deals allow China greater access to the European market for both importing and exporting.

"It's very important for the Chinese to enter through Piraeus to the eastern European and Black

Sea markets, which are really booming right now," says Makrydimitris19 Cosco does not allow

unions and multiple sources report that Greeks working at Cosco get paid half the salary of the

neighboring Greek peer. They have already violated labor regulations, but the Euro Zone

sovereign debt crisis put Greece in a position where it had to accept such a deal.

One should not misinterpret China’s continued regional investment as an endorsement of how

the Euro Zone is handling the Sovereign Wealth Crisis. In fact Jin Liquin, the chairman of CIC,

is a very harsh critic of the way Europe has been coping with the crisis. In fact he has stressed

17 "China's Sovereign Wealth Fund in Big 2012 Turnaround." CNBC.com. http://www.cnbc.com/id/100376168 (accessed April 23, 2014).18 Milmo, Dan, and Gwyn Topham. "China takes 10% stake in Heathrow." The Guardian. http://www.theguardian.com/business/2012/oct/31/China-takes-stake-heathrow?guni=Article:in%20body%20link (accessed April 23, 2014).19 Lim, Louisa. "In Greek Port, Storm Brews Over Chinese-Run Labor." NPR. http://www.npr.org/2011/06/08/137035251/in-greek-port-storm-brews-over-chinese-run-labor (accessed April 23, 2014).

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Europeans should "work a bit harder … work a bit longer" like Chinese citizens, also complained

about "sloth-inducing" labor laws20. China is involved in Europe is because of their desire to

diversify against the dollar, sustain the export market, and safely invest China’s growing

reserves. China’s participation in the Euro Zone crisis strictly is out of self-interest. As evidence,

Chinese leaders have attached some conditionality to their involvement in Euro Zone’s sovereign

debt problems, reiterating that the EU ‘puts its house in order’. If Euro Zone does badly, then

China will have wasted its financial resources.

China’s talk of participating in the international efforts to solve the Euro Zone’s debt crisis

largely lacks the appropriate proportion of follow through. There has been promises made in

March and February of 2012, but there has been neither official statement nor action taken.

China and countries who not a part of the euro bloc want to see the region put more money up

before they commit financial resources to the IMF (who is requesting $500 billion).21 There is no

official commitment as to the amount that China is ready to make available for the Euro Zone’s

rescue fund through the IMF.

China does have additional requests which could be persuade Chinese citizens and leaders to

support Europe Financially. In September 2011, Wen Jiabao, the sixth premier of the People’s

Republic of China, indicated China wanted to be granted Market Economy Status (MES) and

also would like the EU arms embargo lifted. New Zeeland and Singapore already have granted

market economy status. The EU has not, but it is widely regarded that China will earn such status

in 2016.

20 Branigan, Tania. "China sovereign wealth fund official warns on eurozone austerity." theguardian.com. http://www.theguardian.com/business/2012/nov/16/China-investment-corporation-eurozone-austerity-jin-liqun (accessed April 23, 2014).21 Wang, Aileen, and Nick Edwards. "China to keep investing in Euro Zone debt: China central bank." Reuters. http://www.reuters.com/article/2012/02/15/us-China-europe-idUSTRE81E07J20120215 (accessed April 23, 2014).

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In regards to the EU arms embargo, many EU governments and companies are ready to remove

the barrier. This enthusiasm is in large part because of the unfavorable market conditions

plaguing the region. EU leaders hope that China would reward such a policy change with

increased purchases of EU goods.22 However, like MES, this policy change has not happened

either.

Executive Summary

The Euro Zone debt crisis was largely influenced by the global financial crisis starting in 2008 in

the united states. American investors seemed to have learned from this experience, and were

especially isolated from periphery government bonds. Developing Asian countries are using this

crisis as an opportunity to simulate regional trade. They (including China) are in a position to

contribute to restructuring the global financial system.

Although China’s economy is suffering from the Euro Zone crisis, they are able to become

involved while growing their economy and hedging against the U.S. It will be especially

interesting to see how the political atmosphere will change in the coming years as China gains

Market Economy Status. Certainly the recent Euro Zone Sovereign debt crisis has played

instrumental part in reshaping the global power dynamic.

22 "EU Should Keep China Arms Embargo." The Diplomat. http://thediplomat.com/2012/04/eu-should-keep-China-arms-embargo/2/ (accessed April 23, 2014).