Critically analyse how the government debt problems initially faced by a few relatively small economies could trigger such a wide impact in financial markets - Essay Example

The Government Debt Problems Initially Faced by a Few Relatively Small Economies Could Trigger Such a Wide Impact on Bond Markets Introduction The bond market plays a critically important role in the stability of the financial market. For example, a well developed bond market reduces the dependability of private business on banks’ credit. This in turn contributes to pushing the financial market for strengthening the system. Also, the well developed bond market increases ways for diversified securitisation (Sokoler, n.d.).

Government is also highly concerned with the development of the bond market to finance its budgetary requirement. As a matter of fact, such government debt raised through the bond market is considered as the backbone of the economy. Therefore, problems in the government debt also have a wider impact on the bond market on the whole. Impacts on Bond Markets Government raises debt by issuing bonds. Different economies have different target markets for attracting bond buyers. Small economies are faced with limited local options; therefore, most of the debt is internationally financed by advanced economies and the international organizations such as IMF etc.

For example, the size of the public debt and the budget deficits of USA swelled from 62% of GDP in 2007 to 93.6% in 2010. Similarly, Japan reported the swelling up to 199.7% (2010) as compared to 167% (2007) (Lourtie, 2011). This piling up of debt was due to its national debt. Single economy and cross banking were identified as important reasons of the spread of crises. It also brought to limelight the impact of deficiencies in the regulatory framework (IBDE, 2012). The debt crises of the relatively small economies have wide negative impact on the large number of economies.

IMF and other European countries have supported smaller economics to sustain in difficult situations as these economics were facing different challenges to survive from being default. This in turn spread the impact from the few economies to the other countries. The concerns rose as the big economies have already increased their debt levels as a result of the nationalization of the private sector debt, the stimulus plan and the reduced income from tax etc. As evidence, the steep growth of the debt in the G7 economies is depicted in the given below graph: (Nelson, 2013) Members of the European Monetary Union (EMU) facilitate the loan guarantee to each other; this has brought the overall creditworthiness of the Euro zone at stake.

The pressure is mounted mainly from the fact that there is currently no international bankruptcy court present. The absence of an international bankruptcy court could pressurize the defaulting economies to surrender assets to the debtor. This has ultimately increased the pressure on the lending economies and organization to facilitate the debt restructuring etc (Nelson, 2013). For example, the OECD report states that the solution to the government debt crises can be in the form of the debt burden sharing between the lender and the borrower (Wehinger, 2011).

The other reason is also important to understand that government debts are not backed by any collateral instead are based on faith. Therefore, the lenders economies are then strangled to ensure the recovery by other measures such as restructuring or even forgiving. These risks result in inflated bond spreads (IBDE, 2012). The government debt problems of the small economies also create the yield disruption in the other economies. The positive trend of the yield curve and the maturity also turn reverse in the crises situation of the borrowing economies.

In contrast to the positive relationship, the yield curve spread, and the maturity turns negative once the credit worthiness or the sovereign rating of the debt issuer worsens. For example, -800b.p. of spread was reported for Greece during the economic and debt crises. Similarly, it was – 30b.p. for Italy (Wehinger, 2011). This implies the negative perception of the investors of bonds. Another dimension from which the debt crises of a country spread across is through the banks’ lending strategy.

According to the Arteta and Hale (2008), the sovereign debt crises restrict the foreign banks’ lending to the private firms. This strategy continues even after the restructuring of the debt. Bofondi, Carpinelli, and Sette (2012) have noted that during the debt crisis in Italy, the lending by the local banks to private firms increased as compared to the lending by foreign banks. This is particularly in the case when the government bond market is under constant tension. Despite above mentioned concerns, some economists held view that bond markets of advanced economies such as USA are less risky.

This presumption is due to the fact USA has a traceable history of making repayments of debt. Also, the spread offered on bonds reduces the vulnerability of USA in the view of the investors (Nelson, 2013). On the other hand, taking advantage of the interconnected that spread the crisis, the solution is also being attempted to be derived from same. Establishment of the shared Euro-bond is the development towards the solution with one objective of debt servicing of the economies under crises. However, the implementation of the structural reforms is conditioned along side.

It will also contribute in regaining the confidence on the bond market such as UK has reduced the rates at the historic low levels and these factors have played important in regaining the investors’ confidence (IBDE, 2012). Conclusion The sovereign debt crises of the relatively smaller countries have spread across the world. Moreover, among different financial markets to receive impact, the impact on the bond market is also notable. The matter spread not only due to the relative size of the economies.

Instead, the spread is mainly due to the interconnectedness of the wider number of countries. The unified economy of the Eurozone developed the chain through which the impact spread. Moreover, the deficiency on the part of the regulatory systems has complimented the issue. Another factor that contributed towards the spread of the crises was the pressure developing from other dimension such as the stock market and private banking lending etc. Nevertheless, with improvement in the regulation, the recommendations for the recovery are expected to overall support the mechanism.

References Arteta, C., & Hale, G. (2008). Sovereign debt crises and credit to the private sector. Journal of International Economics, vol. 74, no. 1, pp. 53-69. Bofondi, M., Carpinelli, L., & Sette, E. (2012). Credit supply during a sovereign crisis. Bank of Italy mimeo. Available from http://www.tilburguniversity.edu/upload/ca5ed4c4-edae-457c-9fae-fa2d3ff1c6ca_sette.pdf [Accessed March 4, 2014] IBDE. (2012). Sovereign Debt Crisis And Its Impact On World Markets. Available from http://www.ibde.org/attachments/IBDE%20Report%20on%20the%20Sovereign%20Debt%20Crisis%2031-06-2012.

pdf [Accessed March 4, 2014] Lourtie, P. (2011). Understanding Portugal in the Context of the Euro Crisis. Peterson Institute for International Economics, Available from http://www.iie.com/publications/papers/lourtie20110913.pdf [Accessed March 4, 2014] Nelson, R. (2013). Sovereign Debt in Advanced Economies: Overview and Issues for Congress. CRS Report for Congress, Available from http://www.fas.org/sgp/crs/misc/R41838.pdf [Accessed March 4, 2014] Popov, A., and Van Horen, N. (2013). The impact of sovereign debt exposure on bank lending: Evidence from the European debt crisis.

DNB Working Paper, Available from http://www.dnb.nl/en/binaries/Working%20Paper%20382_tcm47-293531.PDF [Accessed March 4, 2014] Sokoler, M. (n.d.). The importance of a well developed bond market - an Israeli perspective. BIS, Available from http://www.bis.org/publ/bppdf/bispap11k.pdf [Accessed March 4, 2014] Wehinger, G. (2011). Sovereign Debt Challenges for Banking Systems and Bond Markets. OECD Journal: Financial Market Trends, vol. 2010, no. 2.