Thursday, June 11, 2009

Causes of Debt Crisis

Causes of Sovereign Debt Crisis Include:

1. Government Borrowing.

High government borrowing often leads to selling bonds to oversees investors. (frequently foreign investors make bad judgements and buy debt from countries who later default.)

2. Bank Loans in foreign currency

If domestic banks take on foreign debts they become liable to repay them in foreign currency. For example, in Iceland, between 2001 and 2008 the three major banks hold foreign debt in excess of €50 billion, or about €160,000 per Icelandic resident, compared with Iceland's gross domestic product of €8.5 billion

3. Bad Debts in Banking system

If you hold this volume of foreign debts and the debtors start to default you lose substantial sums.

Solutions to Sovereign Debt Crisis.

Reduce Budget deficit.

With a sovereign debt crisis, the government will probably be unable to sell government bonds to foreign investors. For example, in June 2009, Latvia failed to sell a single bond at a government auction Reducing the budget deficit will mean the government need to sell less bonds.
  • However, draconian spending cuts could cause a deep recession. e.g. in 2009, the UK has a forecast budget deficit of 12% of GDP. To reduce this deficit would require a huge tax rise and spending cuts.

A devaluation in the currency means it is easier to pay foreign debts.
  • The problem is that a sharp devaluation means foreign investors will want to flee the country as they will lose money. Also the devaluation will cause inflation and economic instability.
IMF Loans

Loans from the IMF or body like the EU, can enable the country to meet current debt obligations. This can provide a short term breathing space and help restore confidence.
  • However, it doesn't address the underlying structural problems.
It can inflate away the debt.

Printing Money can reduce the nominal value of the debt and make it easier to pay the debt, but, it will cause inflation and devalue the exchange rate.

Other Debt Crisis

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