Critically Analyse How the Government Debt Problems Initially Faced by a Few Relatively Small Economies Could Trigger Such a Wide Impact in Financial Markets

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

Introduction
Since the Greece's debt crisis happened, the Euro zone has to confront with a huge sovereign debt crisis, like governments' debt increased, bond yield spreads widened, Euro exchange rate fell as well, which caused that the whole international financial markets gradually lost the confidence. The purpose of this essay is to discuss the impact of this crisis both on foreign exchange and derivative markets. And the rest words is to analyse several possible reasons why this small economy could trigger such a wide impact on global financial markets, in which contagion can be considered as the fundamental and identifiable cause during the whole spread of crisis.

The Impacts of European sovereign debt crisis

Foreign exchange

Foreign exchange market, as the largest and the most liquid financial market, with an average daily trading volume of nearly $1.5 trillion changing hands where statistically it is superior to all US equity and Treasure markets combined (Michelle Chan, 2011), was expectedly deteriorated as well as fluctuated by the ongoing European debt sovereign crisis since 2008.

On one hand, the foreign exchange market reflected considerable stress under the lingering European debt crisis. On the basis of the Financial markets Stability Map(Graph1), apparently, financial markets, particularly the foreign exchange market continued to be weaker and experienced the heightened volatility. This weakness is shown in the graph1 that risks successively increase as the movement gradually moves away from the map center. Dissimilarly, risks in the rest of three components of the financial markets stability map, banking sector funding, debt and equity markets remained largely stable as well as unchanged, compared with the foreign exchange market. Generally to say, as indicated by the trends in the Financial Stability Map, the overall stability of the financial system kept in a robust development.

Graph1 Financial Stability Map
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Source: Bloomberg

On another hand, the foreign exchange rate was deeply influenced as well, particularly the depreciation of the Euro was more prominent against non-European currencies, such as yen, the USD and the GBP, as non-European currencies was coinstantaneously affected by spillover effects from the euro-zone.

According to the graph2, the euro has depreciated against the USD and Japanese yen by around 25 percent since the late 2011, but by approximately 4 to 8 percent against the UK pound. Overall, the euro has depreciated by 8 percent on a trade-weighted basis (TWI) since the mid 2011, fluctuating around its average index.

Graph 2 Euro against Selected Currencies
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Source: Bloomberg; RBA

On the contrary, according to the Graph3, the Japanese yen had been depreciated slightly and modestly against the USD from its nearest highest rate in late November 2011. Generally to say, the yen was smoothly unchanged against the US dollar during the time period of six mouths. Nevertheless, the yen has appreciated by 7 percent against the euro since late 2011, reaching a highest level during past 11 years at the beginning of 2012. Reflecting this in the graph2, Japan’s nominal trade-weighted index (TWI) has recovered to historically high levels, though it remains only above its long-run average in real term (Reserve Bank of Australia, 2012).

Graph 3 Japanese Effective Exchange Rates
[pic]
Source: BIS; RBA

As for the USD, it was appreciated extremely strongly against the euro since late November 2011, seen in...
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