Bonds that a government issues in a foreign currency are referred to as “sovereign debt.” Sovereign debt does not come with a specific charge on a government’s assets. It is simply a promise to pay. In reality, if a government does not pay its sovereign debt upon maturity, the loss of creditability is the biggest threat to the country—it will have a difficult time issuing sovereign debt again.
As the European Union attempts to work out a solution to the sovereign debt crisis by getting money into the hands of the Spanish banks, it is important to take a step back and look at why the sovereign debt crisis is so important to resolve.
The prime minister of Spain has introduced new consumption taxes and spending cuts in the hopes of meeting the European Union’s budget-deficit target for Spain in the next few years. With an already weak economy and unemployment at almost 25%, these cuts are not going over well in the country and will make reaching these targets unlikely.
While the situation spirals out of control, Spanish 10-year bond yields spiked above seven percent, while Italian bond yields pushed above six percent. For countries that are struggling to meet their budget deficits, these high yields are impossible to take on. With lower tax revenue, due to the ongoing recession within the European Union, sovereign debt cannot be rolled over in the market, because these high-interest payments alone would be too much of a burden for these countries to pay.
Italy, as well, is attempting to implement its own austerity measures in order to cut its budget deficit, but Italian bond yields continue to spike, as the market believes the embattled country’s sovereign debt will only get worse. Spain and Italy continue to put pressure on the European Union to provide money at cheap interest rates.
The saga with Greece continues to unfold as well. The country’s sovereign debt is such that it will require another bailout, because with the worsening recession and its tax revenues continuing … Read More