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Sovereign Credit Risk in the Euro Zone

Jamal Ibrahim Haidar - April 2012

What is the current state of sovereign credit risk across Euro zone? Does the recent fiscal crisis extend to other (non Euro zone) countries? Is Greece the center of the problem? How did the current fiscal crisis in the Euro area start? Who is behind it? Why can it evolve? How can it be addressed? And, is a fiscally-challenged country likely to want to leave the Euro zone? This article addresses these questions, argues that a fiscally-weak country is better off in the Euro zone than outside it, and finds that a feasible policy tool can be a bailout associated with tough fiscal conditionality. It also shows that sovereign credit risk adjustment in the Euro zone can happen, using various measures, but not without “fiscal pain”.

Introduction
The roots of the Euro area crisis can be traced back to at least the summer of 2007. Although not picked up by the credit rating agencies until much later then the probability of default on sovereign debt increased in parallel with clear macroeconomic misalignments. These misalignments include recession-triggered budget deficits, bailout-motivated fiscal measures[1], as well as country-specific strategies and political risks - i.e. in the case of Portugal, Italy, Ireland, Greece, and Spain[2].  In the absence of a major restructuring of debt, sovereign credit risk adjustment in these countries can only be achieved through economic growth or an alternative process of financial austerity and/or inflation.  

 

Even at the eleventh hour, when looked at externally, various measures can still be taken to reduce sovereign default probability within the Euro zone. In Italy and Spain, for example, better sovereign credit risk rating might still be restored by the new government teams in power rais...

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