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Briefing

Sovereign Risk in the Eurozone

Appears in: Europe, Macroeconomy, Eurozone, Greece, Ireland, Italy, Spain, Fiscal Policy, Government Bonds

Critical Issues

Background:

When the European Monetary Union (EMU) was launched in 1999, it had a variety of goals, including the elimination of exchange rate risks and the convergence of yield spreads among eurozone countries. The theory of interest rate parity suggests that yield spreads between comparable bonds should have vanished, yet investors did not regard government bonds of different EMU countries as completely interchangeable, and spreads remained even after the EMU took effect. Those spreads were largely inert until the crisis precipitated in 2008 by the collapse of Lehman Brothers, when they began to diverge significantly, most severely Portugal, Italy, Ireland, Greece and Spain (the so-called “PIIGS”). Greece in particular had serious difficulty convincing markets its finances could be righted. This, along with reluctance from some eurozone countries—in particular Germany—to participate in a bailout with the ECB and IMF, raised the specter of an EMU nation defaulting or even the potential break-up of the eurozone. (See the related RGE Strategy Flash: Implications of the EMU/IMF Greece Deal.)

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