Sovereign Risk, Politics and the Eurozone Crisis

Abstract

For a number of decades, sovereign risk was considered by most a defining feature of emerging markets. While emerging market economies experienced repeated cycles of booming capital inflows followed by financial crisis, the environment appeared much calmer in advanced economies, with no default reported in the post-war period. Reflecting this, the direct academic study of sovereign risk was mostly concentrated on the emerging world. However, things have changed dramatically in the last few years. In the aftermath of the global financial crisis, advanced economies saw a sharp rise in their actual and contingent liabilities, making medium-term public debt sustainability increasingly challenging. As a result, a number of developed democracies lost their status as “risk-free” borrowers in financial markets: some saw a significant increase in their financing costs in global markets, while a few lost access outright to international finance. The Eurozone sovereign debt crisis represents most dramatically the increased difficulties of developed democracies in global financial markets. The deterioration in public finances and growth prospects was common to a number of developed economies, including the US, the UK and Japan, as well as most Eurozone economies. However, financial markets punished Eurozone sovereigns, and particularly the weaker economies in the Eurozone,¹ more severely than stand-alone developed democracies.²