After adopting the euro in 2002, Greece, Ireland, Spain, and Portugal found that banks and investors in other euro area countries were more eager to buy their government bonds. This rise in foreign demand for the sovereign debt of these smaller, less economically robust countries on the periphery of Europe’s common currency zone came as no surprise and was in fact intended. A major reason for adopting a single currency was to promote linkages among the national economies and banking systems of the member countries, thereby boosting trade and demand overall.1 Indeed, the increased desire to invest in peripheral countries’ bonds was a sign that markets had begun to view their risk at least partly as a function of the financial strength of the entire euro area (Figure 1), dominated by the major economies of Germany and France.

The rise in foreign demand for the bonds of the peripheral countries kept yields down even as inflation in these economies rose. And their governments, firms, and households took advantage of the resulting decline in borrowing costs, in some cases steeply increasing their national debt as a share of their national gross domestic product and raising their underlying risk of defaulting on their bonds.

The global financial crisis and recession that hit Europe in 2008 led to doubts as to whether heavily indebted euro area countries would be able to repay their bondholders. As doubts about the solvency of these countries increased, yields on their sovereign bonds went up, and the share held by foreign investors sharply reversed. Mirroring the sudden drop in the share held by foreign entities was a surge in the share held by domestic banks and investors.

This article appeared in the Third Quarter 2017 edition of Economic Insights. Download and read the full issue.

[1]One risk that the single currency dispensed with was the exchange rate risk between countries’ currencies, thus allowing further integration.