Investment Article
European Debt Crisis: Resolvable or Insurmountable
At the end of October, the financial markets rallied on news of a new European bailout plan. The plan called for the use of leverage to allow the European Financial Stability Facility (EFSF) – a fund that provides financial assistance to members of the Euro Zone – to control 1.41 trillion euros which could be used to help finance the expenses of member states. Furthermore, the EFSF would invest in European debt alongside a special purpose investment vehicle that would attract money from sovereign wealth funds, such as China or Brazil, and other investors1. Next, the plan determined that 106 billion euros would be injected into the European banking system to help it withstand a Greek debt default and other financial contagion. Finally, a voluntary 50 percent mark down, or “haircut”, on Greece’s outstanding debt held in the private sector would allow for the country to cut its debt-to-GDP ratio. Although the stock market rallied on this news, the plan was met by skepticism by some economists who felt that a larger fund was necessary to prevent financial contagion from the PIIGS – Portugal, Ireland, Italy, Greece, and Spain – from spreading and to help boost the capital buffers of the continent’s banks. Other economists have questioned the current reforms being implemented in the PIIGS. Here are the plan’s consequences for each member of the PIIGS and our assessment on how successful the plan is at solving the Euro Zone’s debt crisis.
Portugal
Since growing at an annualized clip of 5 percent in 1998, Portugal’s GDP growth has decelerated and now risks turning negative for the third time in the past decade2. Once Europe’s center for low-cost manufacturing, it was hurt by the lowering of tariffs on cheap textile imports from Asia in the 1990s and by China’s entry into the World Trade Organization in 2001. Every year since 1999, Portugal has had a large trade deficit with the rest of the European Union, and since 2002, its current account (the sum of exports-imports and interest payments) deficit has averaged almost 10 percent of Gross Domestic Product3. In order to jumpstart its economy, Portugal needs to allow its labor market to become more flexible in order to allow wages to become more competitive globally, to deregulate its services industries, and to increase its ties with fast-growing Brazil. 
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At the end of 2010, Portugal had 161 billion euros in public debt outstanding4. In response to its high debt levels, the government cut its budget deficit by more than two percent in 2010, but also discovered unaccounted debt for some of the local governments that had been accumulating since 2008. With a slowly growing economy, unsustainable yields of over 6 percent on medium-term government debt, and banks reliant on funding from the European Central Bank, Portugal will need money from the EFSF, and could become a country that needs to take a haircut on its debt. Because of its small size though, Portugal appears to not pose a systemic risk to the Euro Zone.
Ireland
In the 1980s, one million Irish people – a third of the population – lived below the poverty line. By 2000, the Irish poverty rate was below 6 percent6. This was caused by a combination of free higher education, a steady decline in the corporate income tax, and an increase in the working age population. With the introduction of the Euro Zone in the late 1990s, interest rates dropped for many of the countries in it. With the ability to obtain loans at a much lower rate, Irish banks and citizens started to funnel it towards one sector: real estate. As author Michael Lewis wrote, “By 2007 Irish banks were lending 40 percent more to property developers than they had to the entire Irish population seven years earlier7.” As the slowdown in the global economy began in 2007, the money pouring into Ireland soon dried up. Without the ability to receive loans, Irish real estate developers, banks, and residents quickly lost their taste for real estate. Real estate prices declined, and Irish banks soon began accumulating losses on their outstanding loans. In order to shore up funding costs for its banks, the Irish government decided to guarantee the debt of all of its banks. As losses skyrocketed for its banks, the Irish government soon found itself in an unmanageable situation: the total losses of Irish banks rose above 100 billion euros or over three times more than the Irish government collected in taxes in 20108. As a result, Ireland’s debt-to-GDP ratio increased from around 25 percent to over 110 percent, resulting in a 67 billion euro bailout from the European Central Bank, IMF, and other Euro Zone members. Because of its extremely high debt-to-GDP ratio, it would not be surprising if private bondholders received haircuts on their holdings of Irish debt in the future, but like Portugal, Ireland’s small size will most likely prohibit the country’s debt from being an insurmountable problem for the Euro Zone.
Italy
As the Euro Zone’s third largest economy (behind Germany and France), Italy’s debt problems could soon become the focal point of the Euro Zone debt situation. Although possessing a relatively low budget deficit of 3.9 percent, its public debt amounts to 118 percent of GDP, much of it accumulated under a socialist government in the 1980s9. Ever since, Italian politicians have attempted to solve the debt problem by raising taxes, a response that has led to widespread tax evasion. “According to a 2007 paper by Austrian economist Friedrich Schneider, the shadow economy in Italy accounted for 22.3% of gross domestic product (GDP), compared to that of Spain 19.3%; Portugal 19.2% and Greece a staggering 25.1%. By comparison, the U.S. shadow economy was 7.2% of GDP10.” Some economists point to these high taxes as the reason why Italy’s growth rate since 2000 has been just 1%11.
The Italian wage-bargaining systems and low productivity, especially in the public sector which employs 15 percent of the labor force, remain the main obstacles to economic growth. Centralized bargaining systems essentially prohibit reductions in wages for permanent workers at many companies. Because of this, many companies are hesitant to hire new workers, especially the young who at best receive temporary positions that do not possess the same benefits as permanent workers and at worst become part of the 27.8 percent between the ages of 15-24 who are unemployed12. In order to grow, Italy should better align wages with productivity – a result that will only occur if the country decentralizes its bargaining system. Italy’s current plan for reform involves increasing the age for retirement from 65 to 67 by 2026 and by selling 5 billion euros in state assets annually. Without a further emphasis on the structural problems of its economy, Italy’s debt situation most likely will not be resolved. With public debt of 1.9 trillion euros, an escalation in Italy’s debt problems could not be solved through funds by the EFSF. In the long term, Italy’s current yields on 10-year debt are not sustainable13. Yet, an average life of 7.1 years on Italy’s current debt provides some protection from paying higher rates on its interest payments14. Assuming Italy issued all new 10-year bonds at 6 percent over the next four years, ING fixed-income strategist Alessandro Giansanti estimated that this would add 18 billion euros to its interest payments by the end of 2015 – a manageable amount for the country15. Consequently, Italy can continue to refinance its debt at relatively high interest rates (6-7 percent on a 10-year bond) without experiencing any short-term issues. Italy has time on its side, but the sooner it implements an acceptable growth strategy the better for the country’s finances – and the ECB’s capital – in the long term.
Greece
Greece’s debt-to-GDP ratio currently stands at 144 percent. Because Greece’s economy is contracting, that number will most likely continue to grow even without Greece having to issue any new debt. In order to put a bandage on the problem, Euro Zone leaders have proposed that private sector creditors (who now account for a minority of the Greek debt because the ECB and EFSF have been buying Greek debt over the past year) accept a write-down of 50 percent on their holdings of Greek debt. This “haircut” would reduce Greece’s outstanding debt by 100 billion euros. Yet, this would only allow Greece’s debt to decline to only 120 percent of GDP by 202016. Many analysts do not believe this will be the only haircut implemented. For this reason Greek debt maturing in more than one year currently trades at between 35-40 cents on the dollar implying that the “market” believes that this debt will be cut by at least 60 percent.
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Another strategy is for Greek debt to be exchanged for debt with longer maturities (for example, 2 year bonds are exchanged for 30 year bonds). This would allow Greece to push their issues further down the road. Unfortunately, Greece’s downtrodden economy and its resident’s persistent tax evasion – there are more registered Porsche owners in the country than taxpayers declaring an income of 50,000 euros or more – threaten to disrupt any plans of a debt restructuring in the future18. The final “option” for Greece would be a plan to leave the Euro zone, involving a return to its former currency the drachma and a default on its outstanding debt. This would most likely cause a run on its banks, a sharp devaluation of its money, high inflation, and a drop in its GDP by at least 20 percent19. In the long term, Greece would have control of its currency and the ability to more effectively control its money supply and interest rates through this power. Also, a devaluation of its currency could have the direct consequence of increasing its exports by making its goods cheaper on the global market. Even despite these benefits, Greece will probably be pressured into staying in the Euro Zone because its exit would create the possibility of other countries leaving the Euro Zone and would mostly create a sell-off in the bonds of the other peripheral countries.
Spain
As the fourth largest economy in the Euro Zone, Spain is also under immense pressure to stimulate its economy while ensuring bondholders that it has control over its debt issues. At only 64 percent of its GDP, the total outstanding debt of Spain is very reasonable compared to the other countries in the PIIGS. Yet, there are worries that Spain might have to bailout many of its banks which were saddled with poor real estate loans after the country’s real estate bubble burst over the past few years20. Moreover, Spain’s unemployment rate is currently at 21.5 percent, while its youth (ages 16-24) unemployment rate stands at a staggering 44.3 percent21. With such high unemployment, a traditional economic approach would suggest an easing of fiscal and monetary policies. Because the country has been swept into the European debt crisis, the country has focused on fiscal tightening rather than easing, and it cannot ease monetarily because it is a part of the Euro Zone and the European Central Bank controls the supply of the money. Why are people worried about Spain’s debt if it has a relatively low debt to GDP ratio? After studying Spain’s high deficit over the past few years, the IMF concluded that Spain’s structural deficit is much larger than it used to be22. The IMF’s report assumed that the decline in the Spanish real estate and financial sectors would hurt the revenue intake of the Spanish government for at least the next decade. Combined with the high unemployment rate and the long length of unemployment benefits (3 years), Spain could possibly have a difficult time of cutting its annual budget gap. At 1.1 billion euros at the end of 2010, Spain’s total outstanding debt is too much for the EFSF to fund23. Although its debt to GDP is relatively low, the amount of outstanding debt for Spain means that the country will have to solve its revenue issues in order to comfort European bond holders and stem the outflow of money from its own bonds.
Bank Recapitalizations
State-bank contagion hinges on the ability of the sovereign nations to improve their finances. The largest purchaser of the debt in any European country is banks located in that country. If a government declares bankruptcy or defaults on part of its debt, most of the banks in the country will fail as well because they have to write down the asset value of all of their holdings of the government debt. Yet, a country’s debt is also held by foreigners so a sovereign bankruptcy or default would not be contained to that particular country. For example, French banks hold the equivalent of 8.5 percent of France’s GDP in the debt of Greece, Ireland, Portugal, Italy, and Belgium. Therefore, the most recent plan for the EFSF called for 106 billion euros to be set aside specifically for bank recapitalizations.
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Yet, the IMF estimates that 200-300 billion euros are needed for bank recapitalizations while Goldman Sachs estimates that 1 trillion euros are needed. A quick look at the total outstanding debt for Spain and Italy demonstrates how quickly the amount of money needed for bank recapitalizations could spiral out of control: a mere 10 percent restructuring in Italian debt would require 190 billion euros in bank recapitalizations – an amount much larger than the 106 billion euros currently pegged as the amount needed for recapitalizations. This also demonstrates the need for the contagion to be contained in Greece, Portugal, and Ireland. Consequently, European banks should be proactive in raising their capital levels in order to protect against future losses in their sovereign debt, but their fate rests on the ability of the PIIGS to cut debt and grow their economies.
Conclusion
The European Financial Stability Fund currently has 440 billion euros of resources (some of which has been used to fund Greece) and over 700 billion euros when funds from the IMF plan and other Euro Zone resources are included. With 3.1 trillion euros of government debt outstanding in the PIIGS at the end of 2010, the EFSF can provide an adequate buffer for these countries should they run into further problems. If the amounts are confined to Greece, Ireland, and Portugal, then the current EFSF resources would probably provide more than enough support to tide over those countries until they could access the public markets. Further problems in Italy and Spain might be sources of problem for the Euro Zone. Therefore, more debt and growth reforms in each of the PIIGS, a larger private fund to help Italy and Spain in case either of those countries runs into further difficulties and additional easing at the European Central Bank all could help the Euro Zone survive its debt crisis over the next two years.
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