One of the best analysis of the current disastrous state of global economy and the systemic crisis developing right now. A must read to understand what is coming on us in the following months.
A Global Album Of Sovereign Insolvency
- 2s30s
- Belgium
- Budget Deficit
- Capital Formation
- Capital Markets
- CPI
- Credit Line
- Creditors
- European Central Bank
- Eurozone
- Fail
- Federal Deposit Insurance Corporation
- Fitch
- France
- Germany
- Greece
- Gross Domestic Product
- Hungary
- Iceland
- Institutional Investors
- International Monetary Fund
- Ireland
- Italy
- Japan
- Monetary Policy
- Moral Hazard
- National Debt
- Nominal GDP
- Norway
- Portugal
- Real estate
- Recession
- recovery
- Sovereign Debt
- Sovereign Default
- Sovereign Risk
- Sovereigns
- Stress Test
- Unemployment
- United Kingdom
- Willem Buiter
When it comes to providing analytical perspectives and empirical insights into the realm of sovereign deterioration, few come close to the work of Reinhart and Rogoff. Citi’s Willem Buiter is one such man. In his latest summary piece describing in excruciating detail just how bad things are at the sovereign level (and judging by tonight's opening print in the EURUSD more are starting to realize this), Buiter provides a terrific country by country guide of what is now an insolvent world, starting with the merely extremely risky, going through the backstop-baiters, and finishing with the time bombs that have already gone off and everybody pretends not to care. For those who do care, this is a definitive guide to what each individual European (and not only) country can look forward to in an age of global moral hazard. The only open question: with China's interest now to preserve the Euro's viability, how will Beijing act in the next few months as the eurozone finally starts unraveling.
But before getting into the gritty details, here is the latest updates series of sovereign charts.
“Gross debt-to-GDP ratios are rising fast across the industrialized world.”
“Gross debt-to-GDP ratios are rising fast across the industrialized world.”
Two implications are worth highlighting, in our view. First, general government gross debt-to-GDP ratios are rising substantially in most countries over the period of 2010 to 2015 and should only have started to come down again, at best, by the end of this period. Second, countries that entered the financial crisis with relatively low debt levels, such as Spain (with a general government gross debt-to-GDP ratio of 36% in 2007), the UK (44%) or Ireland (25%), will see some of the biggest increases, with the implication that the indebtedness of all three of these countries’ sovereigns will no longer be low by 2015, with expected general government gross debt-to-GDP ratios rising to 82% (Spain), 105% (Ireland, even before announcement of the recent bail-out plan) and 84% (UK).
Figure 3 presents a snapshot of debt and deficit levels for the same universe of countries for 2010 and highlights the diversity between countries. Apart from the clear outlier of Ireland, the two countries with the highest (general government) deficits are the UK and the US, leading to large rises in (general government gross) debt-to-GDP ratios in the next few years. By contrast, Belgium and Italy, two countries that have shouldered a relatively high debt burden for many years, have relatively modest — by the standards of AEs after the 2007/8 financial crisis — budget deficits.
“Average government maturities are between five and eight years in most countries”
Figure 4 presents the average maturity of government debt for selected countries. It shows that average maturities are by no means uniform across the country sample. At one end of the spectrum are countries, such as Korea, Norway and the US, with average maturities of around or below four years. Notably, all three of these countries have lengthened the average maturities ofthe outstanding debt between April 2009 and August 2010. The bulk of countries have average maturities of between five and eight years, with the UK being a clear outlier with an average maturity of over 13 years.
“High debt EA periphery is also largely united (except Italy) in running current account deficits and having large negative net international asset positions”
Figure 5 takes a look only at the external side of transactions for the nations as a whole. The first and second columns present the current account balance and the primary external balance, i.e. the current account balance excluding net investment income from abroad. Greece and Portugal stand out with very large current account deficits, exceeding 10% of GDP in 2009, and there is clear daylight between Greece and Portugal and the country with the next highest current account deficit within this sample (Spain, with 5.5% of GDP). Germany’s current account surplus is by far the largest, at just under 5% of GDP, with Japan second at 2.8% of GDP…The final column indicates that a large share of these liabilities is in the form of debt securities rather than foreign direct investment or portfolio equity. Gross external debt accounts for more than half of gross international liabilities in all countries, more than 60% in all countries bar Hungary, and more than 70% in France, Germany, Greece, Italy, Portugal and Spain.
10 Year Sovereign Yieds
Figure 6 and Figure 7 picture the evolution of 10-year yields on sovereign debt. Figure 6 shows that sovereign yields in countries that were largely shielded from the sovereign debt turmoil remained low and evolved largely in a uniform way, with gradual falls in yields from the beginning of the year until September 2010 and a relatively pronounced reversal thereafter. Nevertheless, sovereign yields continue to remain low in historical terms in Germany (2.96% on December 31, 2010), France (3.35%), the UK (3.39%) and the US (3.28%). Even in Belgium, 10-year yields on sovereign debt remain below 4% (3.97%), while yields on Japanese sovereign debt continue to be extremely low (1.12%).
Selected Countries Growth Outlook
The growth outlook, for the euro area as a whole and the high debt countries in particular, is quite poor (see Figure 8). We expect 1.4% growth in euro area real GDP in 2011 and 1.2% in 2012. Growth prospects in the periphery are worse. We expect Greece’s recession to continue in 2011 and 2012, and Portugal to re-enter recession in 2011 and to only start growing again, slowly, in 2012. Spain’s growth is likely to be close to zero between 2010 and 2012, with Italy’s growth rate stable and positive, but low. It is important to note that fiscal consolidation is not the only factor hurting growth in these economies. Other factors include private sector deleveraging due to excessive levels of debt (Spain, Ireland, Portugal), long-standing weak growth potential due to structural supply-side and competitiveness issues (Italy, Portugal, Greece) and banking sector fragility (Spain, Ireland)… Countries that have not been subject to turmoil in sovereign debt markets are expected to fare somewhat better. Germany continues to outperform in the near term, while France is very close to the euro area average. Outside the euro area, growth prospects of high-debt economies are slightly more positive, but UK, US, and Japanese growth rates are likely to be too slow to stop public debt-to-GDP ratios from rising over the next two years.
Change in PIIGS’ Cost of Capital
Interest payments are another area of (total, not primary) government spending that the general government has rather little control over, as they are set by the markets. Average nominal interest rates paid on public debt in the euro area periphery are still low in historical perspective in absolute terms (Figure 12). Relative to GDP, the interest burden has already started to increase, notably in countries that have seen a fall in the denominator, such as Ireland and Greece (see Figure 13)… In 2009, the average cost of debt in the euro area periphery ranged between 4.2% p.a. for Portugal and Italy and 4.8% p.a. for Greece. By comparison, 10-year yields on sovereign debt at year-end in 2010 were 4.9% for Italy, 5.5% for Spain, 6.7% for Portugal, 9.2% for Ireland and 12.5% for Greece. While it will take time for yields on newly issued debt to feed through, the average cost of debt should rise over the next few years. Together with rising debt levels, the higher cost of debt should lead to a substantial increase in the burden of interest payments (even after adjusting for the effect of inflation on the real value of nominally denominated public debt). For example, in Spain, we expect interest payments to rise from 1.8% of GDP in 2009 to 4.5% in 2016 and in Ireland we expect the interest burden to rise from 2.2% to 5.4% of GDP over the same period…The inevitable increase in the average interest cost of servicing the public debt will make achieving fiscal sustainability harder.
“Uncertainty over coverage, accounting treatment and adjustment for cyclical or one-off effects suggest care when trying to interpret debt and deficit numbers”
Public debt and deficit numbers are not written in stone. The saga on the Greek budget deficit is an extreme example (Figure 15). When the budget for 2009 was passed in December 2008, the government forecast the general government gross deficit to be two percent of GDP in 2009. The conservative New Democracy government raised its estimate to between 6% and 8% of GDP in 2009. After winning the general election, the incoming PASOK government almost immediately on taking office raised the estimate to 12.7% of GDP in October 2009. In its first estimate, Eurostat reported a general government deficit-to-GDP ratio of 13.6% in April 2010. But even that was not the end of the story. The latest revision, announced by Eurostat on 15 November 2010, put the deficit for 2009 at 15.4% of GDP. At the same time, deficits for 2006 – 2008 were also revised up, and general government gross debt at the end of 2009 was raised from the previously reported 115% to 127% of GDP. In response, the Greek government raised the target for the 2010 general government deficit to 9.4%, from the previous estimate of 7.8% of GDP.
Composition and Ownership of European Sovereign Debt
The share of the government debt of euro area countries held abroad varies quite widely, ranging from 39% in Spain to 66% in Portugal. Since then, however, the trend has reversed substantially, as the share of external holdings declined by 12 percentage points in Greece and 18 percentage points in Ireland and 20 percentage points in Portugal by Q3 2010. The decline in external holdings was particularly sharp in the second quarter of 2010. Since overall debt levels in these countries were rising fast during this period, total external holdings of Greek and Portuguese sovereign debt fell less, although they, too, did fall, while in Ireland the total amount of sovereign debt held abroad actually increased.
To us, the reasons for this large increase in ‘home bias’ are not entirely clear, but they are part of a wider trend around the world that saw cross-border capital flows collapse, or even reverse, during the crisis. Candidate explanations are increased patriotism, increased pressure by governments on their domestic banks and other institutional investors to absorb additional domestic public debt, repatriation of capital due to fear of default or expropriation by foreign governments, and an increase in actual or perceived information asymmetries
Spain and Italy are slightly different from the other, smaller, EA periphery countries in this regard (Figure 20). The share of sovereign debt held domestically is larger and had not fallen substantially in the run-up to the crisis. The share of external holdings of Spanish sovereign debt fell less, but still noticeably, than in Greece, Ireland and Portugal, while it increased in Italy. In Germany and France, the secular increase in the share of sovereign debt held abroad continued, and possibly strengthened, during the crisis.
Figure 22 and Figure 23 present data on the cross-country exposure of banks from the large EU countries to Greece, Ireland, Portugal and Spain. Relative to GDP, the total exposure of the UK, France and Germany is remarkably similar. The composition, however, is different, with Ireland accounting for the largest share of UK exposure, while Spain represents the largest individual country exposure for Germany and France.15 Italy’s exposure, relative to GDP, is much smaller, but once again, Spain accounts for the largest share of it.
And with that chartist update out of the way, here is how Buiter ranks the sovereign conflagration, from the place where the fire is burning brightest, to where it is merely dormant.
Greece
In our view, Greece is still the eurozone country that is most likely to undergo a restructuring of its sovereign debt in the next few years. The mix of a high fiscal deficit (at 9.6% of GDP for the general government sector in 2010 according to the updated IMF projections and after the recent upward revisions), enormous public debt (gross general government debt stood at 141% of GDP in 2010, according to the IMF), and poor growth prospects make the Greek fiscal situation the least sustainable among the euro peripherals. Greece needs to run a (permanent) general government primary surplus of around 6% of GDP just to stabilise its general government gross debt-to-GDP ratio at the level of around 150% of GDP expected at the end of 2012. The general government cyclically adjusted primary deficit in 2010 is estimated to be around to 4% of GDP. This means that additional tightening equal to 10% of GDP is needed over the next few of years to just stop the gross general government debt-to GDP ratio from rising in Greece.
Admittedly, the adjustment programme has seen some early successes — a reduction of more than 30% YoY in the central government deficit and the passing of a number of significant structural reforms — and these successes may have helped reduce the probability of a credit event in the short term However, more recent data show that the policy-induced slowdown in the economy is reducing tax revenues and higher costs of borrowing (including the cost of borrowing from the other eurozone countries through the Greek facility) are driving up the average cost of debt. Revenues were up by more than 10% YoY in the first six months of 2010, but the growth rate slowed to 4.8% YoY in November.
As a percentage of GDP, interest payments on central government debt in the 12 months ending in November increased to 5.7%, up from an average 5.1% in the previous 18 months. Both factors are likely to continue to lift the deficit, at least partly cancelling out the cuts on the primary expenditure side. Some of these expenditure cuts are in any case likely to be unsustainable, as there is evidence that they were achieved in part by not paying bills, particularly at the level of regional and local government and at the social funds. We estimate that the cost of interest payments on the overall public debt is likely to rise to about 8% of GDP in 2013.
A meaningful improvement in tax revenues is likely to require substantial increases in tax compliance, which for the time being remains elusive. The decision of the Greek government to grant a tax amnesty, against the strong opposition of the IMF/EU/ECB ‘Troika’, is very damaging in this context, in our view. The reason is that such an amnesty may reduce future tax compliance from currently compliant citizens and weaken even further the incentives for non-compliant citizens to change their behaviour, in the expectation of future amnesties.
The implementation of the austerity package has already been accompanied by large strikes, demonstrations and other manifestations of social unrest. Consolidation fatigue is likely to be even more prominent in the future and has the potential to derail the adjustment process. Gross refinancing needs of the Greek sovereign will remain high for the foreseeable future, owing to the high and rising level of gross debt, high interest rates and, at least for 2011, continuing primary deficits. The Greek sovereign was always unlikely to be able to re-access private capital markets at the end of its current adjustment programme (in May 2013), without a substantial restructuring of its debt. On 28 November 2010, ECOFIN correspondingly agreed to consider extending the maturities of the loans in the EU/IMF programme to bring them more in line with those of the Irish package. This would imply an increase in maturities from three years to between 4½ and 10 years, with an average maturity of just over seven years.
In any case, in our view, although maturity lengthening will help to smooth out a redemption hump in 2014/15, it is unlikely to resolve the fundamental solvency issues of the Greek sovereign.
The euro area periphery countries all face different combinations of sovereign debt unsustainability, banking sector vulnerability and, for the real economy, persistent man-made distortions and real rigidities in factor and product markets resulting in low profitability and poor growth prospects. In Greece, the problems are primarily those of fiscal unsustainability and poor growth prospects. The main problem of the Greek banking sector is its exposure to the Greek sovereign — quite distinct from the case of Ireland, where an deeply troubled banking sector threatens to drag down a sovereign that would in all likelihood have been solvent had it not guaranteed so much of the banking sector’s liabilities and assumed its losses.
Ireland
Ireland is the prime example of a country where the sovereign is at material risk of default because of the support extended by the sovereign to the banking sector, through guarantees of unsecured debt and through large injections of capital. Like Iceland, the banking sector in Ireland was too large to save. Unlike Iceland, the Irish sovereign, when faced with the likelihood that it would not be possible to make whole both the banks’ unsecured creditors and its own creditors, did not leave the banks to sink or swim on their own but extended bank guarantees for initially up to €440bn worth of bank unsecured liabilities. With the consolidated sovereign and banking sector likely insolvent, in our view, the key remaining question is whether it will be the banks who default, the sovereign or both.
Ireland was the first country in the EA to announce fiscal tightening in 2008: according to the EU Commission, total tightening amounted to 9% of GDP in 2009-2010 — the same amount the government has recently committed to implement over the next four years. However, it has by now become abundantly clear that such early — some said ‘preemptive’ — tightening was not enough to restore sustainability of the public debt or at least the market perception thereof.
GDP continues to contract compared to the previous year, reflecting private sector deleveraging, a collapse of the previously outsized construction and real estate sector, and the impact of the drastic austerity measures. As a result, the underlying government deficit (excluding the capital injections to the banks) will probably still be in double digits in 2010 (12% of GDP) and around 10% of GDP in 2011. The additional government support to the banking sector (€30.7bn in 2010) appears to have propelled the general government deficit-to-GDP ratio to 32% of GDP in 2010 and the gross general government debt-to-GDP ratio to around 99% of GDP, up from 44% in 2008.
€50bn of the €67.5bn IMF/EU bail-out package is aimed at providing budgetary support.39 Without access to any other funding sources, this amount is expected to cover the sovereign’s funding needs for around two years. Of the €35bn dedicated to restructure the banking system, €10bn will be used for an immediate recapitalisation of the banks to increase their capital ratios from 8% in 2010 to 10.5% in 2011. The remaining €25bn is a credit line that, according to the programme’s designers, is not expected to be used.
At this stage, it is by no means clear that the stream of bad news coming out of the Irish banking sector has ended. In November 2010, UC Dublin professor Morgan Kelly raised his estimate of the total bailout cost for Irish banks from €50bn to €70bn because of an expected sharp rise in mortgage delinquencies in 2011. According to him, 4.6% of Irish mortgages were 90+ days delinquent at end-June and around 25% of mortgage borrowers are expected to be in negative equity at end-2010.40 The funds provided, including the €25bn additional credit facility, may be just about enough to cover the additional losses, but, in our view, statements to the effect that the contingent funds will not be needed are somewhat empty — as noted above, many European officials also declared that they did not expect that the EFSF would ever have to be used.
The Irish bail-out package has eliminated funding risk for the Irish sovereign and the Irish banking sector for now. But it does little to address the fundamental problem that the combination of the Irish sovereign and the domestic banking system is de facto insolvent. Additional fiscal tightening, private deleveraging, tight credit due to the fragile situation of the banking system, and high unemployment should continue to weigh on growth. In our view, the Irish government was right to resist any increase in the corporate tax rate, as an FDI-led resurgence in growth is one of the few growth prospects the Irish economy currently has.
It is already clear that the holders of sub-senior, unsecured bank debt either already have or will need to accept large losses on their holdings. For now, the senior unsecured debt of the banks has not been restructured. But since the value of the unsecured sub-senior debt is not very large, it remains likely that either the senior, unsecured debt of the banks and/ or the sovereign will ultimately need to be restructured. The nature and timing of such a restructuring remain uncertain. The maturity of the loans in the Irish package is substantially longer than in the Greek case (the average maturity in the Irish case is around 7.5 years), reducing immediate restructuring pressures and suggesting also that European policymakers may yet decide to further delay restructuring. On the other side, the Irish government has announced that it will seek to soon introduce a ‘special resolution regime’ for banks, such as the US has with the FDIC, making an early restructuring of the Irish banking system easier and therefore more likely. The two opposition parties that, if the opinion polls are correct, are set to form the next government following general elections early in 2011, are campaigning on a platform that supports haircuts for senior unsecured creditors of the banks.
It is clear that, should Ireland restructure its senior unsecured bank debt unilaterally (that is, not as part of an EA-wide or EU-wide simultaneous sovereign and bank debt restructuring), severe contagion would likely result to the banks in other countries that would be viewed as now at risk of similar bank debt restructuring. Could the EC/ECB/IMF either bully or entice Ireland into not restructuring its banks’ senior unsecured debt?
As regards ‘carrots’, we see only one: a lower interest rate on the EU/IMF facility. The current 5.8% average rate really is an invitation to sovereign default — it makes no sense as part of a package that is meant to avoid sovereign default. Lowering it to, say, 3 percent, might convince a future Irish government at least to postpone restructuring its unsecured senior bank debt.
As regards pressure or ‘sticks’, there is only the threat of ejecting Ireland from the EU/IMF facility and the threat that the ECB would either refuse to purchase Irish sovereign debt through the SMP or refuse to fund the Irish banks through its collateralised ECS facilities. Neither threat seems either plausible or effective. No promise not to restructure the senior unsecured bank debt was part of the EU/IMF programme. Provided the haircuts on the unsecured creditors are harsh enough, the restructured Irish banks should be able to fund themselves in the markets. Threatening the Irish government with exclusion from the SMP could well precipitate an early Irish sovereign default, which might well do more damage outside Ireland than inside.
We conclude that, should the next Irish government decide to restructure the unsecured senior debt of its banks, there is little the rest of the EU or the IMF would be able to do about it. In the case of the IMF, there is the further awkward fact that restructuring senior unsecured debt is part of the standard IMF post-crisis package in emerging markets (EMs). Admittedly, the risk of contagion in past EM crises was likely less than it is today in the EA.
Portugal
As noted, each euro area periphery country faces a distinct set of challenges. So Portugal may not be Greece, but the challenges it faces are more similar to those of Greece (if not quite as dramatic) than those of Spain and Ireland. Portugal’s gross general government debt-to-GDP ratio is likely to be around 80% this year, not far from the EA average and it largely avoided the housing bubbles and banking sector excesses of Ireland (or Spain). However, the government deficit remains stubbornly high and the private sector is highly indebted, to the point that Portugal has the largest negative net foreign investment position in the EA (at minus 113% of GDP at the end of 2009 — see Figure 5). In times of crisis, the debt of private institutions deemed systemically important or too politically well-connected to fail tends to become public debt. The assets, liabilities and funding needs of the private sector must therefore always be considered carefully before a judgment can be reached as regards the current and likely future health of the public finances.
Despite the fiscal austerity package approved in May 2010, the Portuguese central government budget deficit had not yet shown meaningful signs of improvement at the end of November 2010. The year-end target of 7.3% for the general government deficit-to-GDP ratio may only be reached through an accounting trick.41 Another round of adjustment measures is planned for 2011, amounting to 3% of GDP on top of a 1% of GDP adjustment for 2011 already included in the May 2010 fiscal package. However, this year’s experience shows that implementation risks remain high.
Moreover, Portugal also has one of the EA’s highest levels of gross debt in the non-financial private sector, close to 250% of GDP. Net external debt is high and a majority of Portuguese sovereign debt is held abroad (see Figure 18). Unlike in Spain or Ireland, the private deleveraging process does not seem to have started. The current account deficit is still very high at 9½ % of GDP in Q3 2010 — almost unchanged from pre-crisis levels, so there is no evidence either that the country in the aggregate is beginning to live within its means or that it is shifting resources from the non-traded towards the tradable sectors.
Growth in Portugal this year has been less weak than in the other EA periphery countries (Real GDP likely expanded by 1.6% in 2010) and has not fallen short of expectations yet. However, this is at least in part because Portugal has engaged in less fiscal tightening than the other EA periphery nations. The growth outlook is poor. Portugal has suffered from low growth for many years.
Additional tightening measures, the need for private sector deleveraging and tight credit as a result of funding difficulties for the Portuguese banks imply that growth is highly likely to plunge again. A recession in 2011 looks likely. The lack of economic growth and the limited impact of past fiscal tightening measures to lead to a meaningful reduction in the general government budget deficit also imply that there is a substantial risk that deficit targets for 2011 and beyond will not be met.
Yields of Portuguese sovereign debt have already risen markedly. At such high interest rates and with low growth, we consider Portugal to be quietly insolvent and likely to access the EFSF soon.
Spain
Until the end-2010 market turmoil, Spain had benefited from some benign developments. After the publication of stress test results in July, investor concerns about the health of its banking system receded, further aided by a reduction in reported ECB funding of Spanish banks (though the reduction in ECB funding was mainly due to the fact that Spanish banks managed to get access to market funding in an anonymous way through their membership in the London Clearing House). Fiscal revenues also picked up following the implementation of some revenue measures in May 2010, and central government expenditures were declining.
However, substantial risks remain. The results of the stress tests have been discredited throughout the EU. In our view, the banking system remains a key source of uncertainty surrounding Spain and its medium-term fiscal sustainability. The restructuring of the banking sector has only just started, with several mergers among savings banks (the ‘cajas’) agreed in June. The total amount of capital injected into the banking sector by the Spanish government — around €14.4bn (1% of GDP) — appears woefully inadequate in light of the size of the real estate bubble and exposure of the banks to real estate and construction-related assets. By comparison, the Irish government had committed around 30% of GDP even before the most recent recapitalization measures as part of the bailout package42. Reports of ‘deposit wars’ between Spanish banks suggest continuing funding difficulties and will weigh on profitability.
Household and corporate loans stand at around 226% of GDP in Q2 10, and are still increasing. Very high unemployment (in excess of 20% of the labour force) and the shrinkage of construction and real estate sectors have yet to make a substantial impact on bank balance sheets.
On the fiscal side, uncertainty remains about developments at the local and regional level. The majority of expenditure in Spain occurs at the local and regional level and the central government has limited control over the spending decisions of the autonomous regions and the municipalities. Anecdotal evidence of increasing arrears and higher debt issuance by regional authorities suggest caution. In our view, the gross general government deficit target is likely to be reached in 2010, and may be even surpassed, but deficit targets for 2011 and 2012 will be challenging. Also, the growth forecasts of the Spanish government are too optimistic, in our view, as we expect fiscal tightening, tight credit and high unemployment to reduce private sector demand. Additional tightening measures are likely to be required to meet the deficit targets.
With significant additional tightening measures, without large negative surprises in the banking sector and with a stronger growth performance than we currently consider likely, Spain may yet muddle through without external help. But should it need assistance, its funding needs over a three-year horizon would likely be too large for the current lending capacity of the EFSF. In the near term, the size of the EFSF and the ESFM could potentially be extended by the EA and EU member states and/or the ECB could increase its support (e.g. by purchasing Spanish sovereign debt through the SMP and by increased funding of Spanish banks using Spanish sovereign debt as collateral). In the longer term, there may be a need for large-scale restructuring of Spanish bank debt and possibly the sovereign.
Italy
Until recently, Italy had been largely shielded from the sovereign debt turmoil, despite its adverse starting position — it entered the crisis with the highest general government (gross and net) debt-to-GDP ratio in the EA — and its historically poor performance during past episodes of heightened risk aversion.
In our view, relatively tight fiscal policy through the crisis (Italy hardly engaged in any fiscal stimulus) and relatively favourable private sector gross debt, net debt and financial net worth positions make for a much lower degree of overall (public plus private) gross and net indebtedness than in the rest of the EA periphery. Indeed, private plus public gross debt as a percentage of GDP ratios are similar to the levels in France or Germany. A high private saving rate and small general government deficit supported a smaller current account deficit than in the rest of the EA periphery and Italy has a comparatively sound domestic banking system, despite rather low capital ratios. A fairly large domestic investor base, reflecting large levels of private financial wealth, is also likely to make the total investor base somewhat more stable than in countries with high levels of foreign ownership of sovereign debt, such as Portugal and Greece.
However, like Portugal and Greece, Italy suffers from some longstanding structural weaknesses that depress its potential growth. Poor productivity growth and adverse demographic trends will continue to weigh on its trend growth rate, which we estimate to be just below 1% per annum. Moreover, the gross general government debt-to-GDP ratio should remain the second largest in the eurozone (after Greece) for the next few years, and it will most likely continue to edge up in the near term, likely exceeding 120% of GDP in 2011.
Gross refinancing needs should thus stay high and increase the vulnerability of Italy both to funding and liquidity crises and to self-justifying solvency crises should sovereign risk premia rise substantially.
A continuation of the fairly conservative fiscal stance of the Italian government should provide some reassurance to markets about the long-term sustainability of the Italian debt. A major political crisis, however, would constitute a downside risk and could provoke tensions in the market for Italian sovereign debt. In any case, general government debt ratios anywhere near the current Italian level would constitute a source of vulnerability to roll-over crises and ‘sudden stops’.
At this stage, we consider it unlikely that Italy will require access to the EU facilities. Should it do so, it is clear that the current size of the EFSF would be insufficient to satisfy Italy’s funding needs. It would then once again be the ECB that would need to be called upon to stave off sovereign default.
Belgium
Despite going into the crisis with a relatively large gross general government debt-to-GDP ratio, Belgium was not caught up in the sovereign turmoil until very recently. However, public sector debt remains high. Gross general government debt was 96.2% of GDP in 2009, is likely to increase in 2010 and 2011, and surpass the 100% of GDP mark again during our forecast period.
This implies that refinancing needs will remain high, creating the risk that the Belgian sovereign will be caught up in the turmoil should there be renewed market tensions. This is despite the fact that Belgium’s recent history has shown that its general government sector can generate primary surpluses for long periods of time — it was able to reduce its ratio of gross general government debt to GDP from 138% in 1993 to 84% in 2007.
In our view, the main risk in Belgium is political. The last general election took place in June 2010, but it is still without a new government. The role of nationalist parties has increased in Belgian politics, in particular in the Flemish (Dutch) speaking north of the country, which favours a large reduction in the fiscal transfers to the poorer (French-speaking) south and to Brussels, and possibly a break-up of the state. Ironically, the fact that the large government debt is mainly on the balance sheet of the central government (rather than the regions) may be one of the factors holding the country together currently.
Should the country break up, there would be substantial uncertainty about how the national debt will be divided between the three regions and about the duration and other modalities of the process leading up to the division.
France
France was largely untouched by the sovereign debt turmoil in 2010. In fact, as one of only three large European countries with a AAA-rating — the others being the UK and Germany — it may have benefited to some extent from safehaven flows in earlier parts of the year. Recently, however, yields on French sovereign debt have increased substantially, rising from a low of 2.50% at the end of August to 3.37 at the end of December. Such levels are still very low by historical standards, of course, and only bring France back to where yields were in April 2010 before sovereign debt concerns erupted in earnest for the first time. But the recent rise does highlight that markets may have become slightly more discerning in distinguishing between the creditworthiness of different AAA-rated sovereigns, though of course yields on sovereign debt have increased across virtually the entire industrialised world in November and December 2010.
France’s budgetary situation had deteriorated even before the recent crisis and the general government deficit reached 7.6% of GDP in 2009.The government is likely to have reduced this deficit ratio slightly in 2010 and will probably reach the targeted reduction in the general government deficit to 6% of GDP in 2011, but the target of 0% to 3% by 2013 appears too optimistic. This is mainly because we consider the growth forecasts of the French government of 2.0% in 2011 and 2.5% per year from 2012 onwards to be too optimistic.
Furthermore, after the implementation of the pension reform, which will help limit pressure on the public finances in coming decades, further meaningful fiscal austerity measures are unlikely to be implemented before the 2012 presidential election. Further action may be forthcoming after the next election, and we consider such additional fiscal tightening to be necessary to safeguard fiscal sustainability. The main differentiating factor, in our view, between the fiscal prospects of Germany and France, are not current levels of public debts and deficits, but the ability to impose austerity measures and the willingness of the electorate to accept these measures. The recent large-scale protests in France following the announcement of the pension reform plans are a reminder of the difficulty of such fiscal tightening actions in France. The willingness and ability of the government to pass the reform legislation without material watering down of the key reform proposals are a positive from the perspective of restoring fiscal sustainability in France.
For France, as for all countries that suffer from unsustainable public finances but have not yet legislated a multi-year programme of public spending cuts and tax increases sufficient to safeguard sovereign solvency, the jury is still out. Over longer horizons, there may be a risk of a fundamentally warranted French sovereign debt crisis, if sufficient additional fiscal tightening actions are not announced and implemented in time to prevent a further deterioration of the fiscal fundamentals. In the near-term, however, a more urgent risk may be that without further early fiscal tightening measures, France could lose its AAArating, just as the UK was at risk of losing its AAA-rating early in 2010, before and until it announced and started the implementation of a fiscal tightening package worth more than 8 percentage points of GDP.
It is not currently clear to us what the implications of a loss by France of its AAA-status would be for the workings of the EFSF, other than that there will be implications. The effect would most likely involve increases in the funding costs of the EFSF (and therefore also the applicant countries), but could also include loss of the AAA-rating for EFSF bonds or further reductions in the amount of loans that can actually be disbursed.
United Kingdom
News on the fiscal side and for the real economy was mostly positive for the UK in 2010, and it appears to be on track to return to fiscal stability. The UK entered the financial crisis with a relatively low gross general government debt-to-GDP ratio of 44% in 2007, but very high recent deficits — the peak was 11.1% of GDP in 09/10 for the general government deficit and a trend of strongly increasing government expenditure, raised concerns about the sustainability of the public finances in the UK.
The coalition government has outlined and started to implement an ambitious programme, with a focus on reducing public spending and limited tax increases that is supposed to reduce the general government deficit from around 11% in 2009/10 to about 2% in 2014/15. So far, progress has mostly been reassuring.
The fiscal deficit is falling slightly, and the deficit in 10/11 is likely to turn out much lower than the consensus expected a year ago. We expect the general government deficit to fall to about 6% of GDP in 2011/12 and to about only 1% in 2014/15, leading the general government debt-to-GDP ratio to level off at around 80% of GDP.
After growing by 1.7-1.8% in 2010, we expect real GDP growth to reach 2-2.5% YoY in 2011 and 2012. Nominal GDP growth is in line with the historical average, running at 5.5–6% over the forecast period. Some downside risks remain. The bulk of the fiscal tightening has yet to take full effect, and the fiscal tightening should be expected to dampen growth in the coming years. With inflation (on the CPI measure) running at more than 3 percent per annum, and with survey-based inflation expectations edging up in line with recent actual inflation, monetary policy is unlikely to be able to play an active supporting role, should the real economy falter. However, the low pound and the strong financial position of the corporate sector will support the continuing recovery. in our view, and thereby also support the cautiously positive fiscal outlook. Continued sovereign debt turmoil in the euro area would adversely affect the UK through Euro weakness and by dampening growth in the euro area — the UK’s major export market. The exposure of some large UK banks to sovereigns and banks in the periphery of the EA is also a source of concern. However, the crisis also contains some mild positives for the UK, as its relative stability attracts capital inflows, keeps yields on sovereign debt low, and raises the attractiveness of foreign direct investment.
Japan
According to the IMF, Japan’s gross general government debt stood at 218% of GDP in 2009 and its net debt at 112% of GDP. The government budget deficit is estimated to be 9.6% in 2010, the primary (non interest) deficit 9.1% of GDP and the cyclically adjusted primary deficit 7.6% of GDP, with similar levels projected until 2015, the end of the forecast horizon. The recent IMF Fiscal Monitor noted that, of all the countries considered, Japan has the largest total adjustment need required to achieve fiscal sustainability and the largest remaining adjustment beyond measures that have already been planned (Figure 27).
Adverse demographic trends, structural weaknesses, and less-than-forceful macroeconomic and financial policy imply that growth prospects for the Japanese economy are poor. At the same time, there is no sign of planned or actual consolidation. Indeed, Japan has just announced a small fiscal stimulus.43 With such budgetary fundamentals, it is hardly surprising that Japan is one of two G7 countries not to have a triple-A rating (Italy is the other one). It is currently rated Aa2 by Moody (AA by S&P and Fitch, see Figure 28). But government bond yields remain extremely low and CDS rates on Japanese government bonds are only marginally above those of Germany. For the moment, Japan’s sovereign is protected against normal market discipline, despite fiscal fundamentals that would imply a high degree of sovereign risk in other countries, by a very large stock of private financial wealth (the product of high past private saving rates), and an unequalled homebias in Japanese portfolio preferences. Together these act as a form of self-imposed or voluntary financial repression, permitting the Japanese sovereign to borrow at rates well below ‘fair value’.
The large stock of private financial wealth (reflected in Japan having a net foreign investment position of plus 57 percent of GDP in 2009, despite the large net debt of the state) is a fiscal asset to the extent that private wealth, or the income streams it generates, can be taxed in the future. Alternatively, it provides the private sector with the financial resources to accommodate and make up for cuts in public spending categories for which privately purchased alternatives exist, such as health, education and retirement. The home bias is reflected in the fact that about 95 percent of all Japanese sovereign debt is held domestically.
The benign low interest rate equilibrium in Japan is, we think, vulnerable to ‘defection’. Private saving rates are coming down fast as the population ages and declines. Total net household saving has fallen below the net addition to the stock of Japanese sovereign debt, although the Japanese corporate sector continues to be a large net saver. But given the likely future declining trend in the Japanese private sector financial surplus (unless there is a large decline in gross domestic capital formation that offsets the age-related further decline in the private saving rate) and the continuing large public sector financial deficit of Japan, Japan is likely to turn into a current account deficit country before long.
This makes it likely that more Japanese government debt will be bought by foreign investors in the future. Even if existing Japanese government bond holders (households and institutional investors like the postal system) continue to be willing to hold 10-year JGBs at a 1.50 percent interest rate or less, it is unlikely that the rest of the world will absorb significant additions to the stock of Japanese sovereign debt at these interest rates. For the same fundamentals that support the benign low interest rate equilibrium, there also exists a ‘fear equilibrium’. In a ‘fear equilibrium’ the marginal holder of Japanese sovereign debt believes there is a non-trivial likelihood of sovereign default (or of an inflationary and exchange rate depreciation solution to the public debt overhang) and interest rates rise sharply, thus validating the fear of worsening public finances that triggered the increase in interest rates in the first place. The timing of the shift to a ‘fear equilibrium’ cannot be predicted with any degree of precision. But absent any determined and sustained commitment to tackle the unsustainable fiscal programme of the sovereign, the shift from the benign to the fear equilibrium seems bound to happen sooner or later.
And last but not least...
United States
The United States too have also lagged most other advanced economies with rapidly rising public debt levels in making binding commitments on fiscal consolidation. Serious discussions on fiscal reform have only begun very recently, as the mid-term elections of November 2010 made it impossible to reach an agreement that is acceptable to both parties. The ambitious proposals announced by the two co-chairmen of the bipartisan National Commission on Fiscal Responsibility and Reform, which included spending cuts and tax increases that would erase almost $4trn from projected deficits until 2020, was supported by 11 members of the 18-person committee, short of the 14 votes required to send it to the Congress for a vote. The ultimate plan may thus change considerably from the ambitious proposals, but the proposal will most likely improve the level of the debate on fiscal reform in the US.
By some measures, the fiscal position of the US is worse than for the EA as a whole, and even than that of Spain and Portugal, two of the EA periphery countries at risk of being frozen out of the international capital markets. Thus, the general government gross (net) debt is estimated at 93% (66%) of GDP in 2010, the general government budget deficit at 11.1% of GDP, the general government structural (cyclically-adjusted) budget deficit at 8.0% and the general government cyclically-corrected primary (non-interest) deficit at 6.5% by the IMF. Growth prospects, partly for demographic reasons, are however likely to be better in the US than in most of the EA member states.
Full Buiter report, which is public domain courtesy of the NBER
Greece
In our view, Greece is still the eurozone country that is most likely to undergo a restructuring of its sovereign debt in the next few years. The mix of a high fiscal deficit (at 9.6% of GDP for the general government sector in 2010 according to the updated IMF projections and after the recent upward revisions), enormous public debt (gross general government debt stood at 141% of GDP in 2010, according to the IMF), and poor growth prospects make the Greek fiscal situation the least sustainable among the euro peripherals. Greece needs to run a (permanent) general government primary surplus of around 6% of GDP just to stabilise its general government gross debt-to-GDP ratio at the level of around 150% of GDP expected at the end of 2012. The general government cyclically adjusted primary deficit in 2010 is estimated to be around to 4% of GDP. This means that additional tightening equal to 10% of GDP is needed over the next few of years to just stop the gross general government debt-to GDP ratio from rising in Greece.
Admittedly, the adjustment programme has seen some early successes — a reduction of more than 30% YoY in the central government deficit and the passing of a number of significant structural reforms — and these successes may have helped reduce the probability of a credit event in the short term However, more recent data show that the policy-induced slowdown in the economy is reducing tax revenues and higher costs of borrowing (including the cost of borrowing from the other eurozone countries through the Greek facility) are driving up the average cost of debt. Revenues were up by more than 10% YoY in the first six months of 2010, but the growth rate slowed to 4.8% YoY in November.
As a percentage of GDP, interest payments on central government debt in the 12 months ending in November increased to 5.7%, up from an average 5.1% in the previous 18 months. Both factors are likely to continue to lift the deficit, at least partly cancelling out the cuts on the primary expenditure side. Some of these expenditure cuts are in any case likely to be unsustainable, as there is evidence that they were achieved in part by not paying bills, particularly at the level of regional and local government and at the social funds. We estimate that the cost of interest payments on the overall public debt is likely to rise to about 8% of GDP in 2013.
A meaningful improvement in tax revenues is likely to require substantial increases in tax compliance, which for the time being remains elusive. The decision of the Greek government to grant a tax amnesty, against the strong opposition of the IMF/EU/ECB ‘Troika’, is very damaging in this context, in our view. The reason is that such an amnesty may reduce future tax compliance from currently compliant citizens and weaken even further the incentives for non-compliant citizens to change their behaviour, in the expectation of future amnesties.
The implementation of the austerity package has already been accompanied by large strikes, demonstrations and other manifestations of social unrest. Consolidation fatigue is likely to be even more prominent in the future and has the potential to derail the adjustment process. Gross refinancing needs of the Greek sovereign will remain high for the foreseeable future, owing to the high and rising level of gross debt, high interest rates and, at least for 2011, continuing primary deficits. The Greek sovereign was always unlikely to be able to re-access private capital markets at the end of its current adjustment programme (in May 2013), without a substantial restructuring of its debt. On 28 November 2010, ECOFIN correspondingly agreed to consider extending the maturities of the loans in the EU/IMF programme to bring them more in line with those of the Irish package. This would imply an increase in maturities from three years to between 4½ and 10 years, with an average maturity of just over seven years.
In any case, in our view, although maturity lengthening will help to smooth out a redemption hump in 2014/15, it is unlikely to resolve the fundamental solvency issues of the Greek sovereign.
The euro area periphery countries all face different combinations of sovereign debt unsustainability, banking sector vulnerability and, for the real economy, persistent man-made distortions and real rigidities in factor and product markets resulting in low profitability and poor growth prospects. In Greece, the problems are primarily those of fiscal unsustainability and poor growth prospects. The main problem of the Greek banking sector is its exposure to the Greek sovereign — quite distinct from the case of Ireland, where an deeply troubled banking sector threatens to drag down a sovereign that would in all likelihood have been solvent had it not guaranteed so much of the banking sector’s liabilities and assumed its losses.
Ireland
Ireland is the prime example of a country where the sovereign is at material risk of default because of the support extended by the sovereign to the banking sector, through guarantees of unsecured debt and through large injections of capital. Like Iceland, the banking sector in Ireland was too large to save. Unlike Iceland, the Irish sovereign, when faced with the likelihood that it would not be possible to make whole both the banks’ unsecured creditors and its own creditors, did not leave the banks to sink or swim on their own but extended bank guarantees for initially up to €440bn worth of bank unsecured liabilities. With the consolidated sovereign and banking sector likely insolvent, in our view, the key remaining question is whether it will be the banks who default, the sovereign or both.
Ireland was the first country in the EA to announce fiscal tightening in 2008: according to the EU Commission, total tightening amounted to 9% of GDP in 2009-2010 — the same amount the government has recently committed to implement over the next four years. However, it has by now become abundantly clear that such early — some said ‘preemptive’ — tightening was not enough to restore sustainability of the public debt or at least the market perception thereof.
GDP continues to contract compared to the previous year, reflecting private sector deleveraging, a collapse of the previously outsized construction and real estate sector, and the impact of the drastic austerity measures. As a result, the underlying government deficit (excluding the capital injections to the banks) will probably still be in double digits in 2010 (12% of GDP) and around 10% of GDP in 2011. The additional government support to the banking sector (€30.7bn in 2010) appears to have propelled the general government deficit-to-GDP ratio to 32% of GDP in 2010 and the gross general government debt-to-GDP ratio to around 99% of GDP, up from 44% in 2008.
€50bn of the €67.5bn IMF/EU bail-out package is aimed at providing budgetary support.39 Without access to any other funding sources, this amount is expected to cover the sovereign’s funding needs for around two years. Of the €35bn dedicated to restructure the banking system, €10bn will be used for an immediate recapitalisation of the banks to increase their capital ratios from 8% in 2010 to 10.5% in 2011. The remaining €25bn is a credit line that, according to the programme’s designers, is not expected to be used.
At this stage, it is by no means clear that the stream of bad news coming out of the Irish banking sector has ended. In November 2010, UC Dublin professor Morgan Kelly raised his estimate of the total bailout cost for Irish banks from €50bn to €70bn because of an expected sharp rise in mortgage delinquencies in 2011. According to him, 4.6% of Irish mortgages were 90+ days delinquent at end-June and around 25% of mortgage borrowers are expected to be in negative equity at end-2010.40 The funds provided, including the €25bn additional credit facility, may be just about enough to cover the additional losses, but, in our view, statements to the effect that the contingent funds will not be needed are somewhat empty — as noted above, many European officials also declared that they did not expect that the EFSF would ever have to be used.
The Irish bail-out package has eliminated funding risk for the Irish sovereign and the Irish banking sector for now. But it does little to address the fundamental problem that the combination of the Irish sovereign and the domestic banking system is de facto insolvent. Additional fiscal tightening, private deleveraging, tight credit due to the fragile situation of the banking system, and high unemployment should continue to weigh on growth. In our view, the Irish government was right to resist any increase in the corporate tax rate, as an FDI-led resurgence in growth is one of the few growth prospects the Irish economy currently has.
It is already clear that the holders of sub-senior, unsecured bank debt either already have or will need to accept large losses on their holdings. For now, the senior unsecured debt of the banks has not been restructured. But since the value of the unsecured sub-senior debt is not very large, it remains likely that either the senior, unsecured debt of the banks and/ or the sovereign will ultimately need to be restructured. The nature and timing of such a restructuring remain uncertain. The maturity of the loans in the Irish package is substantially longer than in the Greek case (the average maturity in the Irish case is around 7.5 years), reducing immediate restructuring pressures and suggesting also that European policymakers may yet decide to further delay restructuring. On the other side, the Irish government has announced that it will seek to soon introduce a ‘special resolution regime’ for banks, such as the US has with the FDIC, making an early restructuring of the Irish banking system easier and therefore more likely. The two opposition parties that, if the opinion polls are correct, are set to form the next government following general elections early in 2011, are campaigning on a platform that supports haircuts for senior unsecured creditors of the banks.
It is clear that, should Ireland restructure its senior unsecured bank debt unilaterally (that is, not as part of an EA-wide or EU-wide simultaneous sovereign and bank debt restructuring), severe contagion would likely result to the banks in other countries that would be viewed as now at risk of similar bank debt restructuring. Could the EC/ECB/IMF either bully or entice Ireland into not restructuring its banks’ senior unsecured debt?
As regards ‘carrots’, we see only one: a lower interest rate on the EU/IMF facility. The current 5.8% average rate really is an invitation to sovereign default — it makes no sense as part of a package that is meant to avoid sovereign default. Lowering it to, say, 3 percent, might convince a future Irish government at least to postpone restructuring its unsecured senior bank debt.
As regards pressure or ‘sticks’, there is only the threat of ejecting Ireland from the EU/IMF facility and the threat that the ECB would either refuse to purchase Irish sovereign debt through the SMP or refuse to fund the Irish banks through its collateralised ECS facilities. Neither threat seems either plausible or effective. No promise not to restructure the senior unsecured bank debt was part of the EU/IMF programme. Provided the haircuts on the unsecured creditors are harsh enough, the restructured Irish banks should be able to fund themselves in the markets. Threatening the Irish government with exclusion from the SMP could well precipitate an early Irish sovereign default, which might well do more damage outside Ireland than inside.
We conclude that, should the next Irish government decide to restructure the unsecured senior debt of its banks, there is little the rest of the EU or the IMF would be able to do about it. In the case of the IMF, there is the further awkward fact that restructuring senior unsecured debt is part of the standard IMF post-crisis package in emerging markets (EMs). Admittedly, the risk of contagion in past EM crises was likely less than it is today in the EA.
Portugal
As noted, each euro area periphery country faces a distinct set of challenges. So Portugal may not be Greece, but the challenges it faces are more similar to those of Greece (if not quite as dramatic) than those of Spain and Ireland. Portugal’s gross general government debt-to-GDP ratio is likely to be around 80% this year, not far from the EA average and it largely avoided the housing bubbles and banking sector excesses of Ireland (or Spain). However, the government deficit remains stubbornly high and the private sector is highly indebted, to the point that Portugal has the largest negative net foreign investment position in the EA (at minus 113% of GDP at the end of 2009 — see Figure 5). In times of crisis, the debt of private institutions deemed systemically important or too politically well-connected to fail tends to become public debt. The assets, liabilities and funding needs of the private sector must therefore always be considered carefully before a judgment can be reached as regards the current and likely future health of the public finances.
Despite the fiscal austerity package approved in May 2010, the Portuguese central government budget deficit had not yet shown meaningful signs of improvement at the end of November 2010. The year-end target of 7.3% for the general government deficit-to-GDP ratio may only be reached through an accounting trick.41 Another round of adjustment measures is planned for 2011, amounting to 3% of GDP on top of a 1% of GDP adjustment for 2011 already included in the May 2010 fiscal package. However, this year’s experience shows that implementation risks remain high.
Moreover, Portugal also has one of the EA’s highest levels of gross debt in the non-financial private sector, close to 250% of GDP. Net external debt is high and a majority of Portuguese sovereign debt is held abroad (see Figure 18). Unlike in Spain or Ireland, the private deleveraging process does not seem to have started. The current account deficit is still very high at 9½ % of GDP in Q3 2010 — almost unchanged from pre-crisis levels, so there is no evidence either that the country in the aggregate is beginning to live within its means or that it is shifting resources from the non-traded towards the tradable sectors.
Growth in Portugal this year has been less weak than in the other EA periphery countries (Real GDP likely expanded by 1.6% in 2010) and has not fallen short of expectations yet. However, this is at least in part because Portugal has engaged in less fiscal tightening than the other EA periphery nations. The growth outlook is poor. Portugal has suffered from low growth for many years.
Additional tightening measures, the need for private sector deleveraging and tight credit as a result of funding difficulties for the Portuguese banks imply that growth is highly likely to plunge again. A recession in 2011 looks likely. The lack of economic growth and the limited impact of past fiscal tightening measures to lead to a meaningful reduction in the general government budget deficit also imply that there is a substantial risk that deficit targets for 2011 and beyond will not be met.
Yields of Portuguese sovereign debt have already risen markedly. At such high interest rates and with low growth, we consider Portugal to be quietly insolvent and likely to access the EFSF soon.
Spain
Until the end-2010 market turmoil, Spain had benefited from some benign developments. After the publication of stress test results in July, investor concerns about the health of its banking system receded, further aided by a reduction in reported ECB funding of Spanish banks (though the reduction in ECB funding was mainly due to the fact that Spanish banks managed to get access to market funding in an anonymous way through their membership in the London Clearing House). Fiscal revenues also picked up following the implementation of some revenue measures in May 2010, and central government expenditures were declining.
However, substantial risks remain. The results of the stress tests have been discredited throughout the EU. In our view, the banking system remains a key source of uncertainty surrounding Spain and its medium-term fiscal sustainability. The restructuring of the banking sector has only just started, with several mergers among savings banks (the ‘cajas’) agreed in June. The total amount of capital injected into the banking sector by the Spanish government — around €14.4bn (1% of GDP) — appears woefully inadequate in light of the size of the real estate bubble and exposure of the banks to real estate and construction-related assets. By comparison, the Irish government had committed around 30% of GDP even before the most recent recapitalization measures as part of the bailout package42. Reports of ‘deposit wars’ between Spanish banks suggest continuing funding difficulties and will weigh on profitability.
Household and corporate loans stand at around 226% of GDP in Q2 10, and are still increasing. Very high unemployment (in excess of 20% of the labour force) and the shrinkage of construction and real estate sectors have yet to make a substantial impact on bank balance sheets.
On the fiscal side, uncertainty remains about developments at the local and regional level. The majority of expenditure in Spain occurs at the local and regional level and the central government has limited control over the spending decisions of the autonomous regions and the municipalities. Anecdotal evidence of increasing arrears and higher debt issuance by regional authorities suggest caution. In our view, the gross general government deficit target is likely to be reached in 2010, and may be even surpassed, but deficit targets for 2011 and 2012 will be challenging. Also, the growth forecasts of the Spanish government are too optimistic, in our view, as we expect fiscal tightening, tight credit and high unemployment to reduce private sector demand. Additional tightening measures are likely to be required to meet the deficit targets.
With significant additional tightening measures, without large negative surprises in the banking sector and with a stronger growth performance than we currently consider likely, Spain may yet muddle through without external help. But should it need assistance, its funding needs over a three-year horizon would likely be too large for the current lending capacity of the EFSF. In the near term, the size of the EFSF and the ESFM could potentially be extended by the EA and EU member states and/or the ECB could increase its support (e.g. by purchasing Spanish sovereign debt through the SMP and by increased funding of Spanish banks using Spanish sovereign debt as collateral). In the longer term, there may be a need for large-scale restructuring of Spanish bank debt and possibly the sovereign.
Italy
Until recently, Italy had been largely shielded from the sovereign debt turmoil, despite its adverse starting position — it entered the crisis with the highest general government (gross and net) debt-to-GDP ratio in the EA — and its historically poor performance during past episodes of heightened risk aversion.
In our view, relatively tight fiscal policy through the crisis (Italy hardly engaged in any fiscal stimulus) and relatively favourable private sector gross debt, net debt and financial net worth positions make for a much lower degree of overall (public plus private) gross and net indebtedness than in the rest of the EA periphery. Indeed, private plus public gross debt as a percentage of GDP ratios are similar to the levels in France or Germany. A high private saving rate and small general government deficit supported a smaller current account deficit than in the rest of the EA periphery and Italy has a comparatively sound domestic banking system, despite rather low capital ratios. A fairly large domestic investor base, reflecting large levels of private financial wealth, is also likely to make the total investor base somewhat more stable than in countries with high levels of foreign ownership of sovereign debt, such as Portugal and Greece.
However, like Portugal and Greece, Italy suffers from some longstanding structural weaknesses that depress its potential growth. Poor productivity growth and adverse demographic trends will continue to weigh on its trend growth rate, which we estimate to be just below 1% per annum. Moreover, the gross general government debt-to-GDP ratio should remain the second largest in the eurozone (after Greece) for the next few years, and it will most likely continue to edge up in the near term, likely exceeding 120% of GDP in 2011.
Gross refinancing needs should thus stay high and increase the vulnerability of Italy both to funding and liquidity crises and to self-justifying solvency crises should sovereign risk premia rise substantially.
A continuation of the fairly conservative fiscal stance of the Italian government should provide some reassurance to markets about the long-term sustainability of the Italian debt. A major political crisis, however, would constitute a downside risk and could provoke tensions in the market for Italian sovereign debt. In any case, general government debt ratios anywhere near the current Italian level would constitute a source of vulnerability to roll-over crises and ‘sudden stops’.
At this stage, we consider it unlikely that Italy will require access to the EU facilities. Should it do so, it is clear that the current size of the EFSF would be insufficient to satisfy Italy’s funding needs. It would then once again be the ECB that would need to be called upon to stave off sovereign default.
Belgium
Despite going into the crisis with a relatively large gross general government debt-to-GDP ratio, Belgium was not caught up in the sovereign turmoil until very recently. However, public sector debt remains high. Gross general government debt was 96.2% of GDP in 2009, is likely to increase in 2010 and 2011, and surpass the 100% of GDP mark again during our forecast period.
This implies that refinancing needs will remain high, creating the risk that the Belgian sovereign will be caught up in the turmoil should there be renewed market tensions. This is despite the fact that Belgium’s recent history has shown that its general government sector can generate primary surpluses for long periods of time — it was able to reduce its ratio of gross general government debt to GDP from 138% in 1993 to 84% in 2007.
In our view, the main risk in Belgium is political. The last general election took place in June 2010, but it is still without a new government. The role of nationalist parties has increased in Belgian politics, in particular in the Flemish (Dutch) speaking north of the country, which favours a large reduction in the fiscal transfers to the poorer (French-speaking) south and to Brussels, and possibly a break-up of the state. Ironically, the fact that the large government debt is mainly on the balance sheet of the central government (rather than the regions) may be one of the factors holding the country together currently.
Should the country break up, there would be substantial uncertainty about how the national debt will be divided between the three regions and about the duration and other modalities of the process leading up to the division.
France
France was largely untouched by the sovereign debt turmoil in 2010. In fact, as one of only three large European countries with a AAA-rating — the others being the UK and Germany — it may have benefited to some extent from safehaven flows in earlier parts of the year. Recently, however, yields on French sovereign debt have increased substantially, rising from a low of 2.50% at the end of August to 3.37 at the end of December. Such levels are still very low by historical standards, of course, and only bring France back to where yields were in April 2010 before sovereign debt concerns erupted in earnest for the first time. But the recent rise does highlight that markets may have become slightly more discerning in distinguishing between the creditworthiness of different AAA-rated sovereigns, though of course yields on sovereign debt have increased across virtually the entire industrialised world in November and December 2010.
France’s budgetary situation had deteriorated even before the recent crisis and the general government deficit reached 7.6% of GDP in 2009.The government is likely to have reduced this deficit ratio slightly in 2010 and will probably reach the targeted reduction in the general government deficit to 6% of GDP in 2011, but the target of 0% to 3% by 2013 appears too optimistic. This is mainly because we consider the growth forecasts of the French government of 2.0% in 2011 and 2.5% per year from 2012 onwards to be too optimistic.
Furthermore, after the implementation of the pension reform, which will help limit pressure on the public finances in coming decades, further meaningful fiscal austerity measures are unlikely to be implemented before the 2012 presidential election. Further action may be forthcoming after the next election, and we consider such additional fiscal tightening to be necessary to safeguard fiscal sustainability. The main differentiating factor, in our view, between the fiscal prospects of Germany and France, are not current levels of public debts and deficits, but the ability to impose austerity measures and the willingness of the electorate to accept these measures. The recent large-scale protests in France following the announcement of the pension reform plans are a reminder of the difficulty of such fiscal tightening actions in France. The willingness and ability of the government to pass the reform legislation without material watering down of the key reform proposals are a positive from the perspective of restoring fiscal sustainability in France.
For France, as for all countries that suffer from unsustainable public finances but have not yet legislated a multi-year programme of public spending cuts and tax increases sufficient to safeguard sovereign solvency, the jury is still out. Over longer horizons, there may be a risk of a fundamentally warranted French sovereign debt crisis, if sufficient additional fiscal tightening actions are not announced and implemented in time to prevent a further deterioration of the fiscal fundamentals. In the near-term, however, a more urgent risk may be that without further early fiscal tightening measures, France could lose its AAArating, just as the UK was at risk of losing its AAA-rating early in 2010, before and until it announced and started the implementation of a fiscal tightening package worth more than 8 percentage points of GDP.
It is not currently clear to us what the implications of a loss by France of its AAA-status would be for the workings of the EFSF, other than that there will be implications. The effect would most likely involve increases in the funding costs of the EFSF (and therefore also the applicant countries), but could also include loss of the AAA-rating for EFSF bonds or further reductions in the amount of loans that can actually be disbursed.
United Kingdom
News on the fiscal side and for the real economy was mostly positive for the UK in 2010, and it appears to be on track to return to fiscal stability. The UK entered the financial crisis with a relatively low gross general government debt-to-GDP ratio of 44% in 2007, but very high recent deficits — the peak was 11.1% of GDP in 09/10 for the general government deficit and a trend of strongly increasing government expenditure, raised concerns about the sustainability of the public finances in the UK.
The coalition government has outlined and started to implement an ambitious programme, with a focus on reducing public spending and limited tax increases that is supposed to reduce the general government deficit from around 11% in 2009/10 to about 2% in 2014/15. So far, progress has mostly been reassuring.
The fiscal deficit is falling slightly, and the deficit in 10/11 is likely to turn out much lower than the consensus expected a year ago. We expect the general government deficit to fall to about 6% of GDP in 2011/12 and to about only 1% in 2014/15, leading the general government debt-to-GDP ratio to level off at around 80% of GDP.
After growing by 1.7-1.8% in 2010, we expect real GDP growth to reach 2-2.5% YoY in 2011 and 2012. Nominal GDP growth is in line with the historical average, running at 5.5–6% over the forecast period. Some downside risks remain. The bulk of the fiscal tightening has yet to take full effect, and the fiscal tightening should be expected to dampen growth in the coming years. With inflation (on the CPI measure) running at more than 3 percent per annum, and with survey-based inflation expectations edging up in line with recent actual inflation, monetary policy is unlikely to be able to play an active supporting role, should the real economy falter. However, the low pound and the strong financial position of the corporate sector will support the continuing recovery. in our view, and thereby also support the cautiously positive fiscal outlook. Continued sovereign debt turmoil in the euro area would adversely affect the UK through Euro weakness and by dampening growth in the euro area — the UK’s major export market. The exposure of some large UK banks to sovereigns and banks in the periphery of the EA is also a source of concern. However, the crisis also contains some mild positives for the UK, as its relative stability attracts capital inflows, keeps yields on sovereign debt low, and raises the attractiveness of foreign direct investment.
Japan
According to the IMF, Japan’s gross general government debt stood at 218% of GDP in 2009 and its net debt at 112% of GDP. The government budget deficit is estimated to be 9.6% in 2010, the primary (non interest) deficit 9.1% of GDP and the cyclically adjusted primary deficit 7.6% of GDP, with similar levels projected until 2015, the end of the forecast horizon. The recent IMF Fiscal Monitor noted that, of all the countries considered, Japan has the largest total adjustment need required to achieve fiscal sustainability and the largest remaining adjustment beyond measures that have already been planned (Figure 27).
Adverse demographic trends, structural weaknesses, and less-than-forceful macroeconomic and financial policy imply that growth prospects for the Japanese economy are poor. At the same time, there is no sign of planned or actual consolidation. Indeed, Japan has just announced a small fiscal stimulus.43 With such budgetary fundamentals, it is hardly surprising that Japan is one of two G7 countries not to have a triple-A rating (Italy is the other one). It is currently rated Aa2 by Moody (AA by S&P and Fitch, see Figure 28). But government bond yields remain extremely low and CDS rates on Japanese government bonds are only marginally above those of Germany. For the moment, Japan’s sovereign is protected against normal market discipline, despite fiscal fundamentals that would imply a high degree of sovereign risk in other countries, by a very large stock of private financial wealth (the product of high past private saving rates), and an unequalled homebias in Japanese portfolio preferences. Together these act as a form of self-imposed or voluntary financial repression, permitting the Japanese sovereign to borrow at rates well below ‘fair value’.
The large stock of private financial wealth (reflected in Japan having a net foreign investment position of plus 57 percent of GDP in 2009, despite the large net debt of the state) is a fiscal asset to the extent that private wealth, or the income streams it generates, can be taxed in the future. Alternatively, it provides the private sector with the financial resources to accommodate and make up for cuts in public spending categories for which privately purchased alternatives exist, such as health, education and retirement. The home bias is reflected in the fact that about 95 percent of all Japanese sovereign debt is held domestically.
The benign low interest rate equilibrium in Japan is, we think, vulnerable to ‘defection’. Private saving rates are coming down fast as the population ages and declines. Total net household saving has fallen below the net addition to the stock of Japanese sovereign debt, although the Japanese corporate sector continues to be a large net saver. But given the likely future declining trend in the Japanese private sector financial surplus (unless there is a large decline in gross domestic capital formation that offsets the age-related further decline in the private saving rate) and the continuing large public sector financial deficit of Japan, Japan is likely to turn into a current account deficit country before long.
This makes it likely that more Japanese government debt will be bought by foreign investors in the future. Even if existing Japanese government bond holders (households and institutional investors like the postal system) continue to be willing to hold 10-year JGBs at a 1.50 percent interest rate or less, it is unlikely that the rest of the world will absorb significant additions to the stock of Japanese sovereign debt at these interest rates. For the same fundamentals that support the benign low interest rate equilibrium, there also exists a ‘fear equilibrium’. In a ‘fear equilibrium’ the marginal holder of Japanese sovereign debt believes there is a non-trivial likelihood of sovereign default (or of an inflationary and exchange rate depreciation solution to the public debt overhang) and interest rates rise sharply, thus validating the fear of worsening public finances that triggered the increase in interest rates in the first place. The timing of the shift to a ‘fear equilibrium’ cannot be predicted with any degree of precision. But absent any determined and sustained commitment to tackle the unsustainable fiscal programme of the sovereign, the shift from the benign to the fear equilibrium seems bound to happen sooner or later.
And last but not least...
United States
The United States too have also lagged most other advanced economies with rapidly rising public debt levels in making binding commitments on fiscal consolidation. Serious discussions on fiscal reform have only begun very recently, as the mid-term elections of November 2010 made it impossible to reach an agreement that is acceptable to both parties. The ambitious proposals announced by the two co-chairmen of the bipartisan National Commission on Fiscal Responsibility and Reform, which included spending cuts and tax increases that would erase almost $4trn from projected deficits until 2020, was supported by 11 members of the 18-person committee, short of the 14 votes required to send it to the Congress for a vote. The ultimate plan may thus change considerably from the ambitious proposals, but the proposal will most likely improve the level of the debate on fiscal reform in the US.
By some measures, the fiscal position of the US is worse than for the EA as a whole, and even than that of Spain and Portugal, two of the EA periphery countries at risk of being frozen out of the international capital markets. Thus, the general government gross (net) debt is estimated at 93% (66%) of GDP in 2010, the general government budget deficit at 11.1% of GDP, the general government structural (cyclically-adjusted) budget deficit at 8.0% and the general government cyclically-corrected primary (non-interest) deficit at 6.5% by the IMF. Growth prospects, partly for demographic reasons, are however likely to be better in the US than in most of the EA member states.
Full Buiter report, which is public domain courtesy of the NBER
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