The European Sovereign Debt Crisis

I have followed the European Debt Crisis in detail for over a year now and I have been intending to write about it for a while. However the European situation is so dynamic that successive drafts have graced the dustbin. I wanted that the piece I finally publish should be insightful, I was not content to simply write a report on the crisis giving an overview of the debt yields or the debt to GDP ratios of the affected nations. I wanted to present an insight and original view of what direction the crisis is taking, what decisions should have been made and what the future may look like if the right decision are made. So after months in the making, I finally present to you my analysis of the European Sovereign Debt Crisis. Feedback most welcome at:

My analysis of the European Debt crisis revolves around the following points: (1) There is an essential difference between solvent but illiquid nations and insolvent nations. (2) This is a crisis of creditor confidence. To regain creditor confidence, you need to listen to what the creditor is saying. (3) The European Debt Crisis is a crisis at whose heart lies a risk of contagion from hopeless economies such Greece to major global economies such as Italy and Spain. Were it not for the credit market fear of contagion, the crisis would be much smaller and localised in scale. How do we mitigate this risk? Read on.

I shall be examining the 5 crucial nations at the heart of the crisis – (the PIIGS): Portugal, Italy, Ireland, Greece and Spain. Essentially speaking Italy and Spain are solvent in the long run. They have the capability to repay their creditors. Greece is not. There are questions on Portuguese debt sustainability. And Ireland might just pull through. Ireland is expected to tap the credit markets only in late 2013. Thus it close to 2 years to gets its economy back on track and reach the growth path. Ireland already had one of the most liberal economies in the world so there was not much more it could do by way of reforms. Fiscal austerity is hitting the nation hard though. Yet the finance ministry believes that the inherent advantages in the Irish economy including low regulations and an educated and flexible workforce would allow it to re-finance itself once the bailout package ended. Thus I believe that at this moment, the events in Ireland are not going to rock the European boat. Moving onto Portugal. Portugal is a veritable ticking time bomb. It enters the credit markets in the second half of 2013 when its bailout package ends. Its debt to GDP ratio is unsustainable in the long run. The Prime Minister is bold and has passed extensive reforms. However these are enshrined into legislation only in the first half of 2013. The benefits of these reforms may take years to materialize. Thus its plans to enter the credit market in 2013 have been met with skepticism all around. I believe that ideally the Troika – The European Union, the European Central Bank and the IMF, should extend the loan period to 2014 and then negotiate loan restructuring plans. I shall give the rationale for this later. Moving onto Greece. Despite the haircut on its private debt, analysts believe that Greek debt is still unsustainable in the long run and I am personally inclined to agree with them. At some point in the future, Greece is going to need a second haircut to its debt. I believe this date should be pushed back as much as possible. Ideally 2015. I repeat, the quest here is to mitigate the risk of contagion. Now moving onto the key issues. Spain and Italy. Essentially both economies are solvent. Spain in fact boasts of one of the lowest debt to GDP ratios in the European Union at just 71%. I am not saying that the economy is healthy, its overall debt to GDP ratio (not just government debt) is a staggering 363% and one of the highest in the world. Moving onto Italy. At 120% of the GDP, Italian debt is massive. Its the third largest bond market in the world, trailing only the United States and Japan. However intrinsically the economy has a potential to repay its debts. In fact both Spain and Italy’s debt trajectory over the past  decade showed declining debt levels till the global financial crisis erupted in 2008 and the economies had to step up rescue efforts.

The basic point to be understood is that the crisis has achieved these proportions because of fears that the long term debt sustainability of Italy and Spain may be under threat if they continue to re-finance at these interest rates. In recent months both economies have flirted with the psychologically crucial 7% mark. When a nation borrows long term in the range of 7% or above, it spells trouble for long term sustainability. The key then is basically for Spain and Italy to be able to borrow cheaply. With the intrinsic strength in their economy, both nations are on track to re-pay their creditors in the long run. What they are facing currently is a crisis of confidence due to the troubles in Greece and Portugal and due to their recent high levels of fiscal deficit. Spain and Italy both took steps to regain creditor confidence. The wrong ones. Creditor confidence decreased further. Spain and Italy basically opted for fiscal austerity to cut their fiscal deficit. Now I am not saying that fiscal austerity was un-necessary. Fiscal austerity is essential when faced with such debt and deficit levels. Yet credit markets remained unmoved. Why so? As every student of Keynesian economics knows, you increase spending in a recession and balance your budgets during boom time. These governments are following the exact opposite strategy. They increased their debts during the boom time and are desperately attempting to balance their budget in times of deep recession. This would essentially result in a vicious cycle of lower spending, higher un-employment, lower demand for goods, yet lower spending and obviously, lower government taxation  revenue. So fiscal austerity during a recession even hurts the government balance sheets due to lower revenue. Instead, what these governments should have been doing was to listen to the credit markets. What is the voice of the credit market? It is the much reviled credit agency. S&P, the most prominent of the big 3 rating agencies, in the middle of January cut the credit ratings of 9 European Nations. I examined their reports in great detail and herein lies the crux of my analysis. The credit rating agencies and creditors in general are looking for growth. They are crying out for reforms. The Italian and Spanish economies have some of the most rigid labour laws in Europe. They make it extremely hard for an employer to fire an employee. Employees are over-paid, highly privileged, retire young and generally easy going. The laws were skewed against employers and productivity was not comparable to the model of European growth – Germany. This is what creditors feared in the long run. If the gap between German and Spanish-Italian productivity would continue to remain high in the coming decade, the debt to GDP ratio was likely to increase and the intra-continental growth gap would expand.

In an ideal world, Spain and Italy would pass sweeping labour reforms and liberalise their economy. These moves would in turn stimulate growth that would create a virtuous cycle of higher employment and eventually higher tax revenues. Meanwhile after these reforms have been passed, austerity measures can run alongside providing a two prong approach to dealing with the debt crisis.

In the real world however, Spain and Italy started off with austerity measures. They misread the message from credit markets. They started cutting their fiscal deficits. This drove their economy into a recession and increased unemployment and created a vicious cycle. Observing the recession, high levels of unemployment and the high debt to GDP ratio, the yields on their bonds rose slowly to a point where the crisis escalated to a whole new level. However I believe that the situation is not as grim as it looks. Basically events with Ireland and Portugal safely under the bailout package till the second half of 2013, they should not present any major shocks to the European situation. Provided Greece’s negotiations with the International Institute of Finance go well, it should have no trouble receiving its next tranche of bailout loan from the Troika. From that point onward, Greece too should not pose any major shocks to the international markets. Greece is not poised to enter credit markets at any time in the near future. This basically leaves Spain and Italy facing the bond markets. While Italy refinances Euro 337 billion, Spain must rollover debt worth Euro 130 billion.

Thus it is upto the Spanish and Italian economies to convince the bond markets that they are worthy. While the Italian PM, Mario Monti has already passed a range of comprehensive reforms through his cabinet in consultation with labour unions and employers, tougher challenges await. Italy’s largest labour union walked out of the talks (the 2nd largest labour union remained at the negotiating table giving credibility to the cabinet resolution) while associations of individual professions that have lost their protected status are already up in arms. Italy is likely to face months of protest and negotiation before these reforms become legislation. And that is where I drive home my point. Had Italy’s primary focus been reforms that have a positive long and short term effect, rather than austerity, then by January 2012 it would have been poised at a stronger position. However Mario Monti’s professional government has been gaining fans in the European Union with German Chancellor Angela Merkel expressing admiration at the intent shown by the government. There is hope yet. The very act of unveiling the comprehensive reform package should help buck up the confidence level in the credit markets. The Spanish government has promised to unveil  labour, budget stability and financial sector reforms by February.

I believe that ideally the Troika and Germany should try to ensure that Italy and Spain have at least until the end of 2013 to  get their economies back in shape. By then their economies should be in better shape and the reforms process would have given an impetus to growth. Post 2013 if Portuguese and Irish (unlikely) debt is considered unsustainable in the long run, restructuring must take place. I believe that by this time the markets should be able to recognise the difference between stable and liberal economies Spain and Italy and contagion should not spread to them. Moreover Portugal is relatively small on the international scene and its debt restructuring can be handled in a manner that localises its effects as much as possible.

To recap: Italy and Spain must give reforms and liberalisation priority over austerity. This is what the credit markets demand. Once reforms transform into solid legislation, credit markets will relent, bond rates will come down and Italy and Spain will slowly creep out of the danger zone. Ireland is doing reasonable well and is secure till 2013. Its inherent strength might allow it too to creep out of the danger zone. This will leave the spot-light on Portugal. Portugal has passed substantial reforms and must be given an extended year by the troika to allow these to work. Greece is under the bailout loan package for an extended term and the Troika must ensure that the Greek long term debt sustainability issue is not brought back into the open until atleast mid 2014. By this time there will be only Portugal (maybe not) and Greece left in the red zone – all alone.