The eurozone's debt crisis: The cracks spread and widen

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The euro zone's debt crisis

The cracks spread and widen

Panic about the Greek government’s ability to repay its creditors isnfecting other euro-area countries’ sovereign debt. Where will it end?

pr 29th 2010 | From The Economist print edition

AFTER simmering for months, the Greek sovereign-debt crisis has boiled over. The promise

f a rescue by the IMF and the country’s euro-zone partners, worth €45 billion ($60 billion)

r more, is no longer enough to persuade many private investors to hold Greek public bonds.

Opposition to the bail-out in Germany meant that market confidence had all but vanished by

April 27th, when Standard and Poor’s (S&P) slashed its rating of Greek government bonds to

BB+, just below investment grade. The rating agency also lowered its rating on Portugal, to

A-; a day later it downgraded Spain from AA+ to AA.

n keeping with its practice when ratingonds as junk, S&P gave an estimate of the

kely “recovery rate” should the worst

appen. It said bondholders were likely to

et back only 30-50% of their principal were

Greece to restructure its debt or to default.

hat prompted panic in bond markets. The

ield on Greece’s ten-year bonds leapt above

1% and that on two-year bonds to almost

9% at one point on April 28th. Portugal’s

orrowing rates jumped, too (see chart 1). At

hose rates, the racier sort of hedge fund

might still be prepared to gamble on Greece

aying back its debts at face value, but

mainstream funds are abandoning the bonds

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n their droves. The speculators blamed by officials for precipitating the crisis may now be

he only people willing to take a punt on Greece.

Had the rescue been swift and squabble-free, there was a chance, albeit slim, that private

nvestors might have rolled over their existing holdings of Greek debt at tolerable interest

ates. That Greece’s would-be rescuers may not after all stump up the money they promised

s one of the risks that bondholders are loth to bear—though Germany may now approve its

hare of the bail-out by May 7th (see article). Another is that Greece will not be able to

tomach the programme of budgetary and economic reform which the IMF is due to set out

n early May, and on which the euro-zone rescue funds will depend.

A third concern is that even if the programme runs smoothly, the debts that Greece will

ontinue to rack up will be too great for its feeble economy to bear. Earlier analysis by The

Economist suggested that Greek government debt would rise to 149% of GDP by 2014 even

f its deficit reduction went well. It assumes that Greece could sustain a brutal reduction in

ts primary budget deficit (ie, excluding interest costs) of 12 percentage points. Even that

elied on an interest rate of 5%, roughly what euro-zone partners have agreed they will levy

n Greece, on all new borrowing and on maturing debt. If interest costs are much higher,

he government will have to find extra savings elsewhere. The deep cuts will only prolong

Greece’s recession. Wages will have to fall if the country is to regain the cost

ompetitiveness needed for a recovery. Both influences will push down nominal GDP for awhile and make crisis management all the more difficult.

he scale of the task and the bungling of the rescue make the bond market’s capitulation

eem natural. Greece needs so much money that the only thing standing between the

ountry and default is open-ended funding from the IMF and the rest of the euro area. The

45 billion fund announced on April 11th would be enough to cover Greece’s budget deficit

nd repay its maturing debts (including the €8.5 billion that falls due on May 19th) for the

est of 2010. But Greece may need as much again in 2011 and still more thereafter. In an

verage year, Greece has to refinance around €40 billion of its debt (this year, would you

elieve, is a mercifully light one for redemptions). Add to that the €70 billion or so of freshorrowing that may be needed to cover Greece’s cumulative budget deficits until 2014 and

he scale of a credible rescue fund becomes clear.

et Greece’s would-be rescuers may feel they

ave little choice but to press on with the

ail-out. A default that would cut the value of

Greek public debt by a half or more would

ripple the country’s banks. (S&P has also

owngraded four of them to junk status.) It

would also spark a wider financial panic in

urope. Around €213 billion-worth of Greek

overnment bonds are held abroad. The Bank

or International Settlements (BIS) estimates

hat foreign banks’ lending to Greece’s

overnment, banks and private sector was

164 billion at the end of last year. How

much of this is public debt is unclear. But if

alf of the foreign holdings of government

onds are held by banks, and if each

ountry’s banks owns those bonds in proportion to their total holdings of Greek assets, then

erhaps €76 billion is held by euro-zone banks (see table 2).

uro-zone countries might be tempted to let Greece default, force non-bank investors to

ake a hit, and use the funds earmarked to rescue Greece to fortify their banks instead. That

would cost perhaps €53 billion if, as S&P fears, a restructuring of Greek debt resulted in

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osses of as much as 70%. That may look small next to a rescue fund. But if Greece

efaulted it would still rely on its EU partners to fund its budget deficit, which will take time

o shrink from the 13.6% of GDP it reached last year. It seems there are no longer any

ptions for Greece that will not cost its partners a lot.

The risk of contagion

Other countries may now need a helping hand, too. The hope that Greece’s problems could

e contained now seems faint. There is growing anxiety about the poor state of public

nances in Portugal, Ireland, Italy and Spain. Each has some combination of big budget

eficits and high public debt, though none is as financially stretched as Greece. But their

eeper problem stems from a decade when wage growth ran far ahead of productivity gains.

tuck in the euro, they can no longer cure that malady by devaluation. The only remedies

re a period of wage restraint combined with structural reforms aimed at boosting

roductivity. These will take time, as well as political will, to put in place. The danger is that

estless bond investors will not wait.

ortugal is first in the markets’ sights. Its ten-year bond yield rose to 5.7% on April 28th,

he highest for more than a decade, in the wake of the S&P downgrades and the anxiety

bout the size and timing of the Greek bail-out. A week earlier its yields were below 5%.

ortugal could be forgiven for feeling picked on. Although its budget deficit last year was an

larming 9.3% of GDP, that was lower than Greece’s. Its public debt, at 77% of GDP last

ear, is less scary too. That is, in part, the result of a programme to slash the deficit in the

ears before the global financial crisis struck, and gives Portugal’s government a credibility

hat Greece lacks. On April 28th its prime minister, José Sócrates, said he and the opposition

ad reached agreement on speeding up an austerity programme.

et Portugal shares three weaknesses with Greece. First, its economy is small (smaller,

ndeed, than Greece’s), accounting for 2% of euro-area GDP. It offers investors very little

iversification. Those who want safe claims in euros can simply lend to Germany or France,

nd save themselves any worries about Portugal’s economy and public finances.

A second weakness is competitiveness.

Greece at least had a boom after it joined the

uro in 2001. Portugal seemed to exhaust

he benefits of the euro before the currency

was born. It grew healthily in the late 1990s

s its interest rates fell to converge on

Germany’s in the run-up to the euro’s

reation. But it has never recovered

onvincingly from the downturn that

ollowed. GDP grew by an annual average of ess than 1% between 2001 and 2008;

roductivity growth was weak. Nominal wage

rowth of 3% a year further undermined

ompetitiveness.

ortugal has got by on a drip-feed of foreign

apital. Its current-account deficit averaged

% of GDP in 2001-08. The cumulative impact of those deficits is behind the third weakness

t shares with Greece: the foreign debts that its firms, households and government have run

p. The IMF reckons that Portugal’s net international debt (what residents owe to foreigners,

ess the foreign assets they own) was 96% of GDP in 2008, an even higher ratio than

Greece’s (see chart 3).

A good chunk of the gross debt is held by

oreign banks: The BIS puts the figure at €198 billion at the end of last year, around 120%



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f GDP (see table 4). The bulk of this has

een borrowed by homeowners and

usinesses. The debt has to be rolled over

rom time to time, which makes Portugal, like

Greece, vulnerable to a sudden change in

entiment. As with Greece, the bulk of public

ebt is held abroad and the country’s low

aving rate means it too depends on foreign

uyers of fresh debt.

Could contagion spread further? Spain looks

most at risk. Its dependence on foreign

nance is on a par with Greece’s. Spain’s

ublic-debt burden, at 53% of GDP last year,

means its fiscal position is among the least

worrying of all rich countries’ (though an eye-

watering deficit means that burden is rising

ast). The country’s biggest task is to convince foreign investors that its economy will revive

without further infusions of credit. Though Italy has a big public-debt burden, it can hope to

ely on domestic savers to buy its government bonds. Its net foreign debts and current-

ccount deficit are fairly small by rich-country standards. Much of the Irish assets held by

oreigners are factories and offices, rather than bonds and loans, so Ireland is less prone to a

udden stop of overseas finance. It also has a good record of putting its public finances right.

Do the rumblings in Greece signal a wider retreat by investors from sovereign debt?

Defensive Eurocrats point out that the public finances of the euro area as a whole are no

worse than America’s. The IMF reckons that America’s net public debt will be 70% of GDP

his year, against a euro-zone average of 68%. But the zone is not a single fiscal entity and

nvestors are wary of countries whose finances or growth prospects are worse than average.

America has the great advantage of issuing the world’s reserve currency. In crises, scarednvestors rush into American Treasuries, which are prized for their liquidity. That is why

reasury yields fell this week as Greece’s soared. That hunger for American assets has lifted

he dollar against the euro (and the yen, sterling and the Swiss franc) since the start of the

ear. That at least is some comfort for members of the euro zone. When countries

ccounting for more than a third of its GDP are struggling in export markets, that is exactly

what they need.

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The eurozone's debt crisis: The cracks spread and widen