Log out My account Newsletters

Home World Business & finance Science & technology Economics Culture

The euro zone's debt crisis

The cracks spread and widen

Panic about the Greek government’s ability to repay its creditors is
infecting other euro-area countries’ sovereign debt. Where will it end?
Apr 29th 2010 | From The Economist print edition

AFTER simmering for months, the Greek sovereign-debt crisis has boiled over. The promise
of a rescue by the IMF and the country’s euro-zone partners, worth €45 billion ($60 billion)
or 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.

In keeping with its practice when rating

bonds as junk, S&P gave an estimate of the
likely “recovery rate” should the worst
happen. It said bondholders were likely to
get back only 30-50% of their principal were
Greece to restructure its debt or to default.
That prompted panic in bond markets. The
yield on Greece’s ten-year bonds leapt above
11% and that on two-year bonds to almost
19% at one point on April 28th. Portugal’s
borrowing rates jumped, too (see chart 1). At
those rates, the racier sort of hedge fund
might still be prepared to gamble on Greece
paying back its debts at face value, but
mainstream funds are abandoning the bonds

Comment (37)
 Comment (37)
in their droves. The speculators blamed by officials for precipitating the crisis may now be
the only people willing to take a punt on Greece. E-mail

Print
Had the rescue been swift and squabble-free, there was a chance, albeit slim, that private
investors might have rolled over their existing holdings of Greek debt at tolerable interest
rates. That Greece’s would-be rescuers may not after all stump up the money they promised Advertisement

is one of the risks that bondholders are loth to bear—though Germany may now approve its
share of the bail-out by May 7th (see article). Another is that Greece will not be able to
stomach the programme of budgetary and economic reform which the IMF is due to set out
in 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
continue 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
if its deficit reduction went well. It assumes that Greece could sustain a brutal reduction in
its primary budget deficit (ie, excluding interest costs) of 12 percentage points. Even that
relied on an interest rate of 5%, roughly what euro-zone partners have agreed they will levy Advertisement

on Greece, on all new borrowing and on maturing debt. If interest costs are much higher,
the 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
competitiveness needed for a recovery. Both influences will push down nominal GDP for a
while and make crisis management all the more difficult.
Related Items
The scale of the task and the bungling of the rescue make the bond market’s capitulation
From The Economi
seem natural. Greece needs so much money that the only thing standing between the Resentment in German
country and default is open-ended funding from the IMF and the rest of the euro area. The out
Apr 29th 2010
€45 billion fund announced on April 11th would be enough to cover Greece’s budget deficit
and repay its maturing debts (including the €8.5 billion that falls due on May 19th) for the More articles abou
rest of 2010. But Greece may need as much again in 2011 and still more thereafter. In an Economics
average year, Greece has to refinance around €40 billion of its debt (this year, would you
believe, is a mercifully light one for redemptions). Add to that the €70 billion or so of fresh Products & events
borrowing that may be needed to cover Greece’s cumulative budget deficits until 2014 and
the scale of a credible rescue fund becomes clear. Stay informed toda

Subscribe to The Economi

Yet Greece’s would-be rescuers may feel they
and alerts.
have little choice but to press on with the
bail-out. A default that would cut the value of Get e-mail newsletters

Greek public debt by a half or more would

cripple the country’s banks. (S&P has also
Subscribe to The Economi
downgraded four of them to junk status.) It
Twitter
would also spark a wider financial panic in
Europe. Around €213 billion-worth of Greek Follow The Economist

government bonds are held abroad. The Bank

for International Settlements (BIS) estimates
See a selection of The Eco
that foreign banks’ lending to Greece’s topical videos and debate
government, banks and private sector was
Follow The Economist
€164 billion at the end of last year. How
much of this is public debt is unclear. But if
half of the foreign holdings of government
bonds are held by banks, and if each
country’s banks owns those bonds in proportion to their total holdings of Greek assets, then
perhaps €76 billion is held by euro-zone banks (see table 2).

Euro-zone countries might be tempted to let Greece default, force non-bank investors to
take 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
losses of as much as 70%. That may look small next to a rescue fund. But if Greece
defaulted it would still rely on its EU partners to fund its budget deficit, which will take time
to shrink from the 13.6% of GDP it reached last year. It seems there are no longer any
options 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
be contained now seems faint. There is growing anxiety about the poor state of public
finances in Portugal, Ireland, Italy and Spain. Each has some combination of big budget
deficits and high public debt, though none is as financially stretched as Greece. But their
deeper problem stems from a decade when wage growth ran far ahead of productivity gains.
Stuck in the euro, they can no longer cure that malady by devaluation. The only remedies
are a period of wage restraint combined with structural reforms aimed at boosting
productivity. These will take time, as well as political will, to put in place. The danger is that
restless bond investors will not wait.

Portugal is first in the markets’ sights. Its ten-year bond yield rose to 5.7% on April 28th,
the highest for more than a decade, in the wake of the S&P downgrades and the anxiety
about the size and timing of the Greek bail-out. A week earlier its yields were below 5%.
Portugal could be forgiven for feeling picked on. Although its budget deficit last year was an
alarming 9.3% of GDP, that was lower than Greece’s. Its public debt, at 77% of GDP last
year, is less scary too. That is, in part, the result of a programme to slash the deficit in the
years before the global financial crisis struck, and gives Portugal’s government a credibility
that Greece lacks. On April 28th its prime minister, José Sócrates, said he and the opposition
had reached agreement on speeding up an austerity programme.

Yet Portugal shares three weaknesses with Greece. First, its economy is small (smaller,
indeed, than Greece’s), accounting for 2% of euro-area GDP. It offers investors very little
diversification. Those who want safe claims in euros can simply lend to Germany or France,
and 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
euro in 2001. Portugal seemed to exhaust
the benefits of the euro before the currency
was born. It grew healthily in the late 1990s
as its interest rates fell to converge on
Germany’s in the run-up to the euro’s
creation. But it has never recovered
convincingly from the downturn that
followed. GDP grew by an annual average of
less than 1% between 2001 and 2008;
productivity growth was weak. Nominal wage
growth of 3% a year further undermined
competitiveness.

Portugal has got by on a drip-feed of foreign

capital. Its current-account deficit averaged
9% of GDP in 2001-08. The cumulative impact of those deficits is behind the third weakness
it shares with Greece: the foreign debts that its firms, households and government have run
up. The IMF reckons that Portugal’s net international debt (what residents owe to foreigners,
less 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

foreign banks: The BIS puts the figure at €198 billion at the end of last year, around 120%
of GDP (see table 4). The bulk of this has
been borrowed by homeowners and
businesses. The debt has to be rolled over
from time to time, which makes Portugal, like
Greece, vulnerable to a sudden change in
sentiment. As with Greece, the bulk of public
debt is held abroad and the country’s low
saving rate means it too depends on foreign
buyers of fresh debt.

Could contagion spread further? Spain looks

most at risk. Its dependence on foreign
finance is on a par with Greece’s. Spain’s
public-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
fast). 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
rely on domestic savers to buy its government bonds. Its net foreign debts and current-
account deficit are fairly small by rich-country standards. Much of the Irish assets held by
foreigners are factories and offices, rather than bonds and loans, so Ireland is less prone to a
sudden 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
this year, against a euro-zone average of 68%. But the zone is not a single fiscal entity and
investors 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, scared
investors rush into American Treasuries, which are prized for their liquidity. That is why
Treasury yields fell this week as Greece’s soared. That hunger for American assets has lifted
the dollar against the euro (and the yen, sterling and the Swiss franc) since the start of the
year. That at least is some comfort for members of the euro zone. When countries
accounting for more than a third of its GDP are struggling in export markets, that is exactly
what they need.

Readers' comments

Readers have commented on this article (the window for new comments is now closed).

View all comments (37)

Want more? Subscribe to The Economist and get the week’s most
relevant news and analysis.

Classified ads
About The Economist online About The Economist Media directory Staff books Career opportunities Contact us Subscribe

Copyright © The Economist Newspaper Limited 2010. All rights reserved. Advertising info Legal disclaimer Accessibility Privacy policy Terms & Co