Saturday, July 27, 2013

European Debt Crisis Far From Over!

Last July, ECB President Mario Draghi famously promised to do “whatever it takes to preserve the euro.” European stock and bond prices rallied on the news, which apparently caught even a number of Draghi’s cohorts on the ECB Governing Council off guard. However, in relatively short order, the ECB followed his proclamation with the announcement of the OMT, or Outright Monetary Purchase, program in early September. This program offered the unlimited purchase by the ECB of the sovereign debt of any Eurozone nation seeking aid through the currency zone’s bailout funds (the European Stability Mechanism, or ESM, which was being put in place as a permanent fund to replace the temporary European Financial Stability Facility, or EFSF). No nation has sought aid and, as such, the ECB has not purchased bonds through the OMT, since the announcement was made. However, yields on the sovereign debt of troubled Eurozone nations have tumbled since the announcement.  It’s almost enough to make you believe that Europe’s troubles are in the rearview.
Nothing could be further from the truth. As the Eurozone continues to struggle through recession, debt-to-GDP ratios, especially in its most indebted and economically troubled nations, continue their rise unabated. Recently released data from Eurostat, the EU’s official statistical agency, indicates that the currency zone’s debt problems remain firmly ahead of it. In the 12 months through March of this year, debt/GDP for the 17-member Eurozone increased from 88.2% to 92.2%. While debt/GDP rose in each of the 17 nations in the year ended in March, it rose modestly, or even nominally, in a number of countries. In Germany, the Eurozone’s largest economy, it increased a scant 0.10% while in Austria it rose just 0.80%. However, debt/GDP ratios in the so called PIIGS – Portugal, Italy, Ireland, Greece, and Spain – soared, as all but Italy experienced double-digit increases in gross government debt relative to the size of their respective economies. While the rise in Italy was less dramatic, gross government debt was 130.30% of the nation’s economy at the end of the 1st quarter, second only to Greece among Eurozone nations (Chart1). While Greece represents less than 3% of the Eurozone economy, Italy is the currency zone’s 3rd largest economy, accounting for approximately 16% of GDP.

Budget deficits in Europe’s periphery remain worrisome. Italy’s budget deficits have been far more modest than those of the rest of the periphery, its problem being its absolute debt load, the 3rd largest in the world, and its flagging economic growth. On the other hand, Spain, the Eurozone’s 4th largest economy, has the lowest debt/GDP ratio among the PIIGS, but that ratio is rising rapidly due to massive budget deficits. Along with Greece, the country has made virtually no progress on its deficits as a percentage of GDP over the last three years. While Portugal and Ireland have made significant progress in curbing their deficits, they remain far too high (note that Ireland’s deficit ballooned in 2010 as the nation tried to bailout its banking system, which was many times larger than the nation’s economy, and was forced to seek aid) (Chart 2). Of course it is very difficult to reduce a nation’s budget deficit when large portions of its labor force participants remain jobless. With more than 25% of their labor forces out of work, it is not hard to see why Spain and Greece have made no real progress on curbing their budget deficits. Further progress in Ireland, Italy and Portugal will also be hard to come by with each nation suffering from double-digit unemployment (Chart 3). In short, double-digit unemployment is likely to continue to fuel deficits in excess of nominal GDP and debt ratios in will continue to rise. 

Given all of the above, it’s not surprising that the pace at which debt/GDP has grown in the periphery has remained relatively constant over the last five years (Charts 4&5). While Spain has the lowest debt/GDP ratio among the five nation s, the rate at which it has grown, more than 18% annually since the end of 2007, has been staggering and is clearly unsustainable. The rate at which Ireland’s debt/GDP has grown was skewed by its bank bailouts, yet the ratio still grew more than 18% last year. This too is clearly unsustainable. The fact that the rate of change was higher for three of the five countries over the most recent 12-month period than for the entire five plus years in question is not encouraging. Simply put, nothing Europe has done in the last five years has stemmed the rising tide of debt in the troubled periphery nations.

Markets have reacted to the ECB’s promise to provide unlimited assistance to any Eurozone nation seeking aide as though it were a panacea for the ills of over-indebted, non-competitive, European economies. More likely, the bond vigilantes have simply gone into hibernation. The absolute level of Greek debt, coupled with its growth trajectory, suggests that the nation’s 2012 default will not be its last. While the growth trajectory of Italian debt is far more modest, the nation is in its 4th recession since 2002, its labor markets remain rigid, and it government dysfunctional. As such, the nation’s burdensome debt load will likely continue to rise and a debt restructuring seems probable. The absolute levels of debt combined with the pace at which the debt of Ireland and Portugal continues to grow makes them candidates for default as well. While Spain debt/GDP ratio is much more modest than that of the rest of the PIIGS, its unemployment rate and budget deficits suggest that the nation’s debt will continue to rise at a rapid pace. If so, it too will ultimately be a candidate for default.