More than a year after it started in Greece and later spread to three other peripheral countries, Ireland, Portugal and Spain1, the sovereign debt crisis in the eurozone is still ongoing. In the last two years, regulation has begun in these countries and major political measures have been taken. This assessment is confirmed by a forward-looking assessment of the public debt situation in the four countries (Box 1).
Required improvement in the primary balance (% GDP) from its 2010 annual level to its 2015 annual level under different macroeconomic scenarios and. The stabilized levels of debt in the case of the adjustment indicated by the blue part of the bars are the following: 160% in Greece, 123% in Ireland, 98% in Portugal and 84% in Spain. Even in the optimistic scenario, the primary surplus needed to reduce the debt ratio to 60 percent of GDP by 2034 would be 8.4 percent of GDP.
4 Based on current official borrowing rates for Ireland, a sustained primary surplus of 3.7% would be needed from 2015 in the optimistic scenario, and 6.1% in our scenario in the cautious scenario, for the debt ratio between 2014 and 2034 reduced to 60 percent. calculations. Expected interest rates are calculated using the term structure expectation hypothesis, leading to much higher interest rates than in the optimistic scenario.
ASSESSING THE SOFT OPTIONS
Note: Column (d) is not the sum of columns (b) and (c), because the marginal impact of policy measures is smaller (in absolute terms) when market interest rates are lower. Any measure would clearly contribute to reducing Greece's debt burden, both directly and indirectly through lower market interest rates. However, our calculations show that even if all measures were applied, this would still not be enough to make Greece solvent again.
By 2012, markets will value the default option, making it harder for troubled governments to borrow. From 2013, the Greek government, if it really insists on this position, will no longer be able to issue bonds. We estimate that Greece would need (in addition to the three measures in Table 1) a 30% reduction in marketable public debt7 to return to a sustainable path and achieve a 60% share of debt in GDP by 2034.
7 This assumes that assistance loans will be exempt from restructuring and that market reaction to the debt reduction will result in a fall in the spread vis-à-vis Germany to 200 basis points. Under these conditions, a 6 percent persistent primary surplus (the program assumption) from 2015 is needed in our cautious scenario, with a 3.6 percent surplus in the optimistic scenario, to reach the 60 percent debt ratio by 2034.
ASSESSING POTENTIAL SPILLOVERS
The exposure of euro area banks to Irish sovereign risk is small and it is really bank exposure that matters.
A COMPREHENSIVE SOLUTION
STRENGTHENING THE EURO-AREA BANKING SYSTEM
Once such tests have been passed, eurozone countries must proceed immediately with bank restructuring where necessary, which should mean recapitalizing institutions that are viable and closing those that are not. Restructuring of some banks in core countries is likely to be necessary, especially if bank losses turn out to be significant in Spain, the only peripheral country where we estimate that restructuring would have a significant spillover effect on the rest of the euro area. European Bank Treuhand' (Posen and Véron, 2009) to speed up recapitalization and manage any distressed assets that might pass into public ownership, while keeping fiscal spending in national hands.
Beyond the immediate short term, there is an obvious need to establish a solid framework of European banking supervision and resolution. Nothing less than supranational banking supervision and resolution bodies can cope with the kind of financial interdependence that now exists in Europe. However, if this turns out to be politically unrealistic, the eurozone countries must create their own institutions.
Before the crisis, the creation of EU or euro area banking supervision and resolution institutions was considered unacceptable by European countries because it would amount to the pooling of risks associated with bank failures. The crisis has shown that the absence of such institutions places even greater burden-sharing on countries, especially within the euro area, where the ECB has been forced to act as the lender of last resort for potentially insolvent banks.
RESOLUTION OF SOVEREIGN DEBT CRISES
The high rates also undermined the credibility of these programs by somewhat exacerbating Greece's and Ireland's sustainability problem. Interest rates on official loans should correspond to the lender's borrowing costs and operating margin, according to EU aid to Hungary, Latvia and Romania. The experience of the three countries shows that countries may not be ready to absorb the full amount of preferential rate aid once reasonable market borrowing conditions are re-established in order to increase market confidence10.
Longer maturity EU assistance will also reduce the size of the haircut on marketable Greek debt and improve the sustainability of other countries receiving assistance.
FOSTERING GROWTH IN THE PERIPHERAL COUNTRIES
We strongly advocate a temporary refocusing of the structural funds earmarked for the peripheral countries, with money mobilized to support new growth strategies. As argued in Marzinotto (2011), this requires front-loaded EU structural spending (without changing its distribution per country), so that it can contribute to promoting reform and growth during the most acute phase of the adjustment. It also requires a joined-up, coordinated approach, including with the EU-IMF programme, instead of the current silo approach.
In the longer term, the EU can also help by making better use of its budget. The discussion on the next multiannual financial framework for 2014-20 is an opportunity for rethinking new ways to promote investment in the four countries and other crisis-stricken countries, especially in Central and Eastern Europe.
CONCLUSION
Section A1.6 details the calculations for the assessment of the three types of measures currently under consideration (reduction of the interest rate on EU loans, extension of the maturity of official loans, debt buyback from the ECB). Cautious scenario: Expected future interest rates are calculated using the expectation hypothesis about the time structure of interest rates (leading to much higher expected future interest rates than in the optimistic scenario). Portugal and Spain: European Commission forecast from November 2010 to 2012 and a further improvement of 1.5 percentage points of GDP in 2013 and 2014.
Indeed, Table A2 indicates that all components of the SDR interest rate are expected to rise according to exchange-traded futures contracts. The Irish National Treasury Management Agency (2010) argues that IMF loans can be swapped into a 5.7 percent fixed euro lending rate with a 7.5-year maturity, which is in line with the expected rise in the components of the SDR interest rate. One obvious choice is the expected interest rate which is derived on the basis of the expectations hypothesis of the term structure of interest rates (EHTS, see Box 1).
Using the debt maturity structure to calculate the weights, the average spreads between German Bunds were 970 basis points in Greece, 550 basis points in Ireland, 370 basis points in Portugal and 200 basis points in Spain. Consequently, we weighted these expected annual interest rates (in each year between 2011 and 2020) by an assumed constant debt maturity structure to obtain the average interest rate of newly issued debt in each year. If the total interest payments in one year are divided by the total debt balance at the end of the previous year, we get a measure of the average interest rate for outstanding public debt.
Based on the above observations, Greece, Portugal and Spain have weaker growth prospects than Ireland and we see significant downside risk compared to Consensus Economics (2010) forecasts. 24 Figure 2 shows that the average interest rate on outstanding government debt continues to rise in the second half of the decade, while we have assumed constant GDP growth in 2016-2020 (Table 5). Interest rate cut: a reduction in the interest rate on all official EU loans (IMF rates cannot be reduced) to 3.5 percent per year;
Note: extrapolation of the blue curve will lead to a debt ratio of less than 60 percent by 2025. Due to the imperfect comparability of the data we use, as well as the assumptions made in our calculations, these estimates should be considered as illustrative. Source: Eurostat, World Bank (JEDH). Table A12 Breakdown of foreign banks' exposure to sovereign debt. Exposure of foreign banks to the sovereign. 1) The total does not always equal the sum of the columns since domestic exposures are net.
The last column in Table A10 does not equal the sum of the four countries because the exposures are within the block. The figures given in the table are estimates of the nominal value of the debt of the European Central Bank. European Commission (2010) 'Economic Adjustment Program for Greece: First Review - Summer 2010', Occasional Papers 68, European Commission Directorate-General for Economic and Financial Affairs, August 2010.
European Commission (2011) 'Economic Adjustment Program for Ireland', Occasional Papers 76, European Commission Directorate-General for Economic and Financial Affairs, February 2011.
