COVER STORY: LIVING ON THE EDGE
By Laurence Neville
Southern Europe's sovereign debt crisis may appear to have been resolved, but severe trials still lie ahead—particularly for Greece.
The travails of Southern Europe—in particular Spain, Portugal and Greece—continue to dominate the concerns of Europe's politicians and global markets as 2010 draws to a close. Concerns over the ability of the eurozone to survive the debt crisis of its weakest members (of which Spain, Portugal and Greece have top billing) have led to tumbling stock markets and soaring bond spreads periodically throughout the year. Although all three countries have efforts under way to address their problems, there is little doubt that fears about their fate will resurface.
The past year has shown that a two-speed Europe is a reality, where Spain, Portugal and Greece (and, to be fair, other countries, including Ireland) form the European periphery. "The core of Europe—Germany in particular—is recovering well," notes Peter Westaway, chief economist for Europe at Nomura. Meanwhile, there has been plenty of evidence of the economic and political risks facing periphery governments on their hazardous journey. "Real activity is still inevitably impaired by austerity measures. GDP is still falling or set to fall in Greece and Portugal," says Westaway. "Moreover, in contrast with the strong rebound in the core, we expect the fall in periphery activity to be more persistent as activity needs to relocate away from overexpanded sectors, such as construction in Spain." While Spain, Portugal and Greece have done much in 2010 to reinstate stability, the next stage in their rehabilitation could prove harder still.
"This reorientation of activity will ultimately be enhanced by the process of structural reform now given greater urgency by the crisis," says Westaway. "More-flexible labor and product markets will help to bring about the relative price adjustment required to restore competitiveness to the periphery. And productivity-enhancing improvements—for example, the removal of inefficient restrictive practices and barriers to entry—will stimulate long-run growth."
Of the three countries worst affected by the sovereign debt crises of 2010, Spain is the most crucial in terms of preventing a systemic loss of confidence in the eurozone. The scale of Spain's economy dwarfs Portugal's and Greece's, and it is unclear that the EU's €440 billion ($618 billion) European Financial Stability Facility is sufficient to rescue Spain if required. Citing Spain's weak growth outlook, Moody's joined Fitch and Standard & Poor's in September by downgrading the country from its top rating of Aaa to Aa1.
The good news, though, is that Spain is in relatively good shape, says Marco Annunziata, chief economist at UniCredit. "Before the crisis, public debt was fairly low, and while private debt—and in particular mortgage debt—was a problem, private sector deleveraging is happening quickly." Austerity measures, including a 5% reduction in public sector wages and an increased value-added tax (VAT), have been imposed. Spain has also benefited from increased tax revenues as the economy emerged from recession in the second half of the year.
Partly as a result of this proactive approach, Spain's budget deficit shrank by 42.1% to €36.36 billion in the first nine months of the year, giving it a budget deficit of 3.45% of GDP and making it likely that overall government debt (including regional governments) hits its 9.3% target for the full year (compared with 11% of GDP in 2009). In October, prime minister José Luis Rodriguez Zapatero was successful in getting a 2011 budget passed that will implement central government expenditure cuts of almost 8%, compared with 2010 levels. The ultimate aim is to bring down government debt to 6% of GDP.
While Moody's downgraded Spain in September, it acknowledged that the government had "started to address some of the key imbalances in the economy, in particular its very large fiscal deficit, the problems within the savings banks sector, and the high level of unemployment." Annunziata believes the importance of the measures affecting the labor market and banking sector cannot be overstated: "Spain is the only country to have undertaken extensive structural reform voluntarily."
Portugal Pays a High Price
Ballard: Comments about Greece debt restructuring are welcomed
Portugal has addressed its public debt problem—the deficit was 9.3% of GDP in 2009—with a 5% pay cut for public sector workers earning more than €1,500 a month and an increase in VAT. However, while Portugal's measures to reduce debt are welcome, for many observers they happened later than desirable, reflecting some of Portugal's huge problems. "Portugal has two Achilles heels—growth and politics," says UniCredit's Annunziata. "Even during its credit binge years, Portugal grew less than Spain or Greece, for example. How can it now grow against a backdrop of fiscal austerity? Greater flexibility is needed in the labor market, and productivity must be raised. Portugal specializes in low value-added products, which exposes it to exchange rate risk and undermines investor sentiment about the country's ability to address its problems."
Investors' doubts about Portugal's ability to carry through tough austerity policies and reform the broader economy are reinforced by the country's political divisions. Only after bitter dispute was an agreement reached at the end of October on prime minister José Sócrates' 2011 budget, which will cut the deficit to 4.6% of GDP next year from 7.3% in 2010. "The problem is the perception political fighting creates as much as the barriers to problem solving it presents," says Annunziata.
While Socrates' government has taken action broadly similar to Spain's, its lack of opposition support means it cannot promote its achievements. "The government can't afford to take the political flak when it does unpopular things," says Annunziata. The sense that Portugal is making less progress than Spain is reflected in the cost of its borrowing: Even after the budget was agreed upon, on November 1 investors demanded 346 basis points more than German bunds for 10-year Portuguese debt—around six times higher than a year ago and twice the rate that Spain pays.
Greece Debt Restructuring Looms
Greece is a country on a tightrope—and even with an unprecedented safety net (provided largely by Germany) its fate remains uncertain. It has propelled Europe into an economic and constitutional crisis and threatened the stability of its decade-old currency. Although huge efforts have been made to avert catastrophe, it looms continuously and is reflected in the markets: Greece has to pay 9.57% for 10-year funds, for which Germany pays only 2.49%.
Such a cost indicates that something has to give. Pimco, the world's largest bond investor, still expects Greece to default on its debt. At the end of October, Greek deputy prime minister Theodoros Pangalos said that "demonizing debt restructuring is wrong ... debt exists to be restructured, [and] it may be too advantageous to turn it down." Simon Ballard, a senior credit strategist at RBC Capital Markets, says that the comments could be an attempt to preempt a policy shift and that they should be welcomed for "simply stating that such risk is non-zero."
At the least, most observers recognize that Greece will require further assistance. "We expect that Greek loans from the IMF will be extended in due course, although it is clear that the priority is to continue to demonstrate good behavior," says Nomura's Westaway. That good behavior has been apparent, with cuts of almost unprecedented severity under way. "However, the public debt figures for Greece are extremely ugly," says Annunziata. "Even if the country does everything required by the IMF, public debt will hit 145% of GDP in a couple of years because of the enduring recession."
Without the possibility of devaluation to reduce its debt (which effectively saved Turkey from a similar fate in the 1990s), it is difficult to see how Greece can possibly stabilize its situation. As with all of Europe's troubled economies, part of the solution is to improve competitiveness. Relative to the productivity of Germany, for example, Greece has simply been paying itself too much. However, in the short-term Greece's problems are Europe's problems. "Until there is agreement at EU level about a controlled mechanism to compel countries to address their problems—and the penalties associated with that—no private investor will lend beyond the scope of the original package to 2013, and that will cause further problems," concludes Annunziata.