Friday, December 2, 2011

Europe's debt squeeze

Satyajit Das has an excellent illustration of the magnitude of problems facing the Eurozone economies,

"Assuming borrowing costs of 4 per cent and a debt-to-GDP ratio of 120 per cent, Italy needs to grow at 4.8 per cent just to avoid increasing its debt burden where its budget is balanced. At current market borrowing costs of 7 per cent, Italy has to grow at an unlikely 8.4 per cent just to avoid increases in its debt levels.

Given low projected growth rates and elevated borrowing costs, Italy must reduce its debt levels significantly to avoid the risk of insolvency. Assuming interest costs of 4 per cent and growth of 2 per cent, Italy would have to run a budget surplus of 5 per cent per annum for 10 years to reduce its debt to 90 per cent of GDP. Alternatively, it must sell state assets to reduce its debt...

Assuming borrowing costs of 3 per cent and a debt-to-GDP ratio of 81 per cent, Germany needs to grow at about 2.4 per cent to avoid increasing debt levels. France needs to grow at even higher levels."


He writes about the implication of this state of affairs,

"The toxic cocktail of high levels of existing debt, large and seemingly irreversible structural budget deficits, low growth rates and high borrowing costs makes the position of many European countries unsustainable. Beleaguered economies have to run budget surpluses (through spending cuts and tax increases), grow at very high rates, decrease their borrowing costs or achieve a combination of these merely to stabilise their debt."


He points to the futility of fiscal austerity to reduce deficits and argues that debt write-downs are inevitable,

"Events show that the combination of a large stock of debt, intractable, corrosive budget deficits, low growth rates and increasing borrowing costs can result in a rapid slide into a sovereign debt crisis. As interest rates increase as a result of rising investor concern about creditworthiness, attempts to cut the budget deficit merely reduce growth, exacerbating the problem. Without a significant reduction in the amount owed to creditors, the country is locked into a self-defeating cycle of austerity, continuing budget deficits and increasing public debt."


Bond markets are freezing up as evidenced by the rapidly rising bond yields in the last few weeks.



With the cost of Italian long term debt rising well past the 7% mark and public debt at 120% of GDP, Nouriel Roubini feels that any mixture of austerity, higher taxes and structural reforms will not be enough to backstop Italy's slide. He advocates partial debt restructuring involving lengthening the tenor of Italian debt and reducing the coupon rate on existing debts, including that on foreign investors.

In this context, James Surowiecki argues that unlike Greece, the other peripheral economies like Italy and Spain have strong fundamentals and their problem "isn’t the debt itself but, rather, the soaring interest rates", which in turn threatens to turn a liquidity crisis into a solvency crisis. The bond markets reaction has created a vicious cycle: fear of default raises interest rates, and higher interest rates make default more likely. But as Satyajit Das illustrates, even if the ECB agrees to become the lender of last resort, the Italian debt situation has become too bad to be salvaged by merely buying time.

Update 1 (11/12/2011)

The European governments finally agreed on measures for closer economic and fiscal integration with strict rules and semi-automatic sanctions to enforce budget discipline. Since Britain opposed it, instead of changing the Treaty itself, the 17 Eurozone members agreed to for an intergovernmental deal that will have to be negotiated outside the EU legal framework. Of the remaining 9 non-EMU EU countries, six will join the deal immediately while three others are considering it.

Under the deal, each government will adopt a "golden rule" to ensure balanced budget (a structural deficit of no more than 0.5%); the European Court of Justice will ensure that national fiscal rules comply; automatic fines will be imposed for governments that breach 3% deficit limit, unless qualified majority decides otherwise
Firewall. The leaders also agreed to lend €200bn to the International Monetary Fund via their central banks and establish a European Stability Mechanism, the new €500bn fund, to come into effect from July 2012 (this would be in addition to the €440bn European Financial Stability Facility).

In the meantime, the ECB too took important decisions to expand its monetary support. It lowered interest rates by 25 basis points to 1%; agreed to provide unlimited amounts of cheap liquidity to financial institutions for three years (from the earlier one year) should help them buy more bonds; diluted collateral standards and expanded the types of securities it was willing to accept for its credit window operations. The ECB's decision to emerge as a lender of last resort to all financial institutions was intended to overcome technical objections to it lending directly to sovereigns.

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