Monday, February 20, 2012

Eurozone debt sustainability

The most important question surrounding the Eurozone crisis is about the sustainability of the current debt levels, especially given each country's economic prospects.

The simple reality, stripped off all economic theory, is that the debt-to-GDP ratios can come down only if the GDP growth rate (the denominator) is faster than that of the growth in debt stock (the numerator). In other words, so long as the economy declines, even if the debt stock remains the same, the debt-to-GDP ratio will increase.

In this context, even as European economies implement severe austerity policies of wage freezes, government spending cuts, and tax increses, the biggest casualty appears to be growth itself. But for Germany, Eurozone would have been already deep in the red. Eurostat has reported that for the last quarter of 2011 GDP in the 17-nation euro area fell 0.3% from the prior three months, the first drop since the second quarter of 2009. Greece’s GDP slumped 7% in the fourth quarter from a year earlier.

The British economy shrank 0.2% in the last quarter of 2011 and unemployment rate is now at 8.4%, the highest since endd-1995 and is forecast to rise through 2012. In fact, the British National Institute of Economic and Social Research (NIESR) has warned about the country slipping into recession in 2012 and has forecast that the UK economy will contract by 0.1% this year. It has urged the government to loosen its fiscal stance and shore up faltering demand.

The debt-to-GDP ratios of all the peripheral economies have risen sharply since the onset of the Great Recession. They have continued to rise through all of 2011 and are expected to sustian the trend through 2012.

The best indicator of the prospects of a country emerging out of a sovereign debt hole is its primary fiscal balance, which is a measure of the fiscal balance excluding debt service. The Kiel Institute barometer of public debt calculates how much debt countries can bear in the long term by examining the primary surpluses of countries. It is based on the assumption that the ratio of the primary surplus to GDP (the primary surplus ratio, PSR) must be equal to or greater than the debt ratio (S) times the difference between the nominal interest rate (i) and the nominal growth rate (g) if the debt ratio is to remain stable.

PSR ≥ S(i – g)

It maps the primary supluses required by the Eurozone economies to sustain their current debt levels based on the aforementioned assumption. The growth rates, optimistic and pessimistic rates, are long-term rates and the interest rates are the 10 year long-term bond yields. Greece and Portugal face extraordinary challenges even with very optimistic long-term growth scanarios.

In the circumstances, the only way appears to be an early debt restructuring. However, even with this, the extent of haircuts required on Greek debt would almost wipe out its creditors. Portugal, and to a lesser extent Ireland, too would require some form of debt restructuring deals. Fortunately, the bigger economies of Italy and Spain look relatively safe.

See also these stories that chronicle the austerity miseries of Britain, Portugal, and Greece.

No comments: