Managing Risks in the European Periphery Debt Crisis

The euro crisis is often said to have been the consequence of an excessive debt, private or public, and finally both. But that excessive debt would not have resulted in such a serious crisis had the eurozone institutions properly ensured the correct working of the mechanisms of a monetary union.

A centrepiece of the new economic governance structure for the euro area is the so-called European Semester, whose first cycle closes each year in early July with the endorsement of the country-specific recommendations (CSRs) by the European Council. Member state governments are then expected to implement such recommendations into budgetary decisions, structural reforms and employment policies. The recommendations are formulated on the basis of specific challenges previously identified by the Commission in the framework of the annual growth survey (budget and structural challenges) as well as within the macroeconomic imbalances procedure and after hearings of the European Parliament opinion.

Three years into Europe’s crisis, and with worrisome output contractions ongoing in Italy, Spain and Portugal, the different experiences of Ireland and Greece offer useful lessons. A more tempered fiscal consolidation has helped Ireland succeed in restarting the growth needed to underpin debt sustainability and renew bond issuance. Few doubt, as a result, that Ireland’s official creditors will be repaid in full and on time. With a much larger initial debt and little saved from the strong growth registered before 2008, the far harsher fiscal adjustment required of Greece has had a much more negative effect on GDP. This has elevated debt ratios and reinforced doubts about creditworthiness despite fiscal adjustment and principal reductions from private creditors of unprecedented magnitudes. Applying the Irish example in Greece to help restart growth would require some additional funding. The final cost, however, would be much less than might eventually be needed if output continues to fall and doubts about debt sustainability remain entrenched.

In the aftermath of sub-prime crisis in the USA, investors witnessed a much closer scrutiny of the European periphery debt securities by the markets, which intensified during 2009 and dramatically escalated over the subsequent two years. An important dimension of such an escalation concerns the interaction between different market segments and its possible attribution to either objective parameters or behavioural characteristics such as the relative preferences of the markets towards risk. The markets assess and price the riskiness of sovereign debt primarily through two sources of information: first, market prices for traded sovereign bonds and credit default swaps (CDS) and second, credit ratings published by agencies (CRA) such as Standard & Poor’s (S&P), Moody’s and Fitch.

The 2012 Greek debt restructuring was a watershed event in the European debt crisis. It was unprecedented in terms of its size and deep haircut, yet it took place in an orderly manner, with the consent of both private and official creditors. There is an ongoing debate as to whether it should have happened sooner to avoid bailing out private investors with public money. In line with the book’s subtitle, this paper discusses the tradeoff between the need to ensure debt sustainability up front versus the fear of contagion, concerns about euro area bank solvency, and doubts about Greece’s resolve to reform.

On 14 January 2014 the German judges of the Constitutional Court in Karlsruhe came to a preliminary ruling: the European Central Bank’s government bond buying programme (OMT) is illegal according to EU law. The judges referred the case to the European Court of Justice, asking the Luxembourg judges to add conditions to the OMT programme to make it possible for them to reconsider their judgement. These conditions, if implemented, would in fact rob the OMT programme of its effectiveness and make it totally useless. This would create the risk of repeated crises in the government bond markets of the eurozone.

The privatization of state assets constitutes a powerful tool of economic reform but not a panacea. It can be seen as a weighted introduction of private interests, capital and expertise into the portfolio of state assets, which, combined with public interest, could bring operational efficiency and value enhancement. This continuous trade-off between private and public interest is the main determinant of different privatization modes, ranging from full freehold sale in cases with no residual state interests, partial Initial Public Offerings (IPOs) and Secondary Public Offerings (SPOs), to various forms of concession agreements. A carefully structured privatization plan bears significant fruit: (1) the sale of state-owned enterprises running deficits or with accumulated debts would be a relief for the government deficit and debt, respectively; (2) privatization introduces the opportunity of attracting private capital and expertise from abroad, improving the integration of companies in international value chains; (3) privatization also adds to the documentation of a credible sovereign profile for the budget restructuring programmes and the direct reduction of public debt, thus signalling smaller sovereign risk, which pushes borrowing costs lower; (4) a side-effect of improved sovereign funding signals better funding conditions for the private sector, stimulating innovation in banking and business; (5) GDP growth is stimulated, with positive secondary effects to all aspects of economic activity, sovereign debt ratio, sovereign risk, borrowing costs and so on.

The 2008 crisis led to a strong rise in public debts, by around 30 percentage points of GDP in terms of Maastricht debt for the euro area, 50 percentage points for the UK, 45 for the USA, and 60 for Japan (Table 8.1). At the end of 2013, almost all euro area countries will run higher than 60% of GDP public debts. This is also the case for the UK, Japan, and the USA.

With the crisis in the euro area, the issue of the monetary union’s institutional structure has gained in significance. One problem with regard to the longer-term stability of the euro area is the absence of mechanisms to adequately absorb asymmetric cyclical shocks in the individual member states. Such an instrument is essential in order to be able to implement a single monetary policy suitable for all countries. Consequently, the European Monetary Union (EMU) should be equipped with an economic transfer mechanism¹ — for instance, in the form of common unemployment insurance. This is not an instrument to solve the current crisis, but rather to provide greater stability to the EMU in the medium and long term.

Debt is a particularly serious macroeconomic problem in the eurozone. Public debt ratios are high by international historical standards, with no immediate prospect of a significant reduction. Private — corporate and household — debt ratios are either flat or rising. Banks remain fragile and impose a contingent liability on the public purse. The most stressed economies have not had the option of renewing economic growth through exchange rate depreciation and a boost to exports. Thus, fiscal austerity has been their principal instrument to achieve debt reduction. But since austerity also hurts growth, the debt-to-GDP ratios have barely budged. Persistent low growth has also created deflationary tendencies, which further raise the challenge of debt reduction.

Greek, Spanish, Italian and Portuguese corporates turned increasingly to capital markets for funding over the past three years, a positive change from the overwhelmingly bank-funded model that has prevailed historically in the region. How does the corporate funding mix in southern Europe compare with the rest of the continent? What are the main drivers behind the funding shift, and how large is it? What role do credit ratings play in these growing capital markets? What can we learn from the financial performance and insolvency patters from corporates in the periphery? Are all corporates equal in the capital markets? These are the points we will discuss in the current chapter.

While the financial crisis is global in nature, Europe has its own special brand of institutional arrangements that are being tested in the extreme and which have exacerbated the financial crisis. The monetary union is being subjected to asymmetric real shocks, both from abroad and internally. With its inability to adjust exchange rates, these pressures are forced through the labour market and cause unemployment. This has led some countries over past years to try to alleviate pressures with fiscal slippage. The resulting indebtedness has been exacerbated by the financial crisis and recession and this, in turn, has contributed to underlying financial instability.

The last 30 years of developments in financial services legislation have been rapid and astonishing both in Europe and internationally. At a European level since the late 1980s, the EU has invested time and effort in encouraging the establishment of a single, integrated market in financial services. The cycle of Directives for the full liberation of capital movements within the EU closed with Directive 88/361/EEC.¹ In addition, the Second Banking Directive 89/646/EEC,² the essential instrument for the achievement of the internal market for banking services, laid down the foundations of unrestricted rights of establishment and provision of services for credit institutions across the EU, by eliminating the most obstructive differences between member states’ national laws governing credit institutions. In the same year, the Directives on the own funds and solvency ratio of credit institutions were issued to protect savings and create equal conditions of competition between European credit institutions.³ Furthermore, Investment Services Directive 93/22/EEC,⁴ coupled with Directive 93/6/EEC on the capital adequacy of investments firms and credit institutions, created the basis for the freedom of establishment and cross-border provision of investment services within the EU by investment firms and credit institutions entitled to provide such services, thus enhancing the single European capital market.