Sovereign Risk and the Euro Lorenzo Bini Smaghi Member of the Executive Board European Central Bank London Business School 9 February 2011
Introduction The economic and financial crisis the worst since WWII has produced an unprecedented increase in public deficits and debts in all advanced economies The ability of these countries to take the necessary actions to bring the public debt under control is being increasingly challenged, also by financial markets The challenge has started in the euro area 1
Government deficits have increased everywhere General government deficit (as a percentage of GDP) 14 12 2007 2009 10 8 6 4 2 0 Euro area United States Japan United Kingdom Source: IMF WEO October 2010 2
And so has public debt General government gross debt (as a percentage of GDP) 250 200 2007 2015 150 100 50 0 Euro area United States Japan United Kingdom Source: IMF WEO October 2010 3
Stabilisation of the debt in 2013 General government gross debt (as a percentage of GDP) 120 100 80 60 40 Euro area (IMF) United States (IMF) 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: IMF WEO October 2010 4
Within the euro area the dispersion is large General government deficit (as a percentage of GDP) 15 12 9 6 3 0-3 Greece Ireland Spain Portugal Slovakia France Belgium Cyprus Slovenia Netherlands Italy Malta Austria Germany Finland Estonia Luxembourg 2007 2009 Euro area 2009 Source: European Commission's economic forecast autumn 2010 5
Also in terms of debt General government gross debt (as a percentage of GDP) 180 150 120 90 60 30 0 Greece Italy Ireland Belgium Portugal France Germany Austria Spain Malta Cyprus Netherlands Finland Slovenia Slovakia Luxembourg Estonia 2007 2012 Euro area 2012 Source: European Commission - Autumn 2010 Forecast 6
And ageing is bound to make things worse Projected change in age-related government expenditure, 2007-2060 (percentage points of GDP) 20 16 12 8 4 Euro area 0 Luxembourg Greece Slovenia Cyprus Malta Netherlands Spain Ireland Belgium Finland Slovakia UK Germany Portugal Austria France Italy Estonia Source: European Commission Ageing Report 2009 NB: Some countries have, in the meantime, introduced pension and/or health care reform which should reduce long-term increases in agerelated spending 7
Three ways to reduce the debt burden A: Fiscal adjustment B: Inflation C: Default / Restructuring or a combination of the above 8
In the euro area inflation is ruled out The Treaty requires the ECB to ensure price stability Monetary financing is prohibited and markets trust it 9
Inflation expectations remain well anchored Five-year forward break-even inflation rate five years ahead 3.50 Euro area US UK 3.25 3.00 2.75 2.50 2.25 2.00 1.75 Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11 Sources: Reuters, ECB, Federal Reserve Board staff calculations, Bank of England 10
Also in surveys of professional forecasters Inflation expectations six to ten years ahead (annual percentage change) 3.5 3.5 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 2004 2006 2008 2010 1.0 EA United Kingdom United States Source: Consensus Economics 11
This leaves only two ways Plan A: Fiscal adjustment Plan B: Default / Restructuring 12
Euro area countries have opted for Plan A All euro area countries have programmes to reduce the deficit/gdp to below 3% by 2012-2013 Greece and Ireland are implementing EU/IMF adjustment programmes IMF, EU and EU countries are providing Greece and Ireland with unprecedented financial assistance EU countries have created the EFSF and changed the Treaty to create the ESM in 2013 13
Markets/Academics/Commentators have doubts The reasoning is the following: 1. The required fiscal adjustment is too costly 2. It cannot be politically sustained 3. EA solidarity will not hold 4. Therefore the only solution left is Plan B : - (partial) default/restructuring - Exit/split the euro 14
Markets have reflected these doubts 1250 1000 750 Germany France Italy Spain Greece Ireland Portugal 5-yr Sovereign CDS Spreads (basis points) 500 250 0 Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11 Source: CMA DataVision via Datastream 15
Also affecting confidence in the euro Euro Net EUR Pos itions (LHS) EUR/USD Rate (RHS) 140 120 100 80 60 40 20 0-20 -40-60 -80-100 -120 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 1.72 1.66 1.60 1.54 1.48 1.42 1.36 1.30 1.24 1.18 1.12 1.06 1.00 0.94 Source: Commodity Futures Trading Commission (CFTC) 16
What s missing in the reasoning? Plan A is considered too costly but there is no assessment of the costs of Plan B In fact, Plan B is itself extremely costly, in economic and political terms Plan B can be more costly than Plan A: - For the country itself - For the other euro area countries 17
A closer look at Plan B Plan B has been implemented only in developing countries Over the last 20 years, 19 countries out of 120 IMF programmes had debt restructuring: 1998 Ukraine, Russia, Pakistan, Venezuela 1999 Gabon, Indonesia, Pakistan, Ecuador 2000 Ukraine, Peru 2001 Argentina, Cote d'ivoire 2002 Moldova, Seychelles, Gabon 2003 Dominican Republic, Paraguay, Uruguay 2004 Grenada 2005 Dominican Republic 2006 Belize 18
The experience shows Plan B has large reputation / penalty costs Loss of market access Higher future borrowing costs Trade sanctions by creditor countries Broader costs to the domestic economy Output losses 19
High borrowing costs and contagion Evolution of the EMBIG spreads around crisis episodes (in basis points) 8000 Argentina Uruguay (rhs) Brazil (rhs) 3000 7000 2500 6000 5000 2000 4000 1500 3000 1000 2000 1000 500 Source: Haver Analytics. 0 2001 2002 2003 2004 0 20
EMEs experience is not a good guide The experience of the emerging market economies (e.g. Brady plan) cannot be directly applied to the current situation in advanced economies Default in EMEs was typically the result of a foreign exchange crisis, which increased the burden of the foreign debt in an unsustainable way Fiscal adjustment was unsustainable as it fuelled exchange rate depreciation, which increased the burden of the debt 21
EMEs experience is not a good guide (2) The default/restructuring of the debt in developing countries mainly affected foreign creditors When domestic creditors were involved, very restrictive measures were implemented through administrative and capital controls (e.g. corralito in Argentina) 22
Restructuring/Default in advanced economies Affects domestic residents wealth: - directly through the holdings of government debt by the private sector - indirectly, through the role played by government guarantees in the financial sector Produces strong contagion in other countries 23
Residents hold a large share of government debt Euro area: holdings of government debt by residents and non-residents (end 2009) (share of total debt) 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 Debt held by non-residents of the Member State Debt held by residents of the same Member States 0.2 0.1 0 Source: ECB 24
Impact on the domestic financial system A restructuring of sovereign debt has a direct effect on the solvency of domestic financial institutions inter alia through: - direct holding of government debt - access to collateralised credit - government guarantees 25
As shown by the strong correlations: Greece 1500 1250 1000 Sovereign CDS Alpha Bank EFG Eurobank Ergasias SA National Bank of Greece Piraeus Bank 750 500 250 0 Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11 Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points. Source: CMA DataVision via Datastream 26
Ireland 1500 1200 900 600 300 Sovereign CDS Allied Irish Banks Bank of Ireland Irish Life Anglo Irish Bank (rhs) 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0 Jan.09 Jul.09 Jan.10 Jul.10 Jan.11 0 Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points. Source: CMA DataVision via Datastream 27
Portugal 1000 800 600 Sovereign CDS Banco Comr. Portugues Banco Espirito Santo Caixa Geral de Depositos SA Banco BPI SA 400 200 0 Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11 Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points. Source: CMA DataVision via Datastream 28
Spain 600 500 Sovereign CDS BBVA Caixa d'estalvis de Cataluny La Caja de Ahorros y Pension Santander Banco Popular Espanol SA Caja de Ahorros y Monte de Piedad 400 300 200 100 0 Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11 Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points. Source: CMA DataVision via Datastream 29
Effects on the banking system A sovereign default/restructuring produces major losses for domestic banks and fuels a bank run by depositors, which triggers: - Administrative measures, capital controls - Restructuring of bank liabilities (bonds, deposits..) - Credit crunch 30
Effects on the real economy Very sharp contraction, through: - Direct wealth effects - Credit crunch - Non market measures Social/political repercussions difficult to assess (it s not by chance that default/restructuring has occurred mainly in non-democratic systems) 31
Contagion Default/restructuring in one country tends to produce immediate contagion effects in other countries This would impact on financial stability in the euro area as a whole 32
Contagion 1.5 2 1st Principal Component Cross-sect. average of standardized CDS 1 0.5 0-0.5-1 -1.5 Aug08 Nov08 Feb09 May09 Aug09 Nov09 Feb10 May10 Aug10 Nov10 Source: Datastream and ECB calculations Note: basis points, last observation 27 Jan 2011. Extracted from daily data on 5-year euro area sovereign CDS. CDS series and the Principal Component are standardized. 33
Would exiting the euro make it easier? The fear of exiting the euro would accelerate the bank run by domestic residents (to withdraw euro) The domestic banking system would lose access to euro area financial market and to ECB refinancing, and would have to reduce in parallel its assets The redenomination of financial instruments in new (devalued) currency would trigger crossborder litigation but possibly also within the country The country would lose access to EU facilities and funds 34
Is there an optimal timing? When primary balance is achieved, and thus the government does not need to tap the market The negative impact of Plan B is not lower while most of the costs of Plan A have been paid (especially politically) When markets are better prepared (now?) The experience of Lehman Brothers collapse, which was anticipated for some time, shows that markets are never fully prepared for such a systemic event 35
To sum up Plan B implies: Restructuring Wealth effect Demand shock Impact on the banking system Investment Lower capital stock Supply shock Plan A implies: Increase in primary surplus Demand shock 36
Plan A 37
Plan A Plan A is made on the basis of an assessment that the country is solvent Plan A consists of: 1. Fiscal and structural adjustment in the member state to ensure debt sustainability 2. Reform of the governance of euro area to safeguard stability in the euro area 38
Assessing solvency The solvency of a sovereign is different from that of a company or a financial institution Solvency of a sovereign depends on ability/willingness to implement the adjustment programme, against any alternative scenario In particular, the ability/willingness to: - tax (personal, corporate, special..) - cut expenditure - sell assets 39
Debt sustainability analysis The adjustment programme defines a primary budget surplus which would stabilise and reduce over time the debt/gdp, on the basis of: - the interest rate level -growth - the level of debt 40
Debt stability conditions Primary balances needed to stabilise debt-to-gdp ratio Spain Portugal Ireland Greece Debt-to-GDP ratio projected for 2012* 73.0 92.4 114.3 156.0 r-g *European Commission autumn 2010 forecast 2 1.5 1.8 2.3 3.1 4 2.9 3.7 4.6 6.2 6 4.4 5.5 6.9 9.4 Primary balances needed to stabilise the debt-to-gdp ratio (at the level projected by the European Commission for 2012) in the long-run (steady state) under different assumptions for the interest rate-growth differential 41
The adjustment is substantial: Greece Greece: projected general government debt and primary balance under current EU/IMF programme (percentage of GDP) 15 160 10 5 120 0 80-5 -10 Primary balance (% of GDP) (lhs) General government debt (rhs) Real GDP growth (percent) (lhs) 40-15 0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: IMF - Second review under the Stand-By Arrangement 42
And in Ireland Ireland: projected general government debt and primary balance under current EU/IMF programme (percentage of GDP) 15 160 10 5 120 0 80-5 -10 Primary balance (% of GDP) (lhs) General government debt (rhs) Real GDP growth (percent) (lhs) 40-15 0 2009 2010 2011 2012 2013 2014 2015 Source: IMF - Staff Report - Request for an extended arrangement The primary balance figure for 2010 has been corrected for the one-off impact of government support to Irish banks 43
But not unprecedented General government primary balance (as a percentage of GDP) Ireland 10 140 5 120 0 100-5 80-10 60 1981 1982 1983 1984 1985 1986 1987 1988 1989 primary balance real effective exchange rate (1980=100) Sources: OECD, IMF 44
The interest rate level The interest rate on the programme is aligned with IMF rules and procedures Interest rate ± 6% can ensure debt sustainability What is key is the rate at which countries have borrowed, from the market or through the IMF/EU programme If successful, the Program can be lengthened (standard procedure in the IMF) EFSF could be made more effective, e.g. linking the interest rate to performance (while remaining non-concessional) 45
The debt level The higher the debt level, the higher the primary surplus required to stabilise the debt However, a primary surplus is needed in most cases In the case of Greece, the primary surplus required to stabilise and reduce the debt after 2013 is ± 6% If the debt were cut by one-third, the primary surplus would still be relevant 46
Debt stability conditions (repeat) Primary balances needed to stabilise debt-to-gdp ratio Spain Portugal Ireland Greece Debt-to-GDP ratio projected for 2012* 73.0 92.4 114.3 156.0 r-g *European Commission autumn 2010 forecast 2 1.5 1.8 2.3 3.1 4 2.9 3.7 4.6 6.2 6 4.4 5.5 6.9 9.4 Primary balances needed to stabilise the debt-to-gdp ratio (at the level projected by the European Commission for 2012) in the long run (steady state) under different assumptions for the interest rate-growth differential 47
Restoring sustainability The previous slide shows that if the primary surplus needed to achieve sustainability is considered too high because the market interest rate is high, there are two ways to restore sustainability: - reduce the interest rate burden (and lengthen the maturity), while keeping it non-concessional - haircut on debt For (official) creditors the first solution is preferable because it involves no capital loss 48
Market ways to reduce the debt burden Under discussion: buy back at market prices (lower than nominal), by the member state or through the EFSF, subject to strict conditionality Win-win situation: - reduces the debt burden - provides market liquidity - short-term investors can sell (at a loss) 49
Restoring pre-crisis growth will be difficult Real GDP (average growth 1999-2008) Real GDP per capita (average growth 1999-2008) 6.0 4.0 5.0 3.5 4.0 3.0 2.5 3.0 2.0 2.0 1.0 1.5 1.0 0.5 0.0 0.0 Ireland Greece Spain United States United Kingdom Euro area Portugal Germany Japan Ireland Greece Spain United Kingdom United States Euro area Germany Japan Portugal Source: European Commission s economic forecast autumn 2010 Note: Real GDP per capita refers to gross domestic product at 2000 market prices per head of population. 50
But growth is key Restore competitiveness - mainly through domestic adjustment Lack of exchange rate flexibility - not an excuse Structural reforms are essential 51
Devaluation is no panacea Trade openness across euro area countries (exports plus imports in % of GDP, nominal) 180 160 140 120 100 80 60 40 20 0 France Italy Greece Spain Portugal Euro area Finland Germany Cyprus Austria Slovenia Netherlands Slovakia Belgium Malta Ireland Source: European Commission 350 300 250 200 150 100 50 0 Luxembourg 52
Structural reforms start to be implemented Greece Competition and productivity Deregulation of transport and energy sectors Opening up of closed professions Implementation of Services Directive Restructuring of state-owned enterprises and bringing in of private management 53
Labour market flexibility and labour supply Reduction of employment protection Facilitating use of part-time work/flexible work arrangements Reform of the arbitration system Pension reform Extensive reform to improving long-run sustainability Simplification of fragmented system, with universal, binding rules on contributions and corresponding entitlements Increase in retirement age to 65 and contributory period for full pension from 35 to 40 years 54
Ireland Financial system: Stabilise and downsize the banking sector Improve solvency and funding of viable banks Quick resolution for non-viable banks Increase confidence in viable banks by fully recognising losses in loan portfolios Burden-sharing by holders of subordinated debt Product and labour markets Reduction of the minimum wage Reform of the unemployment benefits system Deregulation of sheltered sectors of the economy 55
Portugal 50 structural measures announced mid-december 2010 to be legislated by end-march 2011, including: Fostering the export sector and investment in R&D with tax incentives Reducing administrative burdens of the export sector Strengthening wage flexibility and reducing overall employment protection Improving the rental market Reducing the size of informal economy 56
Spain Product markets End 2009: transposition of Services Directive Early 2010: streamlining of procedures for business creation Labour market June 2010: improvements to some aspects of hiring system and collective bargaining, improving firms flexibility 57
Spain Pension reform January 2011: approval of draft pension reform bill, agreed with social partners, including gradual increase in the retirement age (from 65 to 67) and increase in contributory period for full pension (from 15 to 25 years) Financial system Mid 2010: restructuring of the cajas de ahorro, reform of legal framework, extension of options for issuing equity capital 58
The impact on competitiveness is starting Compensation per employee (Annual % changes) 7 Germany Greece Ireland Portugal Spain 6 5 4 3 2 1 0-1 -2 Average 1999-2008 2010 2011 2012 Source: European Commission (Autumn 2010 forecast). 59
European governance has evolved In less than one year: Financial support for Greece (April 2010) Creation of the EFSF (May 2010) Reform of the SGP (October 2010) Change in the Treaty for ESM (Dec 2010) Comprehensive Package (March 2011) If not sufficient We will do what is needed 60
Why so slow? Fiscal adjustment and governance reform are costly in the short term, from an economic and political view point Governments tend to take the political cost only when they can explain to their constituencies that the alternative (default, euro instability) is much more costly The evidence that the alternative is more costly emerges only under the pressure of the markets 61
Action has been delayed 1000 Greece Spread over German 10-year government bond yield (2009-2010; daily data; in basis points) 900 800 22 February 2010 EC/ECB mission 700 600 500 400 300 200 100 0-100 11 May 2010 Rescue plan Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Sources: Bloomberg, Thomson Reuters Datastream and ECB calculations. Data: Bond yield spreads vis-à-vis the German 10-year government bond, end-of-day data. 62
Action has been delayed Ireland Spread over German 10-year government bond yield (2010; daily data; in basis points) 700 600 500 11 May 2010 Rescue plan 28 August 2010 Dow ngrading by S&P 400 300 200 28 Nov 2010 Announcement of the IMF/EU program 100 0 07 Dec 2010 Presentation of 2011 budget -100 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Sources: Bloomberg, Thomson Reuters Datastream and ECB calculations. Data: Bond yield spreads vis-à-vis the German 10-year government bond, end-of-day data. 63
Conclusions Plan A is painful, but most likely it is less costly than the alternative: - for the debtor countries - for the creditor countries There are ways to make Plan A less costly, more effective, conditional on a positive adjustment track Need to avoid moral hazard 64
Conclusions (2) Euro area governments are committed to Plan A Plan A will deliver stronger fundamentals over the medium term for the euro area and for the member countries 65