A spectre is haunting Europe (coming from Dubai): the spectre of sovereign debt default.
Loaded with massive debts and crippled public finances due to the crisis, many European countries, such as Greece, Ireland, Spain, the Baltics to the Balkans, are now considered at risk by rating agencies as well as and markets. The concerns focus particularly on Greece, while Italy, at least for now, seems out of the spotlight. But is the sustainability of public debt really different in the two countries? Simple calculations show that there are many similarities, and some important differences.
On December 7, Standard & Poor’s put the Greek sovereign debt, currently rated A- on “negative watch”, which is likely to lead to a downgrade. The next day, Moody’s downgraded it to BBB +, with a “negative outlook”. Meanwhile, CDS spreads on Greek debt, increased dramatically to 211 basis points, the peak since March 2009. In comparison, the CDS spreads for Italy are “only” 81 basis points. Currently, investors require a premium of 2.31 percentage points to invest in Greek rather than German debt (the 10 years Bund). For Italy, the interest rate premium is “only” 0.86% (source: Financial Times).
The downgrading of the Greek debt has one important consequence: starting in 2010, the European Central Bank, will strengthen the “requirements” for accepting ABS (Asset Backed Securities) as collateral, in exchange for liquidity funding: these securities will need at least two ratings, of which the lowest should be “A”. Should the same requirement apply to government debt, as it seems likely, a generalized downgrading of the Greek debt will prevent (Greek) banks from using these cheap credit lines in order to invest in Greek sovereign debt (to be pledged to the ECB). An important source of demand for Greek bonds (and of profits for Greek banks) would therefore vanish, with potentially serious destabilizing effects.
In order to compare the sustainability of public debt in the two countries, we must (at least (1)) consider three factors: the primary deficit (the deficit net of interest expense), the difference between the real interest rate (i.e. adjusted for inflation) and the rate of growth of GDP, and the amount of outstanding debt
Italy and Greece (see Table 1, “current” scenario) are not too dissimilar in terms of inflation, nominal interest rate and debt/GDP ratio. The main difference, however, lies in the different sources of debt instability. In Greece the problem lays in the huge primary deficit, probably around 7.5% of GDP, which compares with about 2.5% in Italy. By contrast, the explosive dynamics of Italian public debt has its roots in the strong recession that followed the international crisis, which has almost spared Greece. The recession raises the accumulation of debt relative to GDP through the differential between the real interest rate and the rate of growth. It is easy to show that the primary surpluses required for stabilizing the debt GDP ratio in the two countries, at the current rates, amount to 5.75 (for Greece) and 10.5 (for Italy) points of GDP (see the “stabilizing deficit ”column in the Table). Thus, both countries would require a budget correction (last column) of about 13 percent of GDP!
The different source of the fiscal imbalances, however, implies an important advantage for Italy: unlike Greece, the country could greatly benefit from the economic recovery and from higher inflation. The Table (scenario 1) shows that with a rate of growth of 1%, the fiscal adjustment required in Italy would fall to 4.6% of GDP, while that required in Greece would remain very high, at 11, 2%. Similarly, a very valuable help could come from the European Central Bank: if inflation were to rise to 3% (scenario 2), Italy could stabilize the debt ratio simply by running a balanced (primary) budget, which would require budget cuts of about 2.5% of GDP, a politically feasible adjustment, which should not kill the recovery.
Footnotes: (1) Here I focus only on the dynamics of public debt, and therefore neglect many other important differences between the two countries, namely their saving ratios, current account/GDP ratio, debt maturity, financial sector soundness etc (this article is also appearing in www.lavoce.info , as well as in my blog )
Table 1: Sustainability of public debt in Italy and Greece
Click to enlarge table