How Far Will the PIIGS Fly?

How high is the risk of insolvency for Portugal, Ireland, Italy, Greece and Spain, the most indebted countries in the Euro? Fears are spreading in financial markets, raising interest differentials (350 basis points for Greece, and more than 150 points for Ireland), and CDS premia on sovereigns’ default, weakening the Euro, down 9% from December, and sending shivers across European equity markets. Are these fears well or ill-founded? What lessons can we learn from past crises?

The nearest European crisis, the currency crisis of 1992, witnessed speculative attacks against “weak” currencies, and led to the ejection of the Italian Lira, the British Pound, the Spanish Peseta, the Swedish Krona, from the European Exchange Rate Mechanism, the system of pegs to the Deutsche Mark. But the “attacked” countries managed to devalue their way out of the recession. The problem today is exactly that the Euro makes this impossible. Given that PIIGS’ debts are mainly denominated in Euros, a devaluation with opting out would lead straight to default.


More interesting is the comparison with the debt crises of emerging markets. Put simply, debt crises come in three “pure” types[1]: solvency crises (signaled by a high ratio of external debt to GDP, and a high ratio of public external debt to tax revenues); liquidity crises (that occur when, external debt is concentrated at short maturities, and is typically signaled by high external financing requirements, short-term debt and current account deficit, relative to reserves); “macro-exchange rate” crises, that typically follow a sharp recession and an overvalued real exchange rate.

Table 1 shows the indicators of vulnerability for the PIIGS in 2009. Imbalances are macroscopic. The case of Ireland is the most serious, because it shows symptoms of all the three crises types, solvency, liquidity and recession-overvaluation. The Irish foreign debt is equal to 9 times (!) GDP, the public sector  external debt is more than twice the fiscal revenues, the  reserves of the Bank of Ireland covering only a 460th (!) of financing requirements, the real exchange rate has appreciated by 13% since 2005, GDP has fallen by 7.5% in 2009. The Italian case is the least bad.

Note that fiscal imbalances, certainly a risk factor for all countries, are due largely to the recession. For example, Spain in 2007 had a budget surplus of about 2% of GDP, while in 2009 finds itself with a deficit of 12%. In short, if (and I stress the if)  the same vulnerability criteria for assessing Emerging Markets’ vulnerabilities  were to be used for the PIIGS,  all the countries in the club would be classified high default risk (probability of a crisis in 2010 of 47% , according to Manasse and Roubini (2009))[2]. Fortunately, at least so far, financial markets have applied to European countries much more “tolerant” criteria. The membership of the Euro, access to financial markets and to intergovernmental credit lines, the participation in the Euro System of Central Banks, and the lack of recent episodes of default, are presumably behind this preferential treatment. A doubt remains: how far will the Euro-PIIGS fly?


[1] see Paolo Manasse and Nouriel Roubini, 2009, “Rule of Thumb for Sovereign Debt Crises”, Journal of International Economics  

[2] See the reference in the previous foot note.  

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