Though the combined European Union (EU)-International Monetary Fund (IMF) package worth 750 billion euros averted a default by Greece, the European sovereign debt problem is far from over. This year alone between May and December $588 billion worth of debt will come up for rollover. Will the EU and the IMF be able to arrange similar rescue packages for every country that finds itself in a tight spot? Moreover, these problems will not end with 2010 but will continue far into the future. What is as worrisome is the sheer breadth of the problem: not just Greece, several other nations within the EU - France, Germany, UK, Portugal, Ireland, Italy, and Spain - are today burdened with unsustainable levels of debt.
Genesis of the problem
The common perception is that Europe's sovereign debt woes are the result of the 2008 financial crisis. That is not true. According to a recent research report from Canada's TD Bank Financial Group, except Ireland and Spain, the public finances of all the other EU countries mentioned above were already in tatters at the onset of the 2008 crisis. What is undeniable, however, is that the crisis, by forcing governments to undertake greater public spending at a time when their revenues were falling, exacerbated the situation.
Adverse demographics. Why are these countries reeling under heavy debt burdens? A variety of factors are responsible: anaemic economic growth, fiscal profligacy, etc. But one of the most important underlying factors at play is demographics. Many of these countries have an aging population combined with generous pension and healthcare provisions.
According to a 2009 report published by the European Commission, public age-related spending of EU members will rise between 2008 and 2060. Public pensions will contribute most to this rising bill. Greece, Spain, and Ireland are expected to suffer the steepest jumps in spending.
How serious is the problem?
According to projections by the Organisation for Economic Co-operation and Development (OECD), by the end of 2011 both Italy and Greece are expected to have gross debt to GDP ratios of close to 130 per cent; Ireland, UK, Portugal and France are expected to be in the range of 90-100 per cent; and Germany and Spain, 85 and 75 per cent respectively.
Market participants use gross debt to GDP ratio as a measure of fiscal solvency. Whenever this figure crosses 100 per cent, jitters set in. However, it does not very accurately reflect how solvent a nation is, because while it takes into account the liabilities, it ignores a nation's financial assets.
Net debt (that is total outstanding government debt minus total financial assets) to GDP ratio is a more accurate measure. Going by this measure, all countries are below 70 per cent of GDP, except Italy and Greece, which are at the risk of breaching the 100 per cent mark in the near term.
According to economists at TD Bank Financial Group, besides net debt to GDP, one also needs to look at the composition of the debt: to what extent is the government's debt financed by private domestic savings and to what extent by foreign debt, since foreign borrowing is far riskier than domestic borrowing. Spain, Greece, Portugal and Ireland have all generated insufficient private savings for funding their demand for fixed capital, and have all increased their dependence on foreign investors. They are now hostage to foreign investors' see-sawing risk perceptions.
Whose situation is the worst? TD Bank Financial Group has devised an index that takes into account several factors such as current account balance, debt to GDP ratio, debt held abroad, maturity profiles, and ratings from rating agencies to gauge these nations' risk profiles. According to their index (See table: Most vulnerable), the most risky country is Greece, followed by Portugal, Italy, Ireland, Spain, France, and Germany.
Near-term challenges
In future the markets will keep a close eye on the debt maturity calendar of European countries (see table). What yields lenders demand for refinancing debt will determine a country's fate.
European banks hold considerable amounts of sovereign debt on their books. Increasing yields have already caused the prices of these holdings to decline. If there is a default, a lot of banks, even those belonging to nations that are in good health, will take losses. Some of these banks have already received government bailouts during the 2008 crisis. Their governments may not have the resources for a second bailout.
What is needed, according to economists at TD Bank Financial Group, is coordinated action among Euro zone countries and the IMF to prevent a default by even one country. Piecemeal packages for individual countries will not suffice; if that is done, markets will remain volatile for a long time.
Longer-term remedies
Over the long term, all these nations need to undertake significant fiscal consolidation and come out with roadmaps that are credible and transparent. Reducing sovereign debt will entail raising tax rates, reducing government expenditures, especially on entitlements (pension and healthcare related). All these measures have the potential to cause severe social and political unrest, and will require a lot of political will on the part of these governments.
Since all these countries share the same currency (and hence cannot devalue their currencies in order to enhance their export competitiveness), those with higher labour costs are at a disadvantage. They lose market share and also import a higher proportion of their domestic consumption. Their government's fiscal stimuli leaked out and gave filiip to demand in their more competitive neighbours. These governments need to allow for more flexible labour regulations. They also need to curtail unemployment benefits so that it becomes more attractive for people who can work to go back into the active workforce.
A bleak future
Fiscal austerity could result in low economic growth and high unemployment in the Euro region for a long time. The region could be a drag on global economic recovery. Low growth will also mean lower revenues for governments, which will make their task of deficit reduction harder. What is certain is that the adjustment process will be painful and long drawn out.
India, which has an economy predominantly driven by domestic consumption, should weather this crisis well, just as it withstood the Asian currency crisis and the 2008 financial crisis. Should a default happen, global risk aversion will rise and foreign institutional investors (FIIs) could withdraw funds from the Indian markets. But when they retrieve their confidence, they will flock to markets like India in search of higher returns. If you have faith in the long-term India growth story, use the market declines (precipitated by global events) to buy equities at attractive valuations.
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