Sovereign Debt Crisis: Where Do We Stand?

There have been significant developments in a number of key areas since the European Union (EU) summit in December: A potential Greek debt default, new consolidation measures in Italy and Spain, the search for additional funds to extend the rescue fund and the European Central Bank’s (ECB’s) role in the fight against the crisis. In this note, we give an overview of the current state of play. The relief in the sovereign debt crisis that we have witnessed since early December is not likely to last.

Greece: The Tragedy’s Next Act

On January 17 the troika – consisting of representatives of the EU, the ECB, and the International Monetary Fund (IMF) – once again travelled to Athens to review Greek progress in implementing reforms and budget consolidation measures. Moreover, the visit marks an important step in Greece’s quest for the second bailout package, which was agreed in principle last summer and then modified at the recent summit in November. At present, however, there are still some significant obstacles standing in the way of a positive decision:

• So far, Greece has failed to reach agreement with its private creditors on the details of the “voluntary” haircut. In the event that the negotiations fail or result in a smaller reduction in Greek debt, the IMF is calling for a larger contribution by the European Financial Stability Facility (EFSF) to the second bailout package. Press releases outlining the progress made during negotiations portray a mixed picture, with some suggesting that the negotiations are drawing to a successful close, while others report seemingly irreconcilable differences.

• Greece has fallen markedly behind its consolidation plan. In 2011, the deficit was supposed to have come down to 10% of GDP. Moreover, unless further measures are taken, it also looks set to decline by less than planned in 2012, due primarily to the impact of the domestic recession.

• In addition, Greece is not making sufficient progress in implementing the agreed structural reforms, which is another pre-condition for further financial aid. Thus, for instance, access to certain professions remains limited.

In the weeks ahead, Greece has to push ahead with all of the above issues in order to ensure the release of the next tranche by the troika and the final adoption of the second bailout package. Without the funds, Greece is likely to default no later than March 20 2012, when a EUR 14 bn bond has to be repaid. The risk that Greece may default on its debt is considerable.

Italy: Waiting for Further Structural Reforms

Before Christmas, Italy’s new government pushed another austerity package through parliament. Thus, there is a good chance that Italy may balance its budget by 2013, partly helped by the fact that deficit reduction in 2011 is likely to have come in slightly better than the 3.9% target (chart 1, below). With regards to the badly needed structural reforms, however, no headway has been made so far. During the Christmas holidays, the ministries prepared initial proposals, which are currently being discussed with the unions and the companies. Details are to be provided soon. Our Reform Monitor for Italy will continue to provide updates on this process.1

Chart 1: Budget Consolidation – A Mixed Picture
2011 budget deficit in % of GDP, some figures own estimate,
Portugal: Deficit ratio 1.8% lower thanks to one-off effect

Source: National governments, Commerzbank Research

Spain: Huge Budget Holes

In contrast to Italy, Spain missed its consolidation target by a wide margin last year. According to the new government, the 2011 deficit came to 8.2% of GDP, compared with a target of 6%. Although the Spanish government immediately launched a new EUR 15 bn austerity package of spending cuts and tax hikes, there is a strong risk that Spain will continue to overshoot its consolidation target in the years ahead, as the budget plans of the old government are based on overly optimistic growth assumptions. Thus, the official outlook from April 2011 projected real growth of 2.3% for this year, whereas the current consensus assumes a 0.2% contraction. Even if no further funds are required to support the banking system, the government has to launch additional measures of a similar magnitude to the latest package in order to prevent falling further behind its consolidation plan. Like Italy, the new Spanish government has not yet presented any proposals for structural reforms. Here, too, talks are to be held with the unions and business associations before concrete plans will be presented to the public.2

New Rules in the Euro Zone to be in Place Soon

At December’s EU summit, the majority of EU countries (including all euro countries) agreed to include in their national constitutions a commitment to balanced budgets (or even surpluses). Moreover, it was decided to launch automatic sanctions should a country violate the 3% deficit target, or fail to push its debt-to-GDP ratio below 60% at an appropriate pace. To block the sanctions, a qualified majority in the EU Council will be required in future, whereas so far it had taken approval from a qualified majority of member countries to get this procedure started.

Behind the scenes, there are presently discussions over the concrete form of the respective treaties. However, it remains to be seen which EU countries, apart from the European Monetary Union (EMU) members, will participate. To date, only the UK has refused to back the move although other countries have put them under review. According to German Chancellor Merkel, the agreements should be ready to sign at the end of January, or by March at the very latest.

In Search of More Firepower for EFSF & Co

While discussions are still going on over how the EFSF-leveraging instruments, agreed at the summit in late-October, are to be structured, the politicians have apparently given up hope that they will be able to mobilise more funds for debt-ridden countries this way. Thus, the available funds are insufficient to also support Spain and Italy, if necessary. Of the original EUR 750 bn, just EUR 465 bn would be left if Greece were granted a second bailout package.3 This would be enough to support Italy over the next three years (it requires EUR 450 bn between 2012 and 2014 to repay maturing sovereign bonds4 and to finance its targeted fiscal deficits). For Spain, however, which under such circumstances would certainly also have difficulties, there would be no funds left over. Indeed, in the next three years, Spain’s financing requirement will amount to roughly EUR 270 bn.

Against this backdrop, the search for alternative options to boost the available funds continues:

• In December, the euro countries decided to provide EUR 150 bn in bilateral credit lines to the IMF. It remains to be seen whether other countries will add an additional EUR 50 bn, as was hoped by the EU heads of governments. So far, only some smaller countries have agreed to contribute. In our view, a decision on the participation of bigger countries such as the UK, the USA or China is not to be expected before the meeting of the G20 finance ministers in February. But even if the funds were ramped up by EUR 200 bn, it would still be impossible to bail out Italy and Spain at the same time.5

• This is probably one reason why agreement was reached at the December summit to review the funding volume of the permanent rescue umbrella, the European Stability Mechanism (ESM), by March. As this is to replace the EFSF and the European Financial Stability Mechanism (EFSM), the current lending capacity is set at EUR 500 bn, unchanged from the present overall EFSF/EFSM ceiling. Against this backdrop, the launch of the fund may not only be brought forward (Merkel and Sarkozy hope it will be running around midyear, which, however, still requires ratification from several national parliaments – including the Bundestag), but its lending capacity may also be boosted. The latter, however, is likely to meet with resistance, particularly in Germany and some of the smaller euro countries.

• Although they are not at the top of the agenda at present, common bonds are by no means off the table. In December, the EU Commission presented a paper, which discusses several options. Moreover, the governments of the peripheral countries, but also France, have repeatedly pointed out that such common bonds would be an effective way to combat the crisis. With this in mind, we suggest that they are likely to re-emerge in the political discussion from time to time.

ECB and Bundesbank are Moving …

At least for now, neither the funds supplied by the governments nor the reform measures to date will suffice to restore investor confidence in peripheral bonds. On the back of this, there continues to be strong pressure on the ECB to take a more aggressive stance. Indeed, the central bank has already caved in to some calls. In December, it allotted EUR 489 bn to banks in the first three-year tender and thus substantially helped to reduce their refinancing problems. In particular banks from the peripheral countries apparently used these funds – more or less voluntarily – to buy shorter maturity bonds of their own countries. On the back of all this, uncertainty in the financial markets has recently declined markedly (chart 2, below).

Chart 2: Uncertainty Declining Visibility of Late
ARPI2, Commerzbank index of global risk perception

Meanwhile, even the Bundesbank seems to have softened somewhat. Recent speeches by Bundesbank representatives suggest that in the end the Bundesbank will provide loans to the IMF.6 So far, the Bundesbank wanted to ensure that the additional credit lines are not merely used as a backdoor to illicit monetary financing. Hence, it urged that new resources be transferred to the IMF’s general funding account rather than a special bailout fund for the euro countries. Moreover, to dispel suspicions of evasive transactions, the Bundesbank also insisted on fair burden sharing, to make sure that additional funding is not only supplied by the euro countries. And last but not least, it made it clear that the Bundestag must support the expansion of the IMF funds, as the credit lines are associated with additional risks.

… And are Playing an Increasing Role in the Fight Against the Crisis

Following from the above, the developments in recent weeks have been more or less in line with our baseline scenario. Efforts of the peripheral governments to consolidate their budgets are continuing, and more structural reforms are looming in the months ahead, above all in Italy and Spain. However, neither the national measures nor the political efforts to ramp up funds to fight the crisis are sufficient to restore investor confidence over the long term. Against this backdrop, the ECB will be forced to play an ever greater role in the fight against the crisis. While an escalation may thus be prevented, it is unlikely to put an end to the crisis. And of course, over a long-term horizon, risks to price stability and to the stability of monetary union as a whole will increase on the back of the central bank’s stronger role. The sovereign debt crisis will thus maintain a tight grip on the financial markets this year. The relief in the sovereign debt crisis that we have witnessed since early December is not likely to last.



1 See “Reform Monitor Italy”, Economic Insight, December 15 2011.
2 See also “Spain: The grace period is over”, Week in Focus, January 6 2012.
3 The total lending volume of EUR 750 bn is contributed by the EFSF (EUR 440 bn), the EU funds (EFSM, EUR 60 bn) and the IMF (EUR 250 bn). Of this amount, roughly EUR 68 bn have been reserved for Ireland and some EUR 78 bn for Portugal. On top of that, the three sources have probably contributed around EUR 140 bn to the two Greek bailout packages, the remainder was provided via bilateral credits of other euro countries.
4 Not included in the figures for Italy and Spain are outstanding money market papers, for which Greece, Ireland and Portugal can also secure refinancing on the market at present.
5 This holds all the more, because EUR 38 bn of the additional credit lines from the euro countries are to be provided by Italy and Spain, whereas no contributions are expected from Greece, Ireland and Portugal.
6 In the other Euro zone countries, the funds for the IMF are supplied by the governments. In Germany, they are provided by the Bundesbank.