Sovereign debt crisis news:  bond yield spreads mostly narrow after Greek deal

22 Feb : Yield spreads narrowed further in Italy and Spain after Greek bailout approved.

19 Feb: Massive trade union protests against Spain's labour reforms.

15 Feb : Suggestions that approval of Greek bailout package may be delayed to EU summit of 2 Mar'12, awaiting proof of implementation of austerity measures by Greece.

Strong demand at Portuguese treasury bill auction with lower yields than in previous auction. Portuguese government claims major structural reforms well underway.

14 Feb : Further steep decline in Portuguese bond yields and spreads. Italy and Spain borrowed at significantly lower rates in successful auctions in spite Moody's downgrades.

13 Feb : Greek parliament approved austerity budget demanded by EU/IMF amid violent protests in the streets. Still required are written assurances from politicians that measures will be implemented after the elections pencilled in for Apr'12 as well as clarification about some of the austerity measures.

Portugal's adherence to its bailout programme to be reviewed by EU/IMF/ECB this week. Progress in structural reforms have been made (see below).

Moody's put France and Austria on negative downgrade watch, downgraded Italy, Spain, Portugal.

3 Feb: Euro zone finance ministers cancelled meeting which was to sign off on Greece's second EUR130bn bailout programme after Greek political parties refused to agree to new austerity measures demanded by the representatives of EU, ECB and IMF ("troika").

Yield spreads narrow as confidence rises that sovereign debt crisis is under better control. Expected that banks will borrow substantial funds from ECB at 28 Feb 3yr loan offer.

2 Feb: Spanish government has presented tough proposals to restructure the banking system. Mergers are being encouraged. Banks are to reduce their real estate portfolios by putting properties on the market.

Italy's PM Monti said he will force through labour market changes opposed by trade unions.

France and Italy held successful bond auctions at lower interest rates than a month earlier.

Bank of Ireland cut its 2012 growth forecast to 0.5% (from Oct'11 forecast of 1.8%)

                          Country details below 

10-yr Government bond yields

The euro zones sovereign debt crisis will end once the bond yields of the problem countries are back at affordable levels (or one or other country leaves the monetary union). This requires the budget deficits of the problem countries to shrink. The debt crisis reached its most acute phase so far in Nov'11 after the 26-27 Oct'11 summit failed to come up with credible solutions. The measures taken in Dec'11 by the ECB and by the EU summit calmed the situation. Most bond yields have declined significantly below their Nov'11 peaks on hopes of progress towards lower deficits. Yield spreads, though lower, remain high.

More country details below

Country details below

Spain: resolve of new government to be tested
Budget deficit: 2011: 8.4% (4.4% targeted for 2012); Debt 2011: 70% (rising to 73% in 2012)

Centre-right People's Party won absolute majority in 20 Nov elections, took office 21 Dec'11.  2011 budget deficit 8.4% of GDP rather than the 6% targeted. Mainly due to overspending by regional governments. Government responded with EUR9bn of spending cuts and EUR6bn of tax hikes.

Government confirmed 4.4% deficit target for 2012. But finance minister (and IMF) expressed doubts because of recession. Also government to raise pensions in line with inflation. Occasional rumours Spain may request bailout from EFSF fund and IMF. Strict budgetary controls over finances of regions to be introduced.

IMF said 24 Jan'12 that it expects a prolonged recession in Spain which will make it impossible for country to respect its 2012 budget deficit target of 4.4% (2011 outcome ≥8%).

Government announced tough proposals to restructure the banking system. Mergers are being encouraged. Banks required to set aside EUR50bn provisions to clean up their balance sheets. Banks are to reduce their real estate portfolios by putting properties on the market. Expected to lead to takeover of weak banks by stronger rivals.

Labour reforms to allow companies to set wages outside industry collective bargaining agreements. Central government and state companies to be reorganised and rationalised. New round of budget cuts in Mar'12 when 2012 budget will be presented. Implementation of reforms difficult, success in curbing deficit uncertain, hampered by weak economy.

Massive trade union protests against Spain's labour reforms on 19 Feb.

Belgium: getting a grip at last
Budget deficit: 2011: 4.2% (2.8% targeted for 2012); Debt 2011: 97% (declining to 96% in 2012)

Political deadlock over 2012 budget finally cleared 26 Nov'11. Coalition government formed  540 days after election, led by Walloon Socialist Elio De Rupo. Budget deficit estimated at 4.2% for 2011, deeper than planned as growth slipped. Moody's cut credit rating two notches to Aa3.

Early in Jan'12 government, prompted  by European Commission, introduced EUR1bn spending freeze to ensure 2012 deficit target of 2.8% is respected. Permanent spending cuts expected in Feb'12 budget review.

France: near the edge
Budget deficit: 2011: 5.8% (4.6% targeted for 2012); Debt 2011: 85% (rising to 87% in 2012)

French bond yields rose on fears that faltering growth may raise budget deficit and lose the country's AAA credit rating. Additional EUR65bn of tax increases and spending cuts spread over five years announced in Dec'11.

Early in Jan'12 President Sarkozy said he would now concentrate on promoting growth and employment.  German style labour reforms with flexible labour contracts and lower payroll taxes (offset by 1.6 percentage point VAT hike to 21.2%) to be introduced. A financial transaction tax is to be introduced.

Government cut its 2012 GDP growth forecast to 0.5% (from 1%).

Germany: safe haven status restored
Budget deficit: 2011: 1% (1% targeted for 2012); Debt 2011: 82% (declining to 81% in 2012)

Bund yield rose after failed bond auction 23 Nov'11 on fears Germany will have to shoulder more of bailout costs. Yield spread between 10-yr Bunds and Treasuries widened to 31 basis points end Nov'11.

Since spread reversed as Bunds revert to safe haven status. 9 Jan'12 even brought short term debt with negative yield. Is unprecedented, "flight to safety".

"Firewall": to approach EUR1tr

In order to prevent default in one country, say Greece, spreading to other problem countries a "firewall" is required. To be able to dispose of sufficient resources for eventual bailouts of Italy and/or Spain larger sums than currently available is deemed necessary.

Running the two bailout funds EFSF (EUR250bn currently available) and ESM (to dispose of EUR500bn) in parallel is being discussed as a way to augment the resources available. With the addition of EUR150bn made available to IMF, the total theoretically  approaches EUR1tr considered necessary by IMF.

IMF seeking USD500bn additional resources to boosts its ability to assist problem countries. USD200bn to come from euro zone countries. China appeared ready to contribute. If successful firewall will exceed EUR1tr.

 BUDGET DEFICITS
 

Fiscal Compact (Treaty on Stability, Coordination and Governance in the Economic and Monetary Union)

The treaty was approved at the 30 Jan'12 EU summit by 25 of the EU's 27 members (UK, Czech Republic declined).  It is to be signed 1 Mar'12, then ratified by national parliaments and to enter into force in 2013 once ratified by at least 12 euro zone members. Only countries which have ratified the Treaty will have access to the ESM bailout fund.

The purpose of the treaty is to act as "debt brake", limiting a country's structural budget deficit to 0.5% of GDP. The actual (i.e. cyclical) budget deficit is to be in balance or in surplus.

Various temporary deviations are permitted in "exceptional circumstances" (including severe recessions). Also structural reforms are allowed to slow the path towards the 0.5% for countries exceeding it.

(The various deviations have been criticised by the Bundesbank as making the Treaty too lenient.)

The emphasis on the structural  deficit is to allow a deeper actual deficit in recessions, but requires budget surpluses in boom times.

This to pre-empt a situation where a steep rise in tax revenue in a boom leads to a steep rise in public spending which, when the boom ends, leaves a deficit (as happened in the case of Spain and Ireland during the 2008-09 crisis).

Non compliance of the budget and debt targets are to be reported to the European Court of Justice (ECJ) which may impose a fine of up to 0.1% of the GDP of the offending country (unless waived by a qualified majority).

An adjustment path ("road map") is drawn up by the European Commission to trace the path along which a deficit country is to move to the target of a structural budget deficit of 0.5%.

If a country's debt exceeds the norm of 60% of GDP, the gap is to be closed by 1/20th each year.

A country's debt issuing plans are to be vetted ex-ante by the European Commission and Council.

The Treaty also provides for measures to promote convergence and competitiveness. Structural reforms are to be discussed ex-ante to promote best practice.

Euro zone summit meetings are to be held at least twice a year (fulfilling  a long standing French demand for an "economic government" of the euro zone).

For more details see European-Council

Various observers have qualified the Treaty as of little use. How effective the Treaty will be depends firstly on the determination of the European Commission to apply it. And, secondly, on the willingness of the defaulting country to implement the restrictive measures demanded by the Commission.

Some observers also consider that difficulties may arise in national parliaments during the ratification process.

Government debt

When does a debt burden become unsustainable?
The example of Greece

It is difficult to pinpoint in advance when a country's debt burden becomes unsustainable. But its clear that it cannot rise forever. The debt burden is measured by the debt stock/nominal GDP ratio. The stock of debt rises as the government runs budget deficits while nominal GDP rises as the economy grows and the price level rises. If the debt rises faster than GDP, danger may lie ahead.

With a rising debt burden the financial markets may suspect at some point that the debt may become too large for the government to be able to meet its repayment obligations. As the risk of default rises the market will demand higher interest rates to compensate for the higher risk.

Higher interest payments raise the debt service payments, thereby worsening the budget deficit, further accentuating the risk and increasing the debt service payments, creating a vicious spiral which inevitable leads to default if no remedial action is taken. Even then fiscal restrictions may not reduce the debt burden if the measures reduce growth of the economy or lead to a recession.

Greece's debt ratio was stable for most of the noughties at around 100, not causing any concern. The yield spread between Greek and German 10-year bonds was in the range of 20 to 30 basis points.
 

S ≥ (r - g) D

see De Grauwe. See also Gross and Alcidi, "Adjustment Difficulties and Debt Overhangs in the Eurozone Periphery", May 2011.

Country notes based on Nov'11 data
updated 13 Dec'11

Germany is the only country (of those listed in the table) with a primary budget balance expected for 2012 (a surplus of 1.3% of GDP), larger than the primary budget balance required to stabilise the debt (a deficit of 0.2% of GDP). The latter is particularly low as the economy is expected to grow in nominal terms  faster than the interest rate it may have to pay on its government debt. There is considerable scope for reflation.

France is seeing slower nominal GDP growth in 2012, calling for a primary budget surplus of 1.2%. But a primary deficit for 2012 of 2.5% is expected. A tightening of 3.7% of GDP is thus required to stabilise the debt.

Italy is handicapped by modest nominal GDP growth, high interest rates and a large debt. This calls for a primary budget surplus of 5.9% of GDP to stabilise the debt in 2012. But as a surplus of 3.1% of GDP is expected, only an additional tightening of 2.8% of GDP is required, less than in the case of France.

Belgium: Expected nominal growth of the economy is below the interest rate, calling for primary budget surplus of 1.9% of GDP. The expected primary deficit is 1.3%, thus require an adjustment of 3.2%.

Spain suffers from modest nominal growth and high interest rate but a low debt burden. A primary budget surplus of 3.3% of GDP is required compared to an expected 2012 deficit of 3.5% of GDP, thus a massive 6.7% correction is required, well above what is required in Italy.

Greece: the interest rate is around 30%, the economy in deep recession and the debt is newly two times GDP. This calls for a primary budget surplus of 66% of GDP. In fact Greece does not pay the market rate for its funds, but the subsidised rate of the bailout fund of 3%. Also its debt/GDP ratio is to be reduced to 120% by imposing a debt restructuring. The austerity measures already imposed should bring a primary surplus of 1% in 2012.. This reduces the required correction to 5.7%. Still a mammoth task for an economy already in a deep recession. A drastic further write down of its debt may be unavoidable. Hope is this can be avoided until progress elsewhere reduces risk of contagion.

Portugal: interest rates are around 12%, the economy is shrinking and the debt exceeds GDP. This calls for a primary budget surplus of 15.6% of GDP. Portugal also does not pay the market rate and the austerity measures are expected to bring a 0.8% primary surplus in 2012. This reduces the additional required correction to 4.6%. Still a formidable task.

Ireland: interest rates are high, as is the debt, but the economy is growing. A primary budget surplus of 8% of GDP is required as well as the elimination of the 2012 expected primary budget deficit of 4.3%, a turnaround of 12.2% of GDP. Ireland also does not pay the market rate, but the subsidised rate of 3%. This reduces the required correction to 5.7%.

UK: nominal growth exceeds the interest rate and a primary budget deficit of 1.3% of GDP would stabilise the debt. The expected 2012 primary budget deficit amounts to 4.6% of GDP, the correction required thus amounts to 3.3%. The steep fall in gilts, which benefitted from safe haven flows, has benefitted the UK.

US: growth is well ahead of the interest rate on 10-yr Treasuries (which also benefitted from safe haven flows), but the debt exceeds GDP and the primary budget is expected to show a deficit of 5.4% of GDP. This calls for a correction of 4% of GDP.

The table right is based on the data for Nov'11. The results are highly sensitive to the bond yield and the nominal GDP growth rate.

For a calculation based on May'11 data see below.

From "No Bailout" to Fiscal Compact

The 2008-09 recession was so deep that the 3% deficit limit of the Stability and Growth Pact could be exceeded. The Pact allowed this if a country is “seriously threatened with severe difficulties caused by circumstances beyond its control”. But the European Commission and the ECB insisted that countries are expected to return to the strictures of the Pact as soon as possible.

The individual countries found themselves in widely differing positions (see table above). Already in 2009 it was feared that some countries could find it difficult to refinance their debt, even be forced to leave the euro zone. The yield gap between German government bonds and those of some other euro zone countries at such times widened alarmingly.

Though the euro zone has a "no bail out clause" the European Commission announced early in 2009 that a way had been found for the stronger euro zone countries to assist the weaker ones if needed (without providing any details). In fact the "no bail-out clause" allows bail-outs of a member country following "natural disasters or other exceptional occurrences beyond its control." This covers virtually anything.

In 2009 Ireland was the worst affected. After the collapse of its property boom a startlingly steep decline in the inflow of tax revenues forced the Irish government to introduce severe austerity measures, for fear that the deficit could no longer be financed. The measures sufficed to calm the markets and Ireland was able to borrow at reasonably low rates.

Early in 2010 Greece moved into the firing line after its newly elected government revealed that the country's budget deficit was twice as deep as stated by the previous government. Greece was forced to follow the Irish example and introduced drastic austerity measures. In return Greece was granted substantial financial assistance by member countries.

As solvency fears spread to other deeply indebted south European countries, Spain, Italy and Portugal announced new austerity measures. In order to counter the intensifying pressures on the euro zone's financial system the EU drew up a EUR750bn package of measures during the week-end of 8-9 May'10 after intensive and divisive emergency negotiations (details below).

In spite of the huge amount involved the financial markets, after the initial euphoria passed, reacted with scepticism as many of the details of how the package would be applied were not specified. The package was a compromise between open-ended support favoured by France and much more restrictive support favoured by Germany. The divisions fuelled market scepticism.

To some this was the beginning of the creation of the "fiscal roof" the euro zone lacked. To others it was a temporary, three year, arrangement to tide over current difficulties. Either way the commitment of such a large sum of tax payers' money to financially assist weaker members was a demonstration of the cohesion of the euro zone. Germany in particular accepted that weaker euro zone members can access funds guaranteed by stronger members, a fiscal transfer mechanism of sorts.

Financial markets reacted with scepticism, fearing that the deeply indebted euro zone countries may fail to impose the required fiscal restrictions or that they may stifle growth. But in the course on Jun-Jul'10 the markets gradually accepted that these measures taken by the ECB and the EU  defused the crisis. Meanwhile the European Commission set to work on proposals to address the euro zones debt issues.

The serenity was shattered by Ireland in the autumn of 2010 as the costs of bailing out its failing banks rose to astronomical level. A financial rescue package was negotiated with the EU and the IMF in Nov'10. Portugal in Apr'11 became the third country calling for a bailout. In Mar'11 the European Stability Mechanism (ESM) was created, followed in Jan'12 by the Fiscal Compact (see below).

This may still not be the end.

European Union's financial support packages of May'10

European Financial Stability Facility (EFSF): Euro zone governments in May'10 created a "special purpose vehicle" (SPV) which could raise up to EUR440bn in the markets in the form of loans guaranteed by all euro zone countries.

• The money is lent on in the form of bilateral 3-year loans from euro zone countries to euro zone countries in financial difficulties and subject to these countries implementing fiscal restrictions to contain their budget deficits under close supervision of the IMF and EU ("IMF conditionality").

• EFSF funds may also be used to recapitalise banks.

• When a country is drawing on the fund it will step out of its commitment with the guarantees of the remaining countries scaled up commensurately.

•  The fund is located in Luxembourg and headed by an official from the European Commission (Klaus Regling, a German national).

• Initially it was hoped that if no country requests assistance (i.e. they can raise all they need in the markets), the fund may never be used. The mere existence of the fund, it was argued, may mean that it won't be needed. In fact Ireland became the first country to draw on it.

• EFSF debt got a AAA credit rating. Initially the need for a cash buffer to maintain AAA rating reduced effective lending capacity to EUR230bn. But 20 Jun'11 effective lending capacity was raised to EUR440bn after countries raised their guarantees.

• Japan undertook 12 Jan'11 to buy more than 20% of the bonds to be sold later in month to fund bailout for Ireland.

European Financial Stabilisation Mechanism (EFSM): A EUR60bn rapid reaction stabilisation fund was also created in May'10, controlled by the European Commission and modelled on, and in addition to, the "balance of payments facility" hitherto used to aid EU members not part of the euro zone.

• The money is borrowed by the Commission in the financial markets and EU member countries only become liable if the disbursed money is not eventually paid back by the recipients.

• The funds can be used for all EU members (not only those EU members not part of the euro zone) and was intended as a first line of defence in a financial crisis. (The second line of defence being the EFSF)

• EUR5bn of 2.5% five-year notes were issued 6 Jan'11, the first instalment of financial aid for Ireland. The issue yield was 2.59% and elicited strong demand. The funds were lent to Ireland at 5.51%.

IMF contribution: The IMF contributes one euro to the aid package for every two euros contributed by the EU. On the assumption that the EU package amounts to EUR500bn (EUR440bn + EUR60bn), the IMF's contribution amounts to EUR250bn.

European Stability Mechanism (ESM): In Dec'10 the EU leaders reached agreement on a new permanent bailout vehicle, the ESM, to replace the EFSF in 2013. The ESM is subject to unanimity in decision making and its loans have preferred creditor status (but junior to IMF loans). The ESM is in the form of an amendment to the EU treaties and requires ratification by all 27 member states.

•  the EUR440 EFSF rescue fund is to be leveraged by a combination of an insurance scheme and Special Purpose Vehicles (SPVs), hoping to attract funds from abroad (e.g. from China). If successful it is hoped that the EFSF will dispose of EUR1trillion, rather than just EUR440bn.
• European banks are to be recapitalised with EUR106bn, to be achieved by mid-2012 through retained earnings, share issues, national government contributions and, as a last resort, through the EFSF bailout fund.
• The ECB signalled that it may continue with its bond buying programme.
• Greece was granted a new EUR130bn aid package. A 50% "voluntary" write down of Greek bonds privately held has been agreed with the banks. The aim is to stabilise Greek debt at 120% of GDP by 2020 from 170% currently. Greece is to increase privatisations and parts of its economic policy will be dictated by the EU.
• Italy undertook to step up measures to reduce its debt, accepted IMF monitors.

Much of the detail remained to be decided. The initial reaction of markets was favourable.

Reportedly a euro zone "war cabinet" of sorts had been formed which assumed leadership, meeting frequently and informally. It consisted of Chancellor Merkel, President Sarkozy, ECB's Draghi, IMF's Lagarde and EU's Van Rompuy, Barosso and Juncker. 

•  A new fiscal compact is to limit debt and deficits. Each country to add to its constitution the commitment to a balanced budgets. Legislation to be verified by the European Court of Justice.
• Countries required to submit their budgets to Brussels for vetting. If country's deficit exceeds 3% of GDP, (semi) automatic sanctions to be triggered (unless 85% of euro zone countries vote against sanctions).
• Structural budget deficits to be capped at 0.5% of GDP.
• Compact to be signed by Mar'12. This, some consider, may allow ECB to intervene more aggressively in the bond markets.
• EU central banks to provide EUR200bn to the IMF; funds to be used to aid any countries in financial difficulties (currently these are the most indebted euro zone countries). The contributions of the EU are expected to attract contributions from G20 countries (e.g. China), raising the total to well over EUR200bn.
• The establishment of the permanent EUR500bn EMS bailout fund to be advanced to Jul'12 (from Jun'13). For first year EMS will run concurrently with EFSF bailout fund.
• In the case of a country being bailed out, losses would not be imposed on private sector bond holders (i.e. no "private sector involvement", PSI). Instead IMF practice of case-by-case to be followed. Germany previously insisted on losses imposed on private bond holders.

• An EU Treaty change was ruled out by UK veto, raising legal issues. Introduces new split in EU.
• The fiscal compact is to be embedded in euro zone member countries' national legal system at constitutional level. National debates now taking place. Unlikely to be smooth.
• High level of uncertainty about whether the fiscal compact will be properly embedded in national legislation by all countries within the set time frame.
• Other EU members (not part of euro zone) may join the fiscal compact (six agreed, three considering).
• Most of the detailed provisions of fiscal compact remain to be worked out. Still to be decided how legal limits on budgets will be policed and what penalties will be imposed.
• Can new fiscal rules be enforced by European Commission which has no role in agreements outside the EU Treaty?  Commission seeking way out.
• Proposals to allow the current EFSF bailout fund to continue alongside the EMS fund accepted only for the period Jul'12 to Jun'13.
• Proposal to give a banking license to the EMS funds to allow it to borrow from the ECB and multiply its intervention power also not accepted. Though may be reviewed later.
• ECB continues to say that it will not act as a backstop to the bond market. Insists solution to crisis is in the hands of governments, i.e. taking restrictive measures to bring budget deficits in line with what can be readily financed in the markets.
• Doubts multiply about EUR200bn European central bank loans to IMF and matching contributions from  other countries. UK and US refused, others (China, Brazil) reticent. By 19 Dec European central banks had only agreed to advance EUR150bn to IMF. More may still come in
• S&P rating agency 5 Dec placed euro zone's six AAA rated countries (including Germany, France) on review for possible downgrade.
• S&P downgraded EFSF bailout fund to AA+ (from AAA). This may raise the fund's borrowing costs and reduce its ability to leverage.
   

simplified table
Primary Budget Balance required to stabilise debt in 2012
as % of GDP, calculation based on Nov'11 data

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simplified table
Primary Budget Balance required to stabilise debt in 2012
as % of GDP, calculation based on Nov'11 data

Selected country