Spain is suffering the pain of debt, with Italy next in line
July 03, 2012 00:00 By Chodechai Suwanaporn
The euro-zone debt crisis seems to be worsening by the day.
Recent spikes in Spanish government bond yields underline the fact that the banking bailout will not address the country’s broader fiscal problems. A sovereign bailout is all but inevitable. Thus, any hope that the announcement of a support package for Spanish banks would insulate the country from the turmoil surrounding the Greek general election appear to have been swiftly dashed.
Indeed, while Greek 10-year bond yields fell after formation of a pro bailout coalition government, Spanish 10-year yields rose to above 7 per cent. This pressure might partly reflect uncertainty surrounding the banking bailout itself. The precise size of the package won’t be known until an assessment of the banks’ needs is completed. The range for the Spanish bank bailout is 40-100 billion euros.
At the same time, however, I think that Spain will ultimately require a full-blown sovereign bailout. Although Spain’s public debt to GDP ratio is relatively low at around 70 per cent, the banking package will raise it by around 10 per cent. Meanwhile, weak economic growth will continue to hamper efforts to bring the budget deficit down. Against this background, Spain’s fiscal position may soon look rather less favourable in the coming months and years.
Having said that, there are still some hopes that the European Central Bank (ECB) might step in to keep Spanish borrowing costs down, either by reviving its own sovereign debt purchases or by providing Spanish banks with the money to buy government bonds via additional lending operations (LTROs).
But if such action materialises, it may prove to be counter-productive. More ECB bond purchases would fuel concerns that private bond-holders are being pushed further down in the list of preferred creditors.
Finally, it seems very likely that more general worries about Spain’s economic and fiscal outlook will continue to build. The government’s forecast for the budget deficit to fall to 3 per cent in 2013 rests on a return to positive GDP growth next year, which looks very unlikely. In short, I believe it now appears virtually inevitable that Spain will require a sovereign bailout – possibly very soon.
Of course, there are major uncertainties over the likely size of such a bailout, how it would be financed and what resources would be left to meet the requirements of other troubled countries. But it will be a chilling scenario that such a Spanish sovereign bailout would mark a substantial step-up in the seriousness of the crisis.
As for Italy, the country may have recently avoided the spotlight thanks to developments in Greece and Spain, but I think that its dreadful debt dynamics mean that it remains a ticking time bomb for the euro zone. Until recently, Italy has benefitted from the perception that it is finally tackling the country’s fundamental economic problems. Indeed, last week, the government unveiled new measures to boost growth and encourage inward investment and a privatisation programme to pay off 10 billion euros of debt. Nonetheless, Italian bond yields remain high and briefly rose above 6 per cent after Spain’s banking bailout.
I think that market concerns about Italy are justified and that yields will rise higher. The reform process is likely to lose momentum as the elections, planned for next year, draw nearer.
Just as importantly, Italy’s other well documented economic problems remain. Italy still needs a decade or more of stagnant or falling prices to regain lost competitiveness. Accordingly, over the next ten years, nominal GDP growth is likely to be weaker than it has been over the past decade. Admittedly, this may not be disastrous for Italy’s debt dynamics if it runs a large primary budget surplus and pays a low rate of interest on its debts. But the government expects the average interest rate that it pays on its debts to rise from 4.2 per cent in 2011 to about 5 per cent in 2015. And while it expects the primary surplus to increase to 5.7 per cent of GDP by 2013, its overly optimistic growth forecasts suggest that the surplus will be lower.
Given all this, I think that public debt could climb to about 135 per cent of GDP by 2015, far higher than the government’s forecast, forcing it to seek outside help. One recent suggestion that could avoid a full blown bailout for Italy, estimated at perhaps more than 400 billion euros, is for the EFSF/ESM to purchase government bonds on the secondary market. But in order to reduce Italian interest rates significantly, huge amounts of bonds might need to be purchased. And if the ESM’s bond holdings were treated as senior to those of private creditors, official-sector purchases could drive private-sector investors out of the market.
Given this, I doubt that bond purchases are more than a temporary solution. Accordingly, I think that Italy will need a more formal bailout to cover its financing needs for a few years. Since Spain may soon need a sovereign bailout too, it is vital that the firepower of the bailout funds is dramatically boosted. But given that bailouts will not solve Italy or Spain’s underlying economic problems, moves towards full fiscal union in the euro zone will also be required to bring the crisis to an end.
Dr Chodechai Suwanaporn is executive vice-president, economics and energy policy, PTT Public Company Limited (Chodechai.email@example.com).