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Peter Nielsen, MBA, CFA
John Scott CFA

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EU Sovereign Debt Contagion Mostly Quarantined For Now

June 1, 2010

On May 9th, 2010, the European Union (EU) and International Monetary Fund (IMF) agreed to implement a $1 trillion bailout package to prevent sovereign default in Greece and to prevent the Greek debt crisis from spreading throughout Europe. This move comes shortly after an initial $146 billion package failed to reassure investors.

Under the agreement, the EU will spend €500 billion in loan commitments and guarantees, and the IMF will provide an additional €250 billion. For now, this "Shock and Awe" campaign appears to have tamped anxiety in equity markets across the globe as they rallied strongly after the announcement. But Europe can’t hang the "Mission Accomplished" banner just yet. In exchange for this new lifeline, Greece has agreed to enact dramatic spending cuts to bring its budget deficit below 3% by 2014. Judging from the violent-turned-deadly public protest to these austerity measures, however, the Greek masses are in still in denial about the fiscal discipline that will be required of them.

To understand exactly why the bailout was needed requires a better understanding of the nature of Greece’s fiscal policy and an analysis of why other countries who appear to be in the same boat to do not arouse similar concern.

What is the root cause of the Greek debt crisis? The simple answer is that Greece lived beyond its means for a very long time. The country has a large and generous public sector that accounts for approximately 40% of its relatively small economy. Since entering the common currency zone in 2001, Greece disregarded the EU-mandated budget deficit cap of 3% it pledged to maintain and instead leveraged its EU member status to swell its deficit at low interest rates. In fact, prior to the credit crisis of 2008, Greece was able to borrow at rates similar to Germany.

Being an EU member state with common currency is a double-edged sword. During economic boom times, EU membership allows B-team countries like Greece to borrow funds cheaply. However, during a recession it prevents EU members from implementing autonomous monetary policies to reaccelerate their economic growth. Historically, when a country has a budget crisis, it can reduce its expenses, cut key interest rates to boost domestic demand and/or allow its currency to depreciate to make its exports more competitive. Although the latter two measures can lead to higher inflation, they have the potential to jump-start the growth needed to bounce out of a recession.

Unfortunately, these options are not available to Greece as it has forfeited management of its monetary policy to Brussels, the de facto "capital" of the EU. Unable to control its own destiny, Greece had no choice but to either default or seek a bailout.

But did the EU really need to bail out a free rider like Greece? By every measure, Greece is a small country. Its GDP and population comprise approximately 3% of the total EU, so it seems that Europe could have absolved itself from the Greek crisis. The bigger problem facing the union, however, was (and still is) contagion. Greece’s debt is inextricably linked to the rest of Europe through a banking system already in a weakened state of recovery. Widespread default could be devastating to countries in similarly poor fiscal condition, such as Portugal, Spain, and Italy.

Portugal, for example, is in a predicament similar to Greece’s. Its trade and current account deficits exceed 11% of GDP and its budget deficit is 9% of GDP. If Greece fails, at worst Europe is dealing with a treatable condition (provided that Greece takes its medicine). If both Greece and Portugal fail, the escalated situation is still manageable. However, if the crisis spreads to Spain and Italy, Europe would be dealing with a critical condition requiring emergency action. At this point, the fear is that "too big to fail" may be superseded by "too big to bail."

Table 2: Comparative Statistics

Country	Nominal GDP (billions)	Population (millions)	Trade Balance % GDP	Current Account % GDP	Budget Balance % GDP	External Debt % GDP	Unemployment
Greece	$340.6	10.7	-27.97%	-14.50%	-13.60%	170.79%	10.3%
Portugal	$234.2	10.7	-11.34%	-11.40%	-9.13%	234.20%	10.1%
Italy	$2,181.2	58.1	-0.15%	-2.33%	-5.65%	118.97%	8.6%
Spain	$1,507.6	40.5	-4.64%	-5.44%	-9.49%	168.88%	18.8%
Germany	$3,452.2	83.3	5.50%	4.92%	-5.90%	148.63%	8.1%
France	$2,755.4	64.1	-2.17%	-2.00%	-7.18%	189.97%	9.6%
UK	$2,223.4	61.1	-2.29%	-2.32%	-14.30%	411.68%	7.8%
USA	$14,453.8	307.2	-2.62%	-2.90%	-9.79%	95.25%	10.0%
Japan	$5,019.6	127.1	0.86%	2.82%	-7.63%	42.39%	5.2%

Source: Bloomberg, CIA World Factbook, Bank for Int’l Settlement, All figures as of 4Q2009

By extending financial support to Greece, EU policymakers hope to stem the contagion and prevent it from reaching systemic proportions. Most Greek debt is held by European banks that would endure tremendous pressure on their balance sheets and reserve requirements if forced to write down Greek obligations (see Table 3 below).

Given the above arguments, one could argue that the bailout was motivated by the EUs collective interest in self-preservation rather than by any altruistic effort to save Greece from bankruptcy.

Looking back at Table 2, countries such as the UK, the U.S., and Japan also seem to be facing similar fiscal conditions. However, for now, there are some crucial differences between these countries and Greece that provide some protection.

The UK controls its own monetary policy — freedom over its own interest rates and currency. If needed, the UK can implement any combination of interest rate management, currency devaluation, or high inflation (printing all the British pounds it can). Although the long-term implications of these measures will be counterproductive, they do provide some breathing room to execute sound, long-term fiscal policies.

Japan has the same tools at its disposal, but more importantly, most of its debt is held by domestic investors. Less reliance on foreign investors will help minimize external shocks that can prevent a country from rolling over its debt. Moreover, with its consistent trade and current account surpluses, Japan has sufficient foreign currency reserve to meet its foreign debt obligations.

The U.S. is in the envious position of supplying the world’s reserve currency. During crisis, the world flocks to the safety and liquidity of U.S. Treasurys. Although America’s fiscal condition and mounting future obligations are sources of significant concern, the U.S. still has one of the most dynamic economies and should continue to grow.

This economic strength should not be taken for granted, however. The U.S. could lose its status just as the UK and other European superpowers lost their financial might centuries ago. For now, Europe’s powerful incentive to preserve its own economic health is likely to forestall an epidemic of global proportions. As long as the Greek crisis can be contained, it should not affect the U.S. materially.

 

Copyright 2010 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 4 · No. 6

¹ The Economist. "The cracks spread and widen." April 29, 2010. http://www.economist.com/displaystory.cfm?story_ id=16009119

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