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26 Jun 2013

Eurozone: an uneasy calm

Janet Henry

by Janet Henry

Chief European Economist, HSBC

Eurozone: an uneasy calm (Getty Images/rusm)

Within weeks of Cyprus joining Greece, Ireland and Portugal in the eurozone bailout club, a sense of calm has returned to the peripheral eurozone countries’ bond markets.

However, the periphery’s fundamentals are far from sound. Growth is still not coming back, unemployment is rising to socially unacceptable levels and debt projections continue to be revised up. This economic reality suggests financial markets may wake abruptly from their complacent mood. The calm, such as it is, is an uneasy one.

The rally in government bond markets and the slightly more nuanced approach to austerity will still not stabilise government debt burdens in some peripheral countries any time soon. This leaves at least some countries facing four possible scenarios: better-than-expected growth, “Japanisation”, debt mutualisation or debt restructuring.

The deficit and debt projections are highly sensitive to the nominal GDP growth outlook. If growth surprises even slightly to the upside, the debt burden will ease much more quickly. But although stronger-than-expected growth is clearly the most desirable outcome, recent history suggests it is also the least likely, particularly in the near term.

Alternatively, the eurozone could muddle through for some time in a Japan-style low-growth, low-inflation scenario with more and more private-sector savings channelled into government debt. Even when a recovery starts, most likely on the back of stronger exports, the banking system – which remains undercapitalised – would be unable to sustain it.

Eurozone periphery banks have already increased the share of their assets held in government bonds. Such a scenario could continue for some time: after all, the Japanese situation has been two decades in the making.

But there would be huge difficulties if half of the eurozone members looked increasingly like Japan with persistently rising debt burdens and lower potential growth rates while Germany and a couple of other countries experienced higher immigration, shrinking debt burdens and higher growth.

Another possibility is the eurozone integrating even more closely, with a federal fiscal system developing in which the common budget is large and its disbursement is determined by some kind of unified political process. Common bonds would be issued and government debt pooled – debt mutualisation.

Unsurprisingly, this remains a controversial proposal, particularly in the major creditor countries and, realistically, it is hard to see this happening in the near future.

So another option is simply to accept that we now live in a monetary union in which individual nation states will be prone to default risk from time to time. Currently this seems more likely for private-sector debt and bank restructurings – as in Cyprus – than for governments.

Since the 2012 Greek debt restructuring, the European authorities have persistently reiterated that it was a unique and exceptional case. The huge impact on the Greek and Cypriot banks resulted in massive recapitalisation needs that governments had to fund with more borrowing. However, the net benefit to the Greek debt-to-GDP ratio was hardly noticeable: indeed it is projected to rise again in 2013.

But default can take many forms. The bigger assistance to debt sustainability in Greece has come from the maturity extension, interest-rate reductions and partial deferral of interest payments on official loans – not from haircuts borne by the private sector. This has left Greece’s effective interest rate on its debt stock lower than in any other peripheral country.

So, while everyone is hoping the sheer scale of central bank support being thrown at the global economy – plus greater progress on structural reforms to improve competitiveness – will ultimately produce stronger-than-expected growth, it is more likely the periphery will face some combination of the other three options.

This research was first published on 11 June 2013.
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