the euro debt crisis whats next

IIF RESEARCH NOTE

The Euro Area Debt Crisis: Whats

Next? October 12, 2013

IIF.com Copyright 2013. The Institute of International Finance, Inc. All rights reserved. CONFIDENTIAL

Much has been done since 2010 to reduce macroeconomic imbalances in the Euro

Area periphery and to bolster economic and nancial integration at the EU level

Stronger exports may now be stabilizing output after two years of contraction, but

headwinds remain with scal adjustment continuing and bank lending constrained

Market sentiment, underpinned by OMT, has improved with better economic news

Challenges remain, however, including the need to restore full bond market access

for Portugal as well as Ireland and agree further nancing and relief for Greece

Italy remains at risk over the longer term, with a return to durable growth requiring

deeper structural reforms that political divisions are likely to impede

Progress mutualizing sovereign and bank liabilities looks likely to remain limited,

leaving Euro Area members vulnerable to renewed weakness in market sentiment

Hung Q. Tran

EXECUTIVE MANAGING

DIRECTOR

1-202-682-7449

[email protected]

Jeffrey Anderson

SENIOR DIRECTOR

European Affairs

1-202-857-3636

[email protected]

Stabilizing economic activity in the periphery and renewed growth in the core leaves Europe

better off than at any time since the &nancial crisis intensi&ed during the latter half of 2011

(Chart 1). Fiscal and external de&cits have been reduced, competitiveness improved and

government borrowing costs lowered to more sustainable levels. The stabilization of activity

now offers increased scope for households, &rms and governments to continue to repair

balance sheets that remain heavily leveraged without having to retrench as severely as in the

recent past. Like ongoing &scal consolidation, however, ongoing deleveraging by the private

sector will leave recovery constrained, uncertain and subject to shifting &nancial market

sentiment. Much remains to be done, moreover, to continue reducing &nancial market

fragmentation (Chart 2) and to assure adequate &nancing to those &rms able to bene&t from

the structural reforms that are now being advanced. Unemployment, more critically, remains

at worrisome levels, especially among the young, justifying concerns that political stability

can endure or that output potential will return to earlier levels in some countries.

Jared Bebee

ASSOCIATE ECONOMIST

European Department

1-202-857-3639

[email protected]

Mirjana Milutinovic

INTERN

European Affairs

1-202-857-3339

[email protected]

Average of Cyprus, Greece, Italy, Portugal, Slovenia, Spain, weighted by 2012

nominal GDP. Cyprus, Greece, Ireland, Italy, Portugal, Spain, Slovenia.

Source: Eurostat, DG ECFIN. Source: Datastream

70

75

80

85

90

95

-3

-2

-1

0

1

2009 2010 2011 2012 2013

Chart 1

Euro Area Periphery: Real GDP and Economic Sentiment

change from previous quarter weighted ESI Index

ESI

GDP

0

2

4

6

8

10

12

14

16

18

Spain

Italy

Germany

Ireland

Portugal

Chart 2

10 Year Bond Yields

percent

2012 2013

IIF RESEARCH NOTE

page 2

The Euro Area Debt Crisis: Whats Next?


IMPROVEMENT IS EVIDENT

Europe has moved a long way since early 2010 when the Greek sovereign debt crisis 1ared

up in &nancial markets. The crisis became virulent and spread to other Euro Area member

states, at times threatening the survival of the euro. Four countries (Greece, Ireland, Portugal

and Cyprus) eventually required &nancial support from their European partners and the IMF

for an adjustment program. In addition, Spain needed support for a &nancial sector

stabilization program.

Since then, much progress has been made both at the country level and the EU level, even

though more remains to be done. Together with the four program countries, Spain and Italy

have made signi&cant progress reducing &scal and current account de&cits (Tables 1 and 2).

Except for Italy, the same countries have made good headway reversing sizable

competitiveness losses during the long boom that followed euro adoption. Fiscal de&cits

have been reduced and primary de&cits narrowed or eliminated. (Most impressive, perhaps,

has been Italy, which should have the second largest primary surplus in the Euro Area for a

second straight year in 2013 despite real GDP having fallen more than 8% below its pre-

crisis peak to roughly 5% below potential.) Current account de&cits that ranged as large as

13% of GDP in Greece before the crisis are on course to shift to surpluses by 2014 that will

be as large as 4% of GDP in Spain, Portugal and Ireland, all of which greatly reduces

vulnerability to contagion risk from abroad. Ratios of government debt to GDP, on the other

hand, have increased further to very high levels. Still more worrying, the slow recoveries now

in prospect for the foreseeable future if downside risks can be contained will not be

suf&cient to bring down socially-damaging levels of unemployment which remains the key

challenge to many Euro Area member states.

Among the key Euro Area authorities, there is now clear appreciation that economic and

&scal "integration" must deepen further if monetary union is to be made sustainable.

Economic and &scal coordination has been enhanced, as a result, and discipline

strengthened via new arrangements such as the Six-Pack, the Two-Pack, the Fiscal

Compact, and the European Semester, which allows Excessive De&cit Procedures to be

Table 2

Current Account De4cits

% GDP

2008 2009 2010 2011 2012

Italy -2.9 -2.0 -3.6 -3.0 -0.5

Spain -9.1 -4.4 -3.9 -3.3 -0.5

Greece -13.2 -10.3 -9.2 -8.6 -1.9

Ireland -5.6 -3.1 0.7 0.9 3.8

Portugal -11.1 -10.1 -9.4 -5.8 0.8

Slovenia -6.1 -0.6 -0.4 -0.3 2.1

Cyprus -15.6 -10.4 -9.6 -3.1 -6.4

Source: Eurostat, IMF, Slovenian Ministry of Finance, IIF.

2013 2014

-0.1 0.0

1.9 3.5

1.7 1.6

4.0 4.0

3.0 3.5

4.4 3.8

-1.8 -0.4

Table 1

General Government De4cits, 2010-2014

% GDP

2010 2011 2012 2013 2014

Italy -4.4 -3.7 -2.9 -3.2 -2.1

Spain -9.7 -9.0 -7.0 -6.7 -5.9

Greece -10.8 -9.6 -6.3 -4.1 -3.2

Ireland -10.6 -8.9 -7.6 -7.5 -4.9

Portugal -9.9 -4.4 -6.4 -5.5 -4.0

Slovenia -5.9 -6.4 -4.0 -7.9 -2.6

Cyprus -5.3 -6.3 -6.3 -6.7 -7.5

Source: IMF and Slovenian Ministry of Finance.

IIF RESEARCH NOTE

page 3



launched because of failures to reduce debt as well as de&cits, and the Macroeconomic

Imbalance Procedure, which requires steps to correct a broader range of imbalances than

&scal ones.

Institutionally, the 500 billion European Stability Mechanism (ESM) has been established

and the ECB has become much more active and effective in managing liquidity problems (via

LTROs) or diminishing Euro-exit tail risk (via the OMT). Nevertheless, not much progress has

been made, or is likely, in mutualizing of sovereign and bank liabilities in the Euro Area

member states. Debt mutualization is needed to effectively sever destabilizing linkages

between weak sovereign and bank balance sheets that have been at the root of much of the

crisis. Without mutualization, &scally weak government will remain vulnerable to renewed

banking stresses in the future.

This study analyzes both the "glass half-full" and "glass half-empty" views and offers

thoughts about next steps.

PROGRESS HAS BEEN MADE BY MEMBER STATES

Since 2008, many problem countries in the Euro Area periphery have made strenuous efforts

to reduce the macroeconomic imbalances that had brought them under &nancial market

pressures. And since currency devaluation is no longer possible as an adjustment policy

instrument by virtue of membership in the Euro Area, they have had to make extra efforts

through "internal devaluation" to regain competitiveness lost during the initial years of the

monetary union. In addition, they have begun to implement structural reforms to improve the

potential for growth. Overall, progress has been most impressive in reducing &scal and

external imbalances, tangible but uneven in improving competitiveness and spotty in

advancing structural reforms.

Under pressure from &nancial markets and fellow Euro Area members, those countries

experiencing &nancing strains or loss of market access have adopted stringent &scal

consolidation measures. From 2009 through 2013, structural primary &scal de&cits (adjusted

for cyclical effects and one-offs) have been reduced by 4% of GDP in Italy, 6-7% in Spain,

Table 3

Changes in Structural Primary Fiscal Balances, 2010-20141

% GDP

2010 2011 2012 2013 2014

Italy 0.4 0.5 2.6 0.9 0.2

Spain 1.4 0.4 2.4 1.6 0.8

Greece 6.9 4.8 3.5 2.8 -0.2

Portugal -0.1 3.6 2.9 0.7 1.5

Slovenia -0.5 0.4 2.2 2.1 0.1

Ireland 2.7 1.5 1.5 1.9 1.6

Cyprus 0.4 0.7 3.0 0.3 0.3

Weighted Average2 1.2 0.9 2.5 1.3 0.5 1 General government. 2 By nominal GDP

Source: IMF and Slovenian Ministry of Finance

IIF RESEARCH NOTE

page 4



Ireland and Portugal and 18% in Greece (Table 3, previous page). Fiscal consolidation

programs have been front loaded, relying heavily on tax increases and spending cuts with

larger &scal multipliers than initially assumed, the combination of which contributed to

sharper than expected recessions.

Collapsing domestic demand, in turn, led to a signi&cant increase in unemployment rates,

especially among the young. Labor shedding, especially among lower-productivity sectors

such as construction, helped boost labor productivity signi&cantly in Ireland, Spain and

Portugal. Together with more limited declines in nominal wages, increases in productivity

have yielded declines in relative unit labor costs (RULCs), the broadest measure of external

competitiveness. In Ireland, Greece, Portugal and Spain, these decreases have corrected

75-90% of earlier increases in RULCs from the beginning of monetary union through peaks

in 2008 or 2009 (Charts 3 and 4). In Italy, by contrast, improvements have been more

limited, with Q2 RULCs just 2.5% less than the late 2009 peak and still 14% higher than at

the start of the monetary union in 1999.

The combination of collapsing domestic demand reducing imports and improvement in

competitiveness stimulating exports has brought about impressive improvements in current

account positions. The smallest shift since 2008 will be in Italy, which should run a small

surplus this year, a swing of just over 3 percentage points of GDP from de&cit in 2008.

Greece should see a surplus this year, compared with a 13% of GDP de&cit in 2008. Ireland,

Spain and Portugal may see surpluses of 3-4% in 2014, which represent shifts equal to 10,

13 and 15 percentage points of GDP, respectively, from 2008.

The drivers of current account improvement have differed among countries: Declines in

domestic demand were a major factor in all the major countries. Export growth has been key

in Ireland, Spain and Portugal, although much less than headline &gures suggest because of

signi&cant shares of imported export inputs. Italy will register only about half the 3-4% annual

increases in export volumes these three countries have recorded since 2008. Greece, by

contrast, has yet to return exports to their 2008 level.

Source: Eurostat. Derived from labor productivity and nominal unit labor costs.

Source: Eurostat.

60

70

80

90

100

110

120

1999 2001 2003 2005 2007 2009 2011 2013

IrelandGreeceSpainItalyPortugal

Chart 3

Relative Unit Labor Costs

2005 = 100

-15

-10

-5

0

5

10

15

09Q1 10Q1 11Q1 12Q1 13Q1

Spain

Ireland

Italy

Portugal

Greece

Chart 4

Hourly Compensation

12-month change, percent

IIF RESEARCH NOTE

page 5



With &scal de&cits considerably reduced, the current account surpluses Ireland, Portugal and

Spain will run this year and next means each should post surpluses of private savings over

investments on the order of 9% of GDP or more. Much of this will go to repaying private

sector debt owed foreign lenders by companies and banks. The last, in turn, may continue

being repaid by companies and households. The remainder should be available for use to

&nance at least part of smaller &scal de&cits, at least in Spain. With higher levels of private

sector debt, Ireland and Portugal will need to rely more on foreign lenders for &scal de&cit

&nancing, with or without further of&cial &nancial support in the form of contingent credits or

disbursing loans.

The consequence of the adjustment has been a sharp and protracted recession, with

shrinkage in GDP of 25% in the case of Greece and record high unemployment (Charts 5

and 6). This has caused social tension and weakened political support for persevering with

structural reform. And this is where there is much un&nished business. Important initial

progress has been made implementing labor market reforms (making it somewhat easier to

layoff full time workers and easier to hire part time workers) and pension reforms (extending

minimum retirement age and period of contribution and reducing bene&ts, partly to offset the

loss of pension contribution in1ows as employment has fallen). Portugal, notably, has also

made progress privatizing state owned enterprises. Much more needs to be done on reform,

all the same, to improve 1exibility and dynamism and enhance each economys potential

growth. Otherwise, the limited recoveries currently in prospect will simply not be suf&cient to

make a dent in the extremely high levels of unemployment, building up risks for the future.

OUTPUT IS NEARING BOTTOM

The good news on the economic front is that eight quarters of recession in the Euro Area

periphery seems to be coming to an end. Renewed growth in export volumes slowed the

contraction in aggregate output for seven periphery countries to a seasonally adjusted 0.1%

80

85

90

95

100

105

110

115

2007 2008 2009 2010 2011 2012 2013 2014

Ireland

Greece

Spain

Italy

Portugal

Chart 5

Real GDP Growth, 2007-2014

2005=100

0

5

10

15

20

25

30

2007 2008 2009 2010 2011 2012 2013

Italy Ireland

Spain Italy

Portugal Greece

Chart 6

Unemployment Rate

percent, seasonally adjusted

Spain, Italy, Ireland, Portugal, Greece, Cyprus and Slovenia

IIF RESEARCH NOTE

page 6



in Q2 from 0.5% in Q1 and 0.9% in Q4 2012. Exports of goods and services rose 3.3% after

declining 2.4 % in Q1. This helped to compensate for continued weakness in domestic

spending.

Growth returned in Portugal and Ireland, while recessions slowed in Greece, Italy and Spain

(Table 4, page 7). Buoyed by temporary factors, Q2 growth in Portugal was the highest in

the Euro Area at 1.1%. In Ireland, renewed export growth enabled real GDP to increase

0.4%, the &rst advance after three consecutive quarters of decline caused by further

decreases in domestic demand and expiring pharmaceutical patents. Rebounding Spanish

exports boosted the year-on-year increase to impressive double digits while slowing the

contraction in quarterly real GDP to a minimal 0.1%. Renewed growth in Italian exports

slowed the contraction in Italys real GDP to 0.3% despite a larger decrease in domestic

demand in Q2 than Q1.

Following a soft Q1, exports in the periphery improved markedly in Q2. Spanish exports rose

6% in seasonally-adjusted terms after decreasing nearly 4% the previous quarter, making a

signi&cant increase likely this year as a whole (Chart 7). Improved competitiveness has

helped, as has success in increasing shipments to emerging markets, stronger growth in

which has helped offset more sluggish demand in developed markets, something Portugal

and Greece have been able to do as well (Chart 8). Bolstered by rising shipments of

automobiles and automobile components, Spanish exports also have also bene&tted from

strong competitiveness gains, with relative unit labor costs down 15% from the pre-crisis

peak and 8% lower in Q2 than two years earlier. Similar or larger gains in competiveness

improvements have been registered by Greece, Ireland and Portugal from pre-crisis levels

and compared with 2011. Italy recouped much less of considerably smaller earlier

competitiveness losses through Q3 of last year and has seen much of those gains unwound

in recent quarters as the euro has strengthened vis--vis trading partner countries.

Other factors contributed to the stronger Q2 performance. Irish exports were supported by

recovering demand in the U.K., Irelands largest export market. Portuguese exports were

Source: Eurostat Ratio of exports of goods to emerging market economies vs advanced economies.

Source: Direction of Trade Statistics.

80

90

100

110

120

130

140

150

2008 2009 2010 2011 2012 2013 2014

Ireland Greece

Spain Italy

Portugal

Chart 7

Export Volume

2005 = 100

60

80

100

120

140

160

180

2008 2009 2010 2011 2012 2013

Greece

Ireland

Italy

Portugal

Spain

Chart 8

Exports to Developing Countries

2010 = 100, 12-month moving average

IIF RESEARCH NOTE

page 7



Table 4

Real GDP, by Expenditure

% change vs. previous quarter vs. year earlier

12Q1 12Q2 12Q3 12Q4 13Q1 13Q2 12Q1 12Q2 12Q3 12Q4 13Q1 13Q2

Italy Real GDP -1.1 -0.6 -0.4 -0.9 -0.6 -0.3 -1.4 -3.0 -2.9 -2.8 -2.8 -2.6

Domestic Demand -2.0 -0.9 -1.1 -1.4 -0.5 -0.7 -4.4 -5.8 -5.6 -5.1 -4.1 -4.0

Private Consumption -1.8 -0.6 -1.4 -0.8 -0.5 -0.4 -3.5 -4.1 -4.8 -4.2 -3.2 -3.7

Govt Consumption -2.0 -0.5 -0.4 0.1 0.2 0.1 -2.5 -2.6 -2.1 -3.4 -0.5 0.2

Fixed Investment -3.8 -1.7 -1.1 -1.8 -2.9 -0.3 -7.0 -9.6 -9.0 -7.6 -7.6 -6.1

Exports 0.2 -0.2 0.9 0.1 -1.4 0.6 3.6 1.2 1.1 2.1 -1.4 0.3

Imports -2.6 -1.1 -1.5 -1.6 -0.9 -0.8 -7.3 -8.3 -8.0 -5.9 -5.8 -4.6

Spain Real GDP -0.4 -0.5 -0.4 -0.8 -0.4 -0.1 -1.3 -1.7 -1.7 -1.9 -2.7 -1.7

Domestic Demand -0.5 -1.4 -1.0 -1.8 -0.6 -0.3 -3.4 -3.7 -4.5 -4.8 -4.9 -3.7

Private Consumption 0.2 -1.1 -0.7 -2.0 -0.5 0.0 -2.0 -2.5 -3.3 -3.5 -4.7 -3.2

Govt Consumption -1.8 0.0 -3.0 -0.3 0.0 0.9 -5.4 -3.8 -5.2 -4.8 -3.4 -1.6

Fixed Investment -1.7 -3.3 0.2 -3.0 -1.5 -2.1 -6.0 -7.0 -7.2 -7.7 -7.5 -6.6

Exports -3.1 0.6 6.5 0.6 -3.8 6.0 -1.4 -0.7 3.9 6.7 2.6 11.2

Imports -3.3 -2.2 4.6 -2.6 -4.5 5.9 -8.0 -7.4 -4.4 -2.9 -4.5 4.9

Greece Real GDP -1.5 -1.0 -1.8 -1.6 -0.5 -0.3 -6.7 -6.4 -6.7 -5.7 -5.6 -3.8

Domestic Demand -2.3 -1.6 -2.6 -1.6 -2.1 -1.9 -11.0 -9.2 -11.4 -6.6 -6.8 -7.5

Private Consumption -1.4 -1.7 -2.6 -3.3 -1.9 0.4 -9.5 -8.6 -8.6 -9.6 -8.7 -6.3

Govt Consumption -2.7 -3.0 -2.4 0.1 -1.7 -3.1 1.4 -1.8 -10.2 -5.8 -8.8 -6.1


Exports 1.4 -3.3 0.7 -1.5 0.1 0.6 4.1 -3.0 -4.2 -4.8 -2.5 0.9

Imports -3.1 -0.8 -7.0 2.8 -2.7 -5.2 -14.9 -12.9 -18.7 -8.1 -7.7 -11.8

Portugal Real GDP -0.1 -1.0 -0.8 -1.9 -0.4 1.1 -0.8 -4.0 -2.5 -5.4 -4.9 -2.5

Domestic Demand -0.5 -2.7 0.0 -1.2 -2.1 0.8 -5.4 -9.3 -6.0 -5.9 -6.4 -3.0

Private Consumption -1.9 -1.0 -0.3 -1.9 -0.7 0.4 -5.0 -5.7 -5.7 -5.3 -4.0 -2.6

Govt Consumption -1.3 -0.9 -1.6 -0.4 -0.9 0.0 2.4 -10.5 0.6 -9.9 -6.0 -4.3

Fixed Investment 2.0 -10.4 0.4 -4.4 -2.7 -0.1 -13.0 -17.3 -14.4 -12.2 -15.7 -6.8

Exports 2.0 -1.3 0.5 -1.0 2.6 5.2 7.9 3.6 1.7 -0.2 0.3 7.4

Imports 0.9 -5.9 2.7 0.9 -1.8 4.5 -5.7 -11.1 -7.7 -1.6 -4.0 6.5

Ireland Real GDP -0.5 0.5 -0.8 -0.2 -0.6 0.4 1.8 0.4 -0.5 -1.0 -1.0 -1.2

Domestic Demand 1.3 -2.4 1.6 -0.5 -0.6 -2.0 -2.2 -4.0 0.1 -0.1 -2.0 -1.8

Private Consumption -0.6 0.6 1.1 -0.3 -2.5 0.7 -2.4 -1.6 1.7 0.9 -1.1 -1.3

Govt Consumption 0.2 -1.6 0.1 -0.3 -0.2 -1.0 -2.8 -4.8 -3.0 -2.0 -1.7 -1.7

Fixed Investment 17.1 -23.1 13.3 -1.4 -6.4 -3.4 4.6 -16.0 10.0 1.3 -20.0 0.4

Exports 1.7 -0.7 -0.3 0.6 -3.5 4.3 3.3 1.3 0.4 1.3 -4.1 1.0

Imports 5.1 -5.7 3.4 -0.9 -0.6 0.7 -0.1 -3.0 2.0 1.4 -4.0 2.6

Slovenia Real GDP -0.5 -1.3 -0.4 -1.0 -0.5 -0.3 -0.2 -3.5 -3.0 -3.3 -4.6 -1.7

Domestic Demand -1.0 -3.6 -1.9 -1.8 -0.8 0.2 -2.6 -6.5 -8.5 -8.5 -8.0 -3.5


Govt Consumption -0.4 -0.3 -0.9 -0.8 -0.1 -1.2 -0.2 -0.6 -1.8 -2.4 -1.8 -3.1

Fixed Investment -4.9 -1.3 -1.5 -2.7 1.1 -1.2 -6.2 -6.5 -7.3 -12.3 -3.3 -3.0

Exports -0.9 1.6 -0.1 0.3 1.3 -0.6 1.7 -0.3 0.1 0.8 1.7 2.0

Imports -2.5 -0.7 -2.8 0.1 2.4 -0.7 -1.4 -4.1 -7.1 -6.0 -2.3 0.0

Cyprus Real GDP -0.3 -1.0 -0.8 -1.5 -1.7 -1.8 -1.6 -2.7 -1.9 -3.6 -5.0 -5.9

Domestic Demand -1.2 -2.9 0.4 -4.1 -3.9 -5.3 -6.1 -6.6 -6.5 -8.0 -8.9 -11.5


Govt Consumption 0.6 -1.0 -2.0 -1.3 -1.5 0.0 2.7 0.1 -4.7 -3.4 -6.1 -4.9


Exports 0.8 3.1 -2.1 -2.0 -2.1 0.3 -0.2 3.7 5.1 -0.1 -8.2 -7.2

Imports -1.2 -1.1 0.3 -7.3 -6.9 -7.3 -10.5 -5.0 -4.3 -9.2 -16.8 -18.9

IIF RESEARCH NOTE

page 8



boosted by the stream of new re&nery capacity. Spain, Portugal, Greece and Italy were all

able to bene&t from improving tourism, from a very low base in Greeces case, a

development that is likely to have continued in Q3.

Stronger export performances were accompanied by further declines in domestic demand

during Q2. Across the periphery as a whole, domestic spending fell 0.6%, only marginally

less than in Q1. Private consumption contracted further but by less than in Q1 as modest

upturns were recorded in Ireland, Portugal and Greece, and household spending ceased

falling in Spain. Further declines occurred in Italy and Slovenia and a larger drop was

registered in Cyprus. Fixed investment fell everywhere as output lagged potential, leaving

signi&cant amounts of unused capacity in industry and services. Year-on-year declines

exceeded double digits in Greece, Portugal and Cyprus and ran at 6-7% in Spain and Italy.

Declines were much smaller in Slovenia and in Ireland, where aircraft deliveries for Irish

carriers and leased 1eets have buoyed capital outlays and imports. Low levels of household

investment remain a drag on investment across the periphery.

Smaller declines in private consumption and increases in several countries mainly re1ect

moderating declines in employment or the onset of modest upturns. In aggregate, private

consumption declined 0.2% across the periphery, much less than the decreases of 0.7%

and 1.5% registered in Q1 and Q2. Renewed employment gains in Ireland since mid-2012

and recent stabilization in Spain and Greece have been accompanied by further declines

elsewhere, however. Except in Cyprus, unemployment rates have ticked down from highs

early this year and in 2012 that reached 27% in Spain and Greece, 18% in Portugal, 15% in

Ireland and 13% in Italy. Surveys show that consumer sentiment has improved, mainly in

comparison with 2012, but remains at weak levels.

Household spending looks likely to remain constrained by further downward adjustments to

wages and efforts to pay down debt. Downward 1exibility in wages has increased, thanks

mainly to recent reforms to wage setting mechanisms in Spain, Portugal and Greece. Lower

wages in these countries are helping to improve competitiveness but at the cost of further

Source: European Commission Source: ECB

-20

-15

-10

-5

0

5

10

15

20

1999 2001 2003 2005 2007 2009 2011

Ireland Greece

Spain Italy

Portugal Slovenia

Cyprus

Chart 10

Household Savings Rates, 1999-2012

net saving as percent of net disposable income

0

40

80

120

160

200

2008 2009 2010 2011 2012 2013

Spain Ireland

Portugal Italy

Greece

Chart 9

Household Debt

percent of disposable income

IIF RESEARCH NOTE

page 9



declines in household incomes. These declines are larger in real disposable terms, given

downward rigidities in consumer prices and increases in indirect taxes. Ireland seems the

sole exception as regards wages, given modest increases in average weekly earnings in Q1

and Q2.

Household debt has been reduced in Ireland, Spain and Portugal but remains at elevated

high levels (Chart 9, previous page). Household saving rates, as a result, look likely to remain

mostly positive as deleveraging continues (Chart 10, previous page). Including corporate

borrowing, private sector debt has been little changed since 2010, suggesting that corporate

deleveraging will continue to weigh on hiring and wages.

PROSPECTS ARE UNCERTAIN WITH STILL LARGE DOWNSIDE RISKS

Whether contraction will shift to expansion among the periphery economies after midyear

remains to be seen. Improvements in sentiment indicators, together with further increases in

exports and retail sales suggest growth may have continued in Ireland and Portugal and that

a small positive &gure might be registered in Spain as well (Chart 11). Growth may be more

dif&cult elsewhere. Much will depend on foreign demand, both within the Euro Area and

further abroad. Further increases in export orders through August point to an ongoing

expansion of exports in Q3 and perhaps Q4 as well.

Domestic demand looks set to remain fragile, however. Retail sales &gures have been mixed.

In Q2, declines in turnover volume slowed in Ireland, while increases were recorded in

Greece, Ireland, Italy and Spain. Data through August show growth in Ireland, Portugal and

Spain. Car registrations appear to have picked up as well, rising in Greece, Portugal and

Ireland in the three months leading to August. In Ireland, however, this seems to re1ect

mainly the retiming of registration dates, which caused buyers to defer car purchases from

earlier in the year. In Spain, Italy and Cyprus, by contrast, new car registrations have

contracted further.

Source: DG ECFIN. Source: DG ECFIN.

70

80

90

100

Portugal

Greece

Spain

Italy

Chart 11

Economic Sentiment Indicator

2010 = 100, seasonally adjusted

2012 2013

-90

-80

-70

-60

-50

-40

-30

-20

-10

0

10

2009 2010 2011 2012 2013

Greece Portugal

Spain Italy

Chart 12

Manufacturing Orders

2010 = 100, seasonally adjusted

IIF RESEARCH NOTE

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Industrial production data give fewer positive signs, with output falling in July from Q2 levels

or remaining 1at. August data were better, however. Manufacturing orders registered upticks

in both July and August. Construction data for July registered increases in Spain, Italy and

Ireland but from a weak Q2 (Chart 12, previous page).

Against this backdrop of renewed export expansion and still weak domestic spending,

growth prospects remain constrained. Two factors that will continue to weigh on growth

going forward remain &scal consolidation and the high cost and tougher terms for bank

credit. Though stirring now, surveys suggest that borrowing demand has remain depressed

given uncertain business prospects, heavy existing debts and high borrowing costs

compared with the Euro Area core.

Fiscal adjustment efforts have continued in 2013 but at a more moderate magnitude than in

2012 (Table 3, page 3). A further easing of the pace of consolidation is planned in 2014, but

adjustment looks set to continue everywhere, even in Italy, where additional tightening

seems likely to be needed to make up for less consolidation this year than was originally

planned.

For the periphery as a whole, structural primary balances will tighten this year by half the

2.5% of GDP registered in 2012. The more moderate &gure will mainly re1ect smaller

adjustments in Italy and Spain, but also in Portugal, Slovenia and Greece. Only in Ireland is

underlying &scal adjustment seen as intensifying compared with 2012. This re1ects mainly

the full implementation of measures to control healthcare outlays that were only partly put in

place in 2012.

Further &scal adjustment may be partly offset this year in Italy by repayments of public

spending arrears to suppliers, which should amount to 1.2% of GDP and the same amount

again in 2014. Spain repaid a larger 2.6% of GDP in arrears owed suppliers by regional and

local administrations last year and will repay another 0.8% of GDP in 2013.

How expansionary these payments will be is unclear. Those arguing they will be, which

include the IMF in its most recent assessment of Italy, presume that the cash spent will ease

binding &nancial constraints faced by suppliers that have been tightened by the arrears. A

signi&cant part of the increases in banks NPLs in Italy and Spain in recent years is

understood, however, to have been triggered by public sector spending arrears. Repaying

these arrears would have little direct stimulative effect were suppliers to use them to come

current on past due loans owed banks. Indirect effects should be positive, of course, were

banks able to lend more to others and at lower margins thanks to reduced NPLs.

A further complication is that the spending that gave rise to these arrears has been included

in accruals-basis spending and de&cits each year bills were incurred but not paid. If arrears

repayments are expansionary, there would presumably have been an equivalent

contractionary effect when the arrears were incurred. Adjusting past spending to take arrears

into account might make sense, then, if outstanding amounts of arrears have changed

signi&cantly. Inadequate reporting of arrears makes it dif&cult to know the true story, but

IIF RESEARCH NOTE

page 11



accounts payable, which include payments that are not overdue, have been little changed in

Italy since 2009 (Table 5). Survey data on late payments, moreover, indicate little change in

payments delays since 2010 (Table 6). Accounts payable did rise considerably in Spain in

2011, increasing by 3.1% of GDP that year, before decreasing in 2012 roughly in line with

arrears repayments. Adjusting Spains structural primary &scal balance in line with these

developments, however, gives the impression that Spains &scal stance eased in 2011 by a

dramatic 3.5% of GDP, was broadly neutral last year and is tightening again in 2013 by 3.4%

of GDP (Table 7). This seems hard to square with contractions in domestic demand that

accelerated from 2% in 2011 to about 4% a year in both 2012 and 2013.

However much these arrears repayments might offset &scal tightening, they add further to

government debt. Spain, as a result, will see its general government debt ratio rise to 92%

this year and keep increasing, according to the IMF, to a peak of 106% in 2017-2018.

Despite the largest primary surplus in the Euro Area except for Germany, Italy will see its

general government debt top 132% of GDP by the end of 2013. With an overall &scal de&cit

wider than 7% of GDP, Irelands government debt will increase to 123% of GDP this year.

Table 7

Change in Underlying Fiscal Positions, Spain and Italy, 2011-2014

% GDP

2011 2012 2013 2014

Spain

Structural primary balance change 0.4 2.4 1.6 0.8

Arrears payment change -3.1 2.6 -1.8 -0.8

Net -3.5 -0.2 3.4 0.0

Italy

Structural primary balance change 0.5 2.6 0.9 0.2

Arrears payment change -0.1 0.0 1.2 0.0

Net 0.6 2.6 -0.3 0.2

Memoranda:

Arrears payments

Spain -3.1 2.6 0.8 0.0

Italy -0.1 0.0 1.2 1.2

Domestic Demand

Spain -1.9 -3.9 -3.8 -1.6

Italy 0 -5.3 -2.4 0.3

Table 5

% GDP

Italy Spain Greece Portugal Ireland

2009 5.2 7.6 10.4 3.9 3.7

2010 5.2 8.9 10.1 4.9 3.5

2011 5.3 12.0 8.9 4.4 3.3

2012 5.3 9.3 11.4 3.8 4.0

Source: Eurostat

General Government: Accounts Payable

Table 6

General Government: Late Payments

days late

Italy Spain Greece Portugal Ireland

2009 52 51 70 72 15

2010 86 65 65 84 13

2011 90 66 108 82 14

2012 90 80 114 79 13

Source: Intrum Justicia

IIF RESEARCH NOTE

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Portugals debt ratio will exceed 127%, and Greeces ratio will exceed 175% of GDP.

Included in all these ratios will be borrowing to fund cash reserve positions varying from 10-

15 percentage points of GDP (Table 8).

What effect the further adjustments in the other countries will have on GDP remains to be

seen. Most of last years adjustment in Italy took the form of tax increases, which are likely to

have had smaller near-term multipliers than the spending cuts likely to predominate this year.

Fiscal stances will remain contractionary in any event, even if less so than in 2012. The same

will be true again in 2014, except in Italy and Cyprus.

Reductions in bank funding costs since last year due to the advent of the ECBs Outright

Monetary Transactions and progress on banking union have done little to resuscitate bank

lending. Credit to nongovernment borrowers fell 5.9% from a year earlier for the periphery as

a whole in July, compared with 3.4% in December 2012 (Chart 13). Lending to non&nancial

corporations decreased by 8.3% while that to households fell 2.7%. Lending to corporations

has declined at an increasing rate since December, thanks to larger reductions in Spain and

Italy. These more than offset slower reductions in Portugal and Greece. Lending to

households, by contrast, is declining at a slower pace, thanks to moderating declines in

Spain, Portugal and Greece and a modest increase again in Ireland, which re1ects new

Table 8

General Government Debt, 2010-2014

% GDP

2010 2011 2012 2013 2014

Italy 119.3 120.8 127.0 132.9 132.8

Spain 61.0 69.0 84.0 92.0 98.0

Greece 148.0 170.0 157.0 176.0 174.0

Ireland 91.2 104.1 117.4 123.3 121.0

Portugal 93.2 108.0 123.6 122.9 124.2

Slovenia 38.6 46.9 52.7 67.3 69.0

Cyprus 61.3 71.1 85.8 114.1 123.0

Source: ECB. Source: ECB.

-15

-10

-5

0

5

10

2009 2010 2011 2012 2013

ItalySpainIrelandPortugalGreece

Chart 13

Credit to Nongovernment

12-month change, percent

0

1

2

3

4

5

6

7

8

9

2010 2011 2012 2013

Germany Ireland

Greece Spain

Italy Portugal

Chart 14

Corporate Lending Rates: up to 1 Year/ 1 Million

percent

IIF RESEARCH NOTE

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mortgage borrowing.

Credit contraction continues against a backdrop of still weak but improving borrowing

demand, according to ECB surveys of banks and borrowers. Both surveys point to some

recent increases after long periods of decline. The same surveys register some easing in

bank credit standards, again after long periods of tightening. Reported differences between

interest rates on agreed loans have narrowed to 200-300 bps for &rms in Spain and Italy

over those for German &rms and 400-500 bps for &rms in Portugal and Ireland (Chart 14,

previous page). Actual spreads on offered loans are understood to be considerably wider,

however, at 450-600 bps, taking into account the smaller share of higher-interest, lower

quality credits agreed in the periphery and the larger share of lending with sovereign

guarantees.

Funding cost differences persists, moreover, with most banks paying no less for funding

than their sovereigns at different points along the yield curve. Lending margins, in addition,

continue to re1ect rising volumes of NPLs.

PROGRESS HAS ALSO BEEN MADE AT THE EU LEVEL

The crisis has prompted a substantial improvement in the EU economic governance

structures, crisis management and resolution mechanisms, including the role of the ECB,

and steps toward a European Banking Union.

The EU economic governance structure is now composed of three elements:

The European Semester of economic policy coordination, to help keep EU economies in

sync with each other by avoiding large macro-economic imbalances, bring &scal de&cits

below 3% of GDP and advance needed reforms.

The "Six-Pack" legislation and the Fiscal Compact, which strengthens the Stability and

Growth Pact (SGP) and introduces enhanced surveillance procedures.

The "Two-Pack" legislation to synchronize the budget process whereby Euro Area

member states have to submit their draft budgets to the European Commission by

October 15 of each year for review and comments before sending the budgets to their

national parliaments. The "Two-Pack" also sets out explicit rules and procedures for

enhanced surveillance of member states under stress (in excessive de&cit procedures,

assistance programs, precautionary or disbursing, or the process of exiting such

programs).

The objective of these economic governance structures and mechanisms is to enhance the

coordination and discipline of economic and &scal policies among Euro Area member states

so as to avoid a buildup of macroeconomic imbalances that could trigger &nancial crises.

One obvious omission is a symmetric adjustment among countries incurring large and

persistent current account surpluses, which leaves the burden of adjustment remains with

IIF RESEARCH NOTE

page 14



de&cit countries. This asymmetric approach to adjustment will unfortunately reinforce the

de1ationary nature of the adjustment process experienced by crisis countries, making it

more dif&cult to &nd ways to foster growth strong enough to deal with the unemployment

challenge.

CRISIS RESOLUTION STRUCTURES HAVE BEEN STRENGTHENED

For crisis management and resolution, the main achievement has been the establishment of

the European Stability Mechanism (ESM) with 500 billion in authorized lending capacity,

about 60 billion of which has been approved to be available for direct bank recapitalization

if required conditions are met. Generally, the ESM can offer a requesting member state a full-

line assistance and adjustment program (as in the current four program countries), a

precautionary credit line (which could allow the ESM to buy a certain amount of the country's

government bonds issued on the primary markets), and a &nancial sector stabilization

program (like that in Spain where the government was authorized to borrow 100 billion from

the ESM and drew down 41.5 billion to recapitalize Spanish banks).

Complementing the important roles of the ESM, the ECB has re&ned its crisis resolution

toolkit. The ECB purchased government bonds to stabilize disorderly market conditions (the

Securities Market Program during 2010-11), extended LTROs to supply substantial amounts

of medium-term liquidity to the banking system to overcome market risk aversion and

liquidity crunches, and created Outright Market Transactions (OMT), which gives the ECB the

ability to purchase government bonds on secondary markets without ex ante limits. OMT

purchases are possible, however, only for countries with full bond market access and only if

the requesting member state has concluded a memorandum of understanding

encompassing agreed conditionality, which is needed to secure a precautionary ESM credit

line. Ireland is the &rst country aiming to qualify for such a facility when it exits the current

program at the end of this year. Essentially, the OMT has signi&cantly reduced the tail risk of

Euro exit or collapse, ushering in as a result a period of calm only the past year.

BANKING UNION HAS ADVANCED

At the EU summit on 29 June 2012, policy makers agreed to develop a banking union with

the goal of breaking the vicious linkage between the weak balance sheets of the sovereign

and banking sectors, which has been at the root of the virulent Euro Area debt crisis. Of the

three components of a banking union, a Single Supervisory Mechanism (SSM) is nearing

completion, a Single Resolution Mechanism (SRM) is making progress, but a Single Deposit

Guarantee Scheme (SDGS) has been put on the back burner.

After approval by the European Parliament, the ECB will take over the direct supervision of

the top 130 banks in the Euro Area. National supervisors will remain directly responsible for

the remainder of the 6,000 or so banks, but will have to abide by ECB regulations, guidelines

and general instructions and be subject to the ECB's broad oversight mandate over the

functioning of the SSM. The current schedule calls for the ECB to assume formal supervisory

responsibility by late 2014, probably around October. Before that can happen, however, the

IIF RESEARCH NOTE

page 15



ECB will conduct an Asset Quality Review (AQR) early next year to assure itself of the health

of the balance sheets of banks coming under its supervision and that any capital

de&ciencies identi&ed by the AQR are recti&ed.

It is here that some uncertainty still exists. Ideally, backup arrangements for recapitalization

should be in place before a rigorous bank stress test or asset quality review is undertaken

so that there is no uncertainty as to how banks found to be in need of additional capital will

be dealt with. This has been the key lesson from the US bank stress test that took place in

the context of the TARP program back in 2009. At present, there is no such formal backup

arrangement in place for the ECB AQR, and the debate about having one is still ongoing.

According to media reports, though, an ad hoc arrangement seems to be taking shape.

A bank found to have capital less than a minimum desired level would reportedly be given a

certain number of months to raise capital in the markets. If the capital raising exercise fails

to provide the needed amount of additional capital, the bank will then be determined to

require state aid, causing recently strengthened EU rules to kick in. Those rules call for

shareholders to suffer losses and junior debt to be converted to equity before a bank can

receive state capital support. If this bail-in of shareholders and junior creditors is insuf&cient

to meet the capital requirement, the country in question will then have to use its own &scal

resources to recapitalize the bank. If the government cannot do this on its own, it can

request a Financial Sector Stabilization program from the ESM as Spain has done

meaning the government will responsible for the new debt.

To make this palatable to &scally-constrained governments, it looks like adjustments for

recapitalization outlays will continue to be made by the European Commission when

assessing whether or not a member state is complying with country-speci&c

recommendations handed down by the European Council and speci&c obligations under

the excessive de&cit procedure. Whether markets will be similarly forgiving about debt levels

increased by recapitalization outlays is less clear. It seems reasonable to believe that little or

no distinction will be made in the future, as seems the case now, among the different

reasons debt was incurred. Spain will be seen as having debt equal to 92% of GDP at the

end of next year, rather than 89% net of last years bank recapitalization or 83% net of bank

recap and cash reserves, if those prove to be the correct numbers at that point in time. Italy

will be seen as having debt equal to 133%, even though a small part of that re1ects

obligations taken to support Greece, Portugal, Ireland, Spain and Cyprus via Europes

various &nancial support mechanisms.

MORE NEEDS TO BE DONE ON BANK RESOLUTION

There are two related work streams on resolution: the Bank Restructuring and Resolution

Directive (BRRD), agreed by the European Council in June 2013, and the Single Resolution

Mechanism (SRM), proposed by the European Commission in July.

The BRRD is currently going through the European trialogue, a consultation process

between the European Commission, the European Parliament and the European Council,

IIF RESEARCH NOTE

page 16



and is scheduled to be taken up by the European Parliament early next year. Even if the

directive is approved by the parliament and member states, it will not help with the needed

capital backup arrangement for the ECB AQR since its key provision, requiring the bailing in

of all uninsured creditors and depositors, will not come into effect until 2018.

In the SRM debate, the Legal Service of the European Council has stated that the

establishment of a Single Resolution Authority is consistent with Article 114 of the Treaty on

the Functioning of the European Union but that safeguards are needed to protect the &scal

sovereignty of member states. On this basis, it is likely that a Single Resolution Authority

would be launched, but it is not clear how and by which entity (the Commission, ECOFIN,

new Single Resolution Board, etc.) the authority ultimately will be exercised. Moreover, the

second part of the legal opinion has lent support to countries opposed to setting up a

Single Resolution Fund on a European basis. Such resolution funds are likely to remain

national and be &nanced by contributions from industry. Recent proposals talk call for a

0.8% levy on insured deposits over 10 years.

FURTHER PROGRESS IS NEEDED AT BOTH THE NATIONAL AND EU LEVELS

Overall, the availability of the OMT and ESM has signi&cantly reduced the tail risk of a Euro

exit or collapse. In addition, current account surpluses, primary budget surpluses and

decreased foreign holdings of sovereign debt have reduced individual countries' vulnerability

to external &nancial pressures as well as contagion risk. Despite signi&cant progress at both

the European and national levels, prospects for the Euro Area remain clouded by three

fundamental problems:

Lack of suf&cient growth in the foreseeable future to reduce record high unemployment,

risking rising social and political tension.

Despite improved EU economic governance, macroeconomic adjustment will remain

asymmetric with the burden falling on de&cit countries and no formal obligation for

surplus countries. This will continue to impart a de1ationary bias to efforts to reduce

macroeconomic imbalances.

No mutualization of Euro Area sovereign or bank liabilities. This means the potentially

vicious linkage between the sovereign and bank balance sheets will linger, not having

been severed, with ongoing risks that it may reemerge.

Against the backdrop of increased sovereign debt and high levels of corporate and

household debt, much of the Euro Area periphery will remain vulnerable to shocks for the

foreseeable future.

IIF RESEARCH NOTE

page 17



EUROPEAN BANKING UNION: KEY DATES

Date Banking Union Program Countries Other Events

Oct. 2013 Council to adopt SSM

Oct. 2013 Trialogue negotiations on BRRD to

commence

EoY 2013 Agreement on BRRD to be reached

EoY 2013 Political agreement on SRM to be

reached

Dec. 2013 Program for Ireland runs out

Feb. 2014 Parliament to approve BRRD and DGS

Mar. 2014 Council to adopt BRRD and DGS

Mar. 2014 Parliament to approve SRM

Q1 2014 AQR to be conducted by ECB

Apr. 2014 Council to adopt SRM

Q2 2014 Stress test to be conducted by EBA

May-14 Elections to the European Parliament

Jul. 2014 Program for Portugal runs out

Q3 2014 New European Commission takes of&ce

Oct. 2014 ECB takes over responsibility as

supervisor

Oct. 2014 ESM mandated to directly capitalize

banks

Dec. 2014 Program for Greece runs out

2015 BRRD, SRM, and DGS become effective

Mar. 2016 Program for Cyprus runs out

2018 Bail-in rules become formally effective

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