Old problems, wider tensions? In a momentous two weeks that saw two of the euro area (EA) countries under joint EU/IMF programs have their sovereign debt downgraded to “junk” status, market tensions widened to include two larger economies that together represent almost thirty percent of the whole EA GDP. Is this behavior by the markets truly justified?
Further market tensions in the previously affected EA countries. Early July 2011 saw two of the current three countries under joint EU/IMF assistance programs (Greece, Ireland and Portugal, or EU-3) have its sovereign rating downgraded to below so-called “investment” grade (or what is also known as “junk” status) by one of the three global rating agencies. Within in a week of each other, first Portugal was downgraded to Ba2 and then Ireland, to Ba1 (both still above the Caa1 awarded to Greece, which indicates “substantial risk” and is just three notches above a “default” rating). The strikingly similar reasoning provided for both downgrades stressed a “growing risk” that both countries would need a second round of official financing (that in spite of the fact that disbursements for the current Portuguese program agreed in May have just started, and that Ireland has delivered on all of its program commitments so far).
Italy and Spain. Nevertheless, the most striking development during the past few days was the further spread of market tensions towards Italy and Spain, when their CDS spreads spiked to new highs. One of the elements that seem to have spurred this is the scale of their stock of sovereign debt (see Graph 1). Albeit still below the average level of debt to GDP in the EU-3, the scale of the debt stock of Italy and Spain is very large, at almost 2.4 trillion € combined, of which around 1.1 trillion € is held by non-residents (or around 3 times the EU-3 total). The majority of this debt is held by other EA countries, but large portions are also estimated to be held by US and UK financial institutions.
Similar underlying fundamentals? Is the apparent behavior of markets, aggregating those 5 EA economies together, truly justified by their fundamentals? Part of the fundamentals-based view of the markets seems to be linked to what one could call “growth pessimism” towards this set of countries, which is on its turn is arguably related to a perception of “competitiveness loss”. Are these arguments true? As it turns out, looking at the countries’ growth performance (see Graph 2), although Italy has been underperforming the EA since the late 1990s, both Spain and the EU-3 have grown much faster than the EA aggregate over the same period. This underlies one of the most prized features of EU membership: the “convergence” of its less developed members to higher income levels.
Competitive loss? The same differentiated picture holds true when one compares the relative competitiveness of those economies, as measured, for instance, by their unit labour costs (ULC). The ULC-based real effective exchange rate (REER) for both Italy and Spain has moved largely in line with the EA’s aggregate –by far, their most important market– since the mid-2000s, while the EU-3 average (albeit strongly influenced by Ireland) has actually shown a significant gain in competitiveness towards the EA since the mid-2000s (see Graph 3).
Fiscal sustainability. Even in terms of their fiscal position, just the outstanding stocks of public debt in Graph 1 are far from telling the whole story. Their cyclically adjusted deficits (in other terms, adjusting for events like the “Great Recession” of 2008-2009) show that Italy, in spite of its large stock of debt, has run a fiscal position largely similar to that of the EA, in aggregate as was the case with the EU-3 (see Graph 4). Spain, on the other hand, registered a better performance than the EA until 2008. Also, the large deficits of the EU-3 are significantly influenced by the Irish need to support its domestic banking sector. Even the apparent more grim picture presented in Graph 1 for the Italian debt stock should also take into consideration the relatively small amount of this debt held by non-residents (almost half of the share observed in Ireland or Portugal), which would limit the pass-through of potential shocks.
How has this affected the developing countries? As in previous instances of EA-linked stress, the last bout of market instability has also had limited side effects for developing countries, as measured by CDS spreads (see Graph 5).
Differences do matter. None of the above should be understood to indicate that these countries do not have serious underlying vulnerabilities: they clearly do. Nevertheless, it is important to consider the positions of individual countries when evaluating the sustainability of their growth and fiscal positions.