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Prospects Weekly: Financial markets battered by Eurozone sovereign- and liquidity-risk fears

Global Macroeconomics Team's picture
Global financial markets were hit hard this week, unconvinced that European leaders are doing enough to prevent contagion of the sovereign-debt crisis in Greece—as widespread financial contagion could push the global economy back into recession. The credibility of the Greek rescue package is being questioned, given the severity of the adjustment (11% share of GDP cut in the fiscal deficit over 3 years) and public outcry against the austerity measures. Countries with high sovereign debt, fiscal deficits and contingent liabilities, in particular, are at risk of contagion, but current heightened market-uncertainty is leading to flight-to-quality, which could raise rates across countries. Investors are also wary that, as many countries face substantial fiscal consolidation ahead, the implementation of fiscal exit-strategies could be highly synchronized and poses downside risks to global growth—although the coming adjustments may not be wholly unprecedented at the country level.
Greece‘s unfolding debt crisis and mounting concerns over Eurozone sovereign- and liquidity-risk battered world financial markets. Equities tumbled and credit default swaps (CDS) spreads soared, even after Greece reached a bail-out package with the EU and IMF last weekend. CDS spreads for Greece, Spain, Portugal, and Italy jumped to fresh record-highs and this year’s gains on global equities have been wiped out. Worries about elevated European debt, tightening credit, and Eurozone cohesiveness led to further depreciation of the euro, which hit a 14-month low against the U.S. dollar (as of May 6). Benchmark U.S. Treasuries surged on a general flight-to-quality, which if sustained would lead to higher borrowing costs across nearly all countries. 
Mounting pressures on government coffers have raised concerns about sovereign-debt sustainability. Already elevated sovereigndebt levels are likely to rise over the near-term across many countries, given the degree of fiscal deterioration since the onset of the crisis. Private sector debt is also elevated and contributing to rising non-performing loans that represent significant contingent liabilities, should banks need to be recapitalized. Uncertainty about these dynamics has been centered on Greece— with a fiscal deficit of 13.6% and sovereign external debt of 107% (as shares of GDP)—but increasingly on other economies (many in Europe) with high fiscal deficits, debt and contingent liabilities, and on Eurozone cohesiveness given these stresses and the decline in competitiveness of debt-burdened members. Spillover risks are also tied to international banks pulling out of third countries to cover losses in Europe, and to a possible credit freeze. 
The extent of fiscal adjustment that individual countries are facing is not wholly unprecedented, as over 20 high-income countries made deficit reductions of at least 5% of GDP since the 1970s— including Israel’s 11% share of GDP cut achieved in 3 years. However, many of these countries benefited from exchange-rate depreciation. While some countries have begun tightening fiscal policies—despite the compounding negative effects on growth, given the lack of fiscal space—many more countries will also pursue significant fiscal adjustment in the near-term, once economic recovery becomes more firmly established. This is likely to result in highly synchronized consolidation, posing downside risks to global growth, likely putting pressure on aid to developing countries. 

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