Some Thoughts On The Debt Dynamics In Europe
By Win Thin
In its Fiscal Monitor published in November, the IMF makes a crucial point about growth rates and debt dynamics. It points out that the larger the differential for any country between real interest rates (borrowing costs) and real growth (with the differential defined as r – g), the larger the increase in the primary budget balance (budget ex-interest payments) that is needed just to stabilize the debt/GDP ratio. The IMF did a comprehensive study across both DM and EM, noting that EM countries typically have negative r – g (due in large part to high growth rates) while DM tend to have positive r – g (due in large part to low growth rates).
We have long posited that euro zone efforts so far to address the crisis are likely doomed to failure because of this basic concept from the IMF. Borrowing costs (r) have risen, not fallen, despite the Greek and Irish bailouts, despite the European bank stress tests, despite the creation of the EFSF. On the other hand, fiscal austerity measures are keeping growth (g) very low for most of the euro zone, and so those countries are forced into even greater austerity (running bigger primary surpluses) in order to prevent debt ratios from blowing out even more. To us, this is akin to bailing water from a sinking ship at the same rate that the water is coming in. The ship can stay afloat, but the actual hole is not being addressed and so it will eventually sink when the person bailing finally tires.
Markets have fixated on 7% borrowing as some sort of threshold for a country having to go to the EFSF. We would posit that under the IMF concept of r – g, borrowing costs don’t even have to rise that high to help unravel a country’s debt dynamics. Let’s look at IMF growth forecasts for 2011 for the major euro zone countries and compare them to real 10-year borrowing costs to obtain r – g. The differential is largest for Greece at 11.6%. Next is Ireland at 6.6%, then Portugal at 5.5%. Spain comes next at 3.4%, Italy at 2.0%, the Netherlands at 0.5%, and Belgium at 0.4%. Having a high r – g doesn’t automatically mean that the debt dynamics collapse, but rather underscores just how difficult a task it will be for the euro zone periphery to avoid that collapse by having to run bigger and bigger primary surpluses. We have long argued that the first round of budget cuts are often the easiest, with subsequent ones getting more and more difficult given slow growth as well as rising popular opposition to even more austerity.
There has been talk that the stronger euro zone countries (read Germany) somehow subsidize the high borrowing costs experienced by the weaker countries. Looking at the (r – g) gap for the periphery, however, it would seem that the subsidies needed to drop r down to g for these countries may simply too great to bear, especially if Spain and Italy are thrown into the mix. And just breaking even here does nothing to reduce the mountain of debt that already exists for these countries. Here, r – g must be negative, and we reiterate our view that without EM-type rates of growth, euro zone countries simply cannot grow their way fast enough out of this debt trap. Other measures that are reportedly being discussed by European policy-makers include expanding the EFSF, allowing it to directly purchase member bonds, and lowering the cost of EFSF aid. None of these are enough to close the r – g gap substantially, in our view. We continue to believe that large-scale debt restructuring with significant haircuts is the only sustainable solution to the euro zone’s current debt woes.