The dramatic fall in Eurozone sovereign bond yields has led some to herald the end of the crisis. We believe this is premature. In reality, the fragile recovery remains under threat from the record debt levels built up during the financial crisis; these debts are not going away any time soon.
For Portugal, Spain, Greece, Italy, Ireland, and Slovenia, debt as a share of GDP increased by an average 106 percentage points of GDP between early 2006 and the peak quarter in 2013. But the ratio has decreased by only 3 percentage points of GDP since that peak. This strongly suggests that the deleveraging process has only just begun.
It’s worth remembering that for Ireland, Spain and Slovenia, the government debt overhang was a consequence of the financial crisis in the Eurozone, rather than the root cause of it. Indeed, in the period before the crisis, sovereign debt had declined in these countries. The situation was different in Greece and Italy, where the largest debtor was the government.
Following the 2008 collapse of Lehman Brothers, cross-border capital flows stopped and then reversed, with huge implications for debtors in deficit countries. Debt levels turned out to be unsustainable, asset prices dropped, nonperforming loans surged, and a banking crisis ensued.
Rising government debt and deficits, sometimes financed through official loans from the International Monetary Fund and other Eurozone government support programmes, provided a buffer preventing outright deflationary spirals and an even deeper drop in domestic demand and employment. The flip side was that they added to national economies’ overall debt burdens in the form of rising government borrowing. This offset the incipient deleveraging, via repayment or default, of private sector debtors. As a result, the debt overhang persists today.
According to European Central Bank data, overall private and public sector debt in the periphery countries remains near record highs – as a percentage of GDP and in absolute terms. And the high debt-to-GDP ratio has been exacerbated by a decline in nominal GDP across the periphery. A comparison of narrow net external debt as a share of current account receipts reveals that almost half the sovereigns in the global top-20 are Eurozone members.
For some Eurozone economies, private sector debt at the end of 2013 was down from its peak, but typically only marginally. To identify the rate of deleveraging, we have calculated a debt reversal ratio for each country, which shows that the most progress has been made by Spain and Ireland. It is no coincidence that to date Spain and Ireland have been the only periphery sovereigns upgraded by Standard & Poor’s (other than Greece and Cyprus, after their respective defaults).
It is also possible to simulate the potential future trajectory of the deleveraging process for the private sector (households and companies). Assuming recent private debt-to-GDP reductions continue, one possible outcome would be that deleveraging in Spain advances the furthest, returning to 2001 levels, while Portugal, Ireland and Slovenia would return to debt levels last seen in 2004 to 2005. Greece, on the other hand, would see the slowest rate of deleveraging. By 2020, Portugal and Ireland would still have the highest private leverage ratios, while Italy’s and Slovenia’s private sector would continue to be the least indebted relative to GDP.
There is no simple answer to establish where the new debt equilibrium might lie. An economy’s appropriate leverage level depends on a multitude of factors, including interest rates, debt structure, assets owned by debtors, economic conditions, demography and many more. But it’s reasonable to assume that a long stretch of deleveraging still lies ahead in most periphery economies. Indeed, public sector debt levels are continuing to rise – deleveraging has not even begun.
The fragile economic recovery in the Eurozone is likely to remain subdued in the medium term, and this is reflected in our sovereign ratings. Moreover, if recovery expectations disappoint, this could exacerbate political polarisation, and thus pose an increasing threat to sustaining growth-enhancing, but often unpopular, reforms. Without a swifter economic recovery and growth in employment, popular dissatisfaction could swell. But ultimately, growth will remain dependent on net export performance, as domestic demand will face continuous headwinds.
With the deleveraging process in the Eurozone periphery barely underway, efforts to reduce the persistent debt overhang are likely to stunt growth prospects in the periphery for many years to come. They’re not out of the woods yet.