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over 20% in Q1) and, last but not least, the public
finances.
This adjustment will continue to imply a protracted
period of subdued growth and low or even negative
inflation. In the absence of a credible adjustment in
fiscal trends possibly associated with structural
reforms, the most urgent being a reform of the labour
market, this is likely to involve persistently high fiscal
deficits and a rising public debt. In the short term, the
biggest risk is represented by the stability of the
banking sector. The banking sector appears to have
withstood the financial crisis remarkably well so far,
but the collapse in the housing market remains a
significant source of uncertainty and a reason for
concern especially with regard to the cajas (savings
banks).
The problem is that Spain’s share of eurozone GDP
is around 12%, almost five times as big as that of
Greece. Providing the same scale of assistance to
Spain as to Greece would thus require a sizeable
contribution that would be more difficult from a
political point of view.
Ireland
Similar to Spain, Ireland’s problems also emanate
from a domestic demand, housing and credit boom,
fuelled in part by the positive interest rate shock the
economy experienced when it joined the euro.
The difference is that Ireland is much further down
the path of adjustment than any of the other
peripheral countries. Measures to reduce the deficit
were announced as early as July 2008. Three
budgets and two expenditure reviews over the past
two years have produced paper savings of around
7% of GDP and the government has made a multiyear
commitment to find additional savings out to
2013. These measures, as well as skilful debt
issuance by the NTMA and the high quality of
announced reform, helped push Irish sovereign debt
spreads down substantially from their 2009 highs.
The government’s impressive commitment to fiscal
reform is, however, only part of the sovereign risk
story in Ireland. A banking crisis at the end of 2008
and start of 2009 prompted the government to step in
and effectively underwrite the banking system. The
state has guaranteed liabilities with a maturity of up
to five years issued before September 2010, injected
capital into some institutions and nationalised others.
More recently, it has begun purchasing assets from
the banks at a deep discount to book value to force
them to crystallise losses on their commercial
property portfolios – a process that is further
increasing the state’s level of ownership of the
domestic banking system.
Chart 3: Spain’s Financial Balances
(% of GDP, 4Q Avg.)
Source: Reuters EcoWin Pro
The aggressiveness of Ireland’s fiscal reforms needs
to be put in this context. With the state underwriting
the banking system, whose liabilities amount to
roughly 300% of GDP, the government had no
choice but to act decisively to regain market
confidence. This is also why the recent sharp
widening of Irish spreads over the past few weeks is
such a worrying development; the viability of the
government back-stop to the banking system is
determined by confidence in the sovereign.
Italy
We have all along been more positive on Italy. Italy’s
public deficit deteriorated less than the eurozone
average in 2009, as discretionary intervention was
limited. Combined with more structural factors such
as the low indebtedness of the private sector and the
banking sector’s higher resilience to the financial
crisis, this should continue to support Italian bonds
compared with those of the eurozone’s peripheral
countries. However, given the high and rising debtto-GDP
ratio and low structural growth, Italian public
finances are of course extremely sensitive to an
interest rate shock. In our central scenario we
assume that interest rates will remain low but the
recent market reaction to the Greek deal highlights
there are risks.
Bottom line
There are significant differences between the Greek
situation and that of other peripherals and it would be
simplistic to group all them together. But while less
acute, there are chronic problems in peripheral
economies. With markets not minded to discriminate
at present, the authorities need to get ahead of the
game. The question is – will they?
Luigi Speranza / Eoin O’Callaghan 7 May 2010
Market Mover
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