After months of uncertainty and fears that the Greek sovereign debt crisis would spread to larger, core economies in the eurozone, sending the global economy back into recession or even signalling the end of the single currency, European leaders reached an agreement in principle on October 27th 2011, on a deal to contain the eurozone debt crisis. Although the details need to be finalised, news of an agreement boosted financial markets. However, Italian government debt problems remain a concern.
Background to the eurozone debt crisis
The eurozone sovereign debt crisis began in Greece in 2009 when it emerged that the government had underreported its debt figures. This resulted in an initial bail-out agreement in 2010 and a second bail-out agreement in 2011 but concerns about insufficient government austerity resulted in fears of a Greek debt default from mid-2011. Greece has the highest public debt burden in the eurozone at an estimated 165.4% of GDP in 2011.
Ireland and Portugal have also been bailed out as a result of their escalating government debt problems following the global economic downturn of 2008-2009. These countries had the third and fourth highest public debt burdens in the eurozone in 2011 at an estimated 109.3% and 106.0% of GDP respectively. Furthermore, Ireland has the highest general government budget deficit in the eurozone at a projected 10.3% of GDP in 2011.
Many European countries had high government debt levels before the global economic downturn following years of public transfers, overspending and early retirement. However, economic recessions, high unemployment and unprecedented government stimulus measures following the global financial crisis in 2008 exacerbated government debt levels across the region. Prospects of weak economic growth, low productivity and structural problems have resulted in further investor uncertainty about the ability of governments to service their debt.
- Greece, Portugal and Ireland are three periphery economies in the eurozone accounting for 6.1% of the overall eurozone economy in 2010;
- Problems reached crisis point in mid-2011 when fears of contagion spread to Italy and Spain, the third and fourth largest economies in the eurozone which together accounted for 28.5% of the eurozone economy in 2010;
- Italy has the second highest public debt burden in the eurozone at an estimated 121.1% of GDP in 2011 and the fourth largest public debt in absolute terms in the world at an estimated €1.9 trillion in 2011;
- Following bailouts to Ireland, Greece and Portugal, the eurozone’s rescue fund, the European Financial Stability Facility (EFSF) would have an estimated €250-€290 billion left, not enough to deal with government debt problems in larger economies, should the need arise.
Eurozone Government Finances: 2011
% of GDP
Source: Euromonitor International from National Statistical Offices/Eurostat/International Monetary Fund/OECD/ International Financial Statistics
Note: figures are forecasts
What has been agreed?
A three-pronged preliminary agreement was announced at the European summit on October 27th 2011 with the aim of restoring stability to the crisis-ridden region:
- Greece: Investors agreed to write off 50% of the value of Greek debt – this should reduce the Greek government debt by €100 billion to bring the public debt burden down to 120.0% of GDP by 2020 compared to an estimated 180.0% of GDP without the deal. A €130 billion bail-out package for Greece was also approved by the EU and IMF, up from the €109 billion agreement in July 2011;
- Rescue Fund: The “firepower” of the EFSF, which currently stands at €440 billion, will be strengthened with analysts estimating that the fund will increase to a headline figure of around €1 trillion. This will include a risk insurance for new debt purchased, and a special purpose investment vehicle for investors, which could also include investments from countries such as China or Brazil;
- Bank recapitalisation: Banks are required to raise more capital in order to boost liquidity and provide enough capital reserves (a 9% capital ratio) to provide buffers against future potential government debt defaults. €106 billion in new capital is to be raised by June 30th 2012. Governments will step in if this can’t be achieved through private investors and a loan from the EFSF would be a final option. For particularly vulnerable banks, recapitalisation could result in another credit crunch if lending to consumers and businesses is restrained.
Why does the Eurozone matter?
The eurozone is home to some of the world’s largest economies – any downturn in the region or continued sovereign debt crisis would have global repercussions. At the October summit, European leaders declared that the eurozone debt crisis was the biggest challenge facing European leaders since the Second World War:
- The eurozone region accounted for 19.2% of the global economy in 2010;
Contribution to Global GDP: 2010
% of global GDP
Source: Euromonitor International from IMF
Note: GDP is calculated in US$ terms
- The eurozone was home to 329 million inhabitants in 2010 accounting for 4.8% of the world population;
- Total consumer expenditure in the region accounted for 18.9% of the global consumer market in 2010;
- The eurozone’s imports and exports amounted to just over a quarter of world levels in 2010 making the region an essential part of global trade flows.
The announcement has been hailed by European leaders as a success and although ambitious, anything less would have resulted in further volatility in financial markets, renewed capital flight from the region and an acceleration of the global economic slump evident since mid-2011. Financial markets reacted positively to the announcement while the euro and oil prices also strengthened. However, some analysts were expecting a bigger boost to the EFSF of around €2 trillion and an even larger “haircut” of up to 60% of Greek debt.