Special Report: Eurozone Debt Crisis Intensifies

The eurozone crisis which started with Greece is now spreading to Italy and Spain. The debt crisis is being exacerbated by low economic growth in both countries and has coincided with the US debt crisis in July 2011. Fears have grown over an increased likelihood of a double dip recession in many developed economies, although European Central Bank actions may help to calm markets in the short term.

Key points

  • The eurozone crisis which started with Greece and spread to other small, periphery economies, with Ireland and Portugal also receiving bailouts, is now spreading to Italy and Spain. The European Financial Stability Fund (EFSF) cannot afford to rescue the two larger economies of Italy and Spain (or even Italy alone);
  • Italy and Spain are the 3rd and 4th largest economies in the eurozone. They accounted for 16.9% and 11.6% of eurozone GDP respectively in 2010. This compares to a combined 6.1% for Portugal, Ireland and Greece in the same year;
  • The debt crisis is exacerbated by low economic growth in both countries, which hinders attempts to draw down government debt;
  • Analysts are now turning to look at France – the eurozone’s second-biggest economy accounting for 21.1% of eurozone GDP in 2010 – where the government has so-far failed to instigate a comprehensive austerity programme. The French government deficit ran at 7.0% of GDP in 2010 and its public debt at 81.7% of GDP;
  • The eurozone crisis has coincided with the US debt crisis and has revealed the fragility of the recovery from the global economic downturn of 2008-2009, in heavily indebted developed economies. These economies find themselves in a precarious position between curtailing deficits and instigating austerity programmes – which it is feared may lead to a double-dip recession.

Italy and Spain join the club

The eurozone crisis which started with Greece and spread to other small, periphery economies, with Ireland and Portugal also receiving bailouts, is now spreading to Italy and Spain as well as economic minnows such as Cyprus.

In July 2011, eurozone leaders agreed a second bailout deal for Greece, and also agreed more powers for the European Financial Stability Fund (EFSF) – the Eurozone’s bailout fund. However, this fund of €440 million is not enough to rescue the two larger economies of Italy and Spain (or even Italy alone) should they also find it impossible to borrow on international debt markets.

This is leading to a crisis of confidence among financial markets and could become a self-fulfilling prophecy – as more uncertainty pushes up interest rates, which in turn increases the likelihood of Italy and Spain being unable to meet their debt obligations.

The crisis has been forestalled by the European Central Bank purchasing Italian and Spanish government bonds, which has acted to lower interest rates and calm markets. However, this is only a temporary solution to the problem of the two countries’ debt burden.

What’s happening?

The size and importance of the Italian and Spanish economies is a key factor in deepening the crisis:

  • Italy and Spain are the 3rd and 4th largest economies in the eurozone. They accounted for 16.9% and 11.6% of eurozone GDP respectively in 2010. This compares to a combined 6.1% for Portugal, Ireland and Greece in the same year;
  • Public debt reached €1,843 billion in Italy (higher than the combined debt of Greece, Ireland and Spain) and €639 billion in Spain in 2010, equivalent to 119% and 60% of GDP. This compares to 142% in Greece, 96% in Ireland and 83% in Portugal;
  • In 2010, the government deficit meanwhile reached €71.2 billion, equivalent to 4.6% of GDP in Italy and €98.2 billion, equivalent to 9.2% of GDP, in Spain. This compares to a eurozone average of 6.1% and a eurozone high of 32.2% in Ireland.

General Government Deficit and Public Debt in PIIGS Economies and Eurozone Average: 2010

% of GDP

C&C 8.16.11 1
Source: Euromonitor International from IMF

The situation is exacerbated by slow economic growth, which hinders attempts to draw down government debt:

  • The recovery in Italy and Spain remains muted. Real GDP growth in the first quarter of 2011 stood at 0.1% and 0.3% quarter-on-quarter, compared to 0.8% in the eurozone as a whole;

Real GDP Growth in Italy, Spain and the Eurozone: Q2 2010 – Q1 2011

% growth on previous quarter

  C&C 8.16.11 2

Source: Euromonitor International from national statistics and Eurostat

  • Both countries must overcome structural problems in order to drive economic growth in the future. Italy is suffering from poor productivity, a weak labour market and fragile private consumption. In Spain, domestic demand is expected to remain weak in 2011 due to a combination of record levels of unemployment, a continuing readjustment in the construction sector and the continued deleveraging of households, business and government;
  • Political uncertainty adds to both countries’ problems. Disaffection with the political class is rife in Spain where a general election will be held in November 2011 with the opposition Popular Party tipped to win. In Italy a series of domestic crises involving Prime Minister Berlusconi, divisions within the government and a slim majority in parliament are combining to create a political crisis of confidence.

Serious ramifications for the eurozone

The continued crisis is putting pressure on the Eurozone as a whole and its member-states:

  • The very future of the eurozone is being brought into question. A key issue being debated is the lack of fiscal union. The sustainability of the divergence of competitiveness between member states, with the periphery states suffering from low productivity, is also being questioned;
  • EU mechanisms for decision-making and its leaders’ ability to cope with the crisis have been highlighted. The July 2011 agreement for a second bailout of Greece and decision to increase the scope (to enable the EFSF to buy bonds) and financing of the EFSF has to be ratified by all eurozone members – which can’t happen until at least September 2011 because of summer recesses;
  • Analysts are now turning to look at France – the eurozone’s second-biggest economy accounting for 21.1% of eurozone GDP in 2010. The French government deficit ran at 7.0% of GDP in 2010 and its public debt at 81.7% of GDP. The government has so-far failed to instigate a comprehensive austerity programme and has no viable plans for cutting its deficit. If the French government has to contribute more to the bailout fund then under this added pressure analysts are questioning the country’s own ability to manage its debt.

Global shockwaves

The eurozone crisis has coincided with the US debt crisis:

  • Fears over the US government’s ability to finance its debt led to its credit rating to be downgraded in August 2011 from the top triple A grade to AA+ – the first time in its history that the USA has lost its top rating. This led to a sell-off of shares and severe falls for European, Asian and US stock markets;
  • Fears over a slowdown in US growth are also growing. Problems in the USA the world’s largest economy, which in 2010 contributed 23.1% of global GDP and accounted for one-in-every three dollars of consumer spending, have increased fears of a double dip recession; and combined with the eurozone crisis has revealed the fragility of the recovery in heavily indebted developed economies.

Flow-on effects of the twin crises include:

  • With volatile financial markets the price of gold, perceived to be less risky, has reached record highs. On the 9th August 2011 it stood at US$1,770 an ounce. In the first half of 2011 it was up 25.4% in US$ terms on the same period of the previous year;
  • The Swiss franc has also gained ground – again as it is seen by investors as a safe haven during times of crisis. In the 30 days to August 10th 2011 the Swiss franc was up 40.0% on the US$ compared to the same period of the previous year. The strength of the Swiss franc is hurting Swiss exporters and as a result the Swiss government has pledged to act to weaken the currency.

Prospects

Governments in indebted countries are treading a tightrope between alleviating fears of a default amongst investors by instigating austerity programmes and tax rises in order to draw down debt without cutting spending so severely that economic growth stalls and recession returns.

Much of Europe is facing an increased likelihood of a return to recession. Consumer confidence in the eurozone fell in July 2011, unemployment remains stubbornly high, and is not set to return to pre-crisis levels until 2020, and the recovery remains fragile.

Without strong economic growth the sustainability of austerity measures cannot be assured. Eurozone growth is forecast at 1.8% in both 2011 and 2012 – hardly a stellar performance – with Italy and Spain expected to see even slower rates of growth: 1.0% and 0.8% in 2011 and 1.3% and 1.6% in 2012 respectively. Interest rates are already at historic lows in many countries and governments have no more room to introduce measures to kick-start their economies. Options for any future crisis are therefore limited in many developed economies.

The very future of the eurozone has been brought into question. Many analysts are questioning whether it is viable or desirable to have a single currency without a common fiscal policy. Debate still continues on if and how individual countries could leave the currency union and what impact that might have on the eurozone as a whole.