Sinking and swimming in Europe

The debt crisis deepens and European countries, including Ireland, founder - or float - which raises questions of its severity, length and the best way to rescue the diverse economies.

ALASTAIR WINTER is the chief economist at Daniel Stewart.

Despite all the talk about the delicate state of public finances in Europe, do people really know what is going to hit them? Do the politicians “get it” but are too scared to bear the news? The table below sets out a structure for answering such questions.

The banks are vulnerable to defaults by sovereign and private borrowers in the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain) and eastern Europe, and may need government help during the phasing-in of Basel III. In Germany the red-green opposition parties could return to power in the 2012 elections if voters punish Angela Merkel, the country’s chancellor. However, Germans make things people want to buy and do not borrow much, hence they are wading to shore. Britain is swimming towards the shore, but there is a long way to go.

In France recent protests over the increase in the retirement age suggest they think they can walk on water. The country has a large annual deficit and poor growth prospects, but President Nicholas Sarkozy is reluctant to do much about it before the elections in 2012. Sooner or later the country’s AAA rating will be in doubt – borrowing will become more difficult and more cuts will be imposed.

”The single currency is buoyed up by its status as the principal alternative to the dollar, and talk of its death is greatly exaggerated”

Italy’s public finances seem to work but the country relies on bank lending, including from foreign banks. Its politicians seem too obsessed with themselves and each other to see the dangers ahead.

In Spain unemployment of 20% and a construction boom and bust, in a still relatively inflexible economy, are proving to be heavy burdens. Spain is swimming but weighed down.

The Portuguese government and opposition are playing electoral games while the economy stagnates. There is a real danger that access to the bond market will be cut off and the International Monetary Fund (IMF) and European Union (EU) will have to step in. Portugal is in water up to its chin. (article continues below)

Ireland is well out of its depth. Nemesis is falling on the people as cuts are made. Brave plans to return to the bond market next year look unrealistic. The arrival of the IMF and EU team was not a surprise.

George Papandreou, Greece’s prime minister, deserves better, but the country is drowning heroically. The IMF and EU will soon need to look beyond Greece’s initial €110 billion (£95 billion) bail-out fund.

The single currency is buoyed up by its status as the principal alternative to the dollar, and talk of its death is greatly exaggerated. The weaker PIIGS countries are featured in the table but also included for comparison are the EU “big three” – Britain, France and Germany.

Rows one and two quantify the challenges of compliance with the reinforced Stability and Growth Pact: high public debt/GDP (any excess over 60% must be reduced by one-twentieth each year), and annual public deficit/GDP ratios (which must be reduced to 3% by 2014-15). The figures shown are for 2009 and are mostly expected to be higher by the end of 2010.

Rows three and four show the IMF’s latest forecasts for GDP this year and next. Rows five, six and seven indicate the major targets of each country’s deficit and debt reduction programme. Row eight shows whether the reduction programmes have already started or not. Row nine adds a third dimension to the challenges by showing the total exposure of each country’s major banks to the sovereign risk of the PIIGS countries, as a percentage of their tier-one capital.

Row 10 shows the percentages for each of the PIIGS’s banks’ exposures to their own government. In their study of the July European bank stress tests, Adrian Blundell-Wignall and Patrick Slovik of the Organisation for Economic Cooperation and Development concluded that the solvency of many banks was dependent on the solvency of their own governments and, crucially, vice versa.

Fitch’s credit ratings for sovereign bond issues in row 11 still influence investors’ appetite for government bonds. Row 12 shows the spreads over benchmark 10-year German bund yields for the PIIGS’s sovereign bonds, which are rising almost daily. Rows 13 and 14 add another dimension in a subjective assessment of the overall attitude to debt and deficit reduction of each country’s ruling party and the main opposition. Either “A”, the deficit is a temporary problem: government should move more slowly to preserve jobs, rely on tax increases rather than cut services, and increase the retirement age.

Or “B”, the deficit is a serious problem: government should spread the pain between public sector employees, users of public services and taxpayers. There is both a rapidly escalating burden in borrowing and a finite investor appetite to lend.