IIF RESEARCH NOTE
The Euro Area Debt Crisis: Whats
Next? October 12, 2013
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Much has been done since 2010 to reduce macroeconomic imbalances in the Euro
Area periphery and to bolster economic and nancial integration at the EU level
Stronger exports may now be stabilizing output after two years of contraction, but
headwinds remain with scal adjustment continuing and bank lending constrained
Market sentiment, underpinned by OMT, has improved with better economic news
Challenges remain, however, including the need to restore full bond market access
for Portugal as well as Ireland and agree further nancing and relief for Greece
Italy remains at risk over the longer term, with a return to durable growth requiring
deeper structural reforms that political divisions are likely to impede
Progress mutualizing sovereign and bank liabilities looks likely to remain limited,
leaving Euro Area members vulnerable to renewed weakness in market sentiment
Hung Q. Tran
EXECUTIVE MANAGING
DIRECTOR
1-202-682-7449
Jeffrey Anderson
SENIOR DIRECTOR
European Affairs
1-202-857-3636
Stabilizing economic activity in the periphery and renewed growth in the core leaves Europe
better off than at any time since the &nancial crisis intensi&ed during the latter half of 2011
(Chart 1). Fiscal and external de&cits have been reduced, competitiveness improved and
government borrowing costs lowered to more sustainable levels. The stabilization of activity
now offers increased scope for households, &rms and governments to continue to repair
balance sheets that remain heavily leveraged without having to retrench as severely as in the
recent past. Like ongoing &scal consolidation, however, ongoing deleveraging by the private
sector will leave recovery constrained, uncertain and subject to shifting &nancial market
sentiment. Much remains to be done, moreover, to continue reducing &nancial market
fragmentation (Chart 2) and to assure adequate &nancing to those &rms able to bene&t from
the structural reforms that are now being advanced. Unemployment, more critically, remains
at worrisome levels, especially among the young, justifying concerns that political stability
can endure or that output potential will return to earlier levels in some countries.
Jared Bebee
ASSOCIATE ECONOMIST
European Department
1-202-857-3639
Mirjana Milutinovic
INTERN
European Affairs
1-202-857-3339
Average of Cyprus, Greece, Italy, Portugal, Slovenia, Spain, weighted by 2012
nominal GDP. Cyprus, Greece, Ireland, Italy, Portugal, Spain, Slovenia.
Source: Eurostat, DG ECFIN. Source: Datastream
70
75
80
85
90
95
-3
-2
-1
0
1
2009 2010 2011 2012 2013
Chart 1
Euro Area Periphery: Real GDP and Economic Sentiment
change from previous quarter weighted ESI Index
ESI
GDP
0
2
4
6
8
10
12
14
16
18
Spain
Italy
Germany
Ireland
Portugal
Chart 2
10 Year Bond Yields
percent
2012 2013
IIF RESEARCH NOTE
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The Euro Area Debt Crisis: Whats Next?
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IMPROVEMENT IS EVIDENT
Europe has moved a long way since early 2010 when the Greek sovereign debt crisis 1ared
up in &nancial markets. The crisis became virulent and spread to other Euro Area member
states, at times threatening the survival of the euro. Four countries (Greece, Ireland, Portugal
and Cyprus) eventually required &nancial support from their European partners and the IMF
for an adjustment program. In addition, Spain needed support for a &nancial sector
stabilization program.
Since then, much progress has been made both at the country level and the EU level, even
though more remains to be done. Together with the four program countries, Spain and Italy
have made signi&cant progress reducing &scal and current account de&cits (Tables 1 and 2).
Except for Italy, the same countries have made good headway reversing sizable
competitiveness losses during the long boom that followed euro adoption. Fiscal de&cits
have been reduced and primary de&cits narrowed or eliminated. (Most impressive, perhaps,
has been Italy, which should have the second largest primary surplus in the Euro Area for a
second straight year in 2013 despite real GDP having fallen more than 8% below its pre-
crisis peak to roughly 5% below potential.) Current account de&cits that ranged as large as
13% of GDP in Greece before the crisis are on course to shift to surpluses by 2014 that will
be as large as 4% of GDP in Spain, Portugal and Ireland, all of which greatly reduces
vulnerability to contagion risk from abroad. Ratios of government debt to GDP, on the other
hand, have increased further to very high levels. Still more worrying, the slow recoveries now
in prospect for the foreseeable future if downside risks can be contained will not be
suf&cient to bring down socially-damaging levels of unemployment which remains the key
challenge to many Euro Area member states.
Among the key Euro Area authorities, there is now clear appreciation that economic and
&scal "integration" must deepen further if monetary union is to be made sustainable.
Economic and &scal coordination has been enhanced, as a result, and discipline
strengthened via new arrangements such as the Six-Pack, the Two-Pack, the Fiscal
Compact, and the European Semester, which allows Excessive De&cit Procedures to be
Table 2
Current Account De4cits
% GDP
2008 2009 2010 2011 2012
Italy -2.9 -2.0 -3.6 -3.0 -0.5
Spain -9.1 -4.4 -3.9 -3.3 -0.5
Greece -13.2 -10.3 -9.2 -8.6 -1.9
Ireland -5.6 -3.1 0.7 0.9 3.8
Portugal -11.1 -10.1 -9.4 -5.8 0.8
Slovenia -6.1 -0.6 -0.4 -0.3 2.1
Cyprus -15.6 -10.4 -9.6 -3.1 -6.4
Source: Eurostat, IMF, Slovenian Ministry of Finance, IIF.
2013 2014
-0.1 0.0
1.9 3.5
1.7 1.6
4.0 4.0
3.0 3.5
4.4 3.8
-1.8 -0.4
Table 1
General Government De4cits, 2010-2014
% GDP
2010 2011 2012 2013 2014
Italy -4.4 -3.7 -2.9 -3.2 -2.1
Spain -9.7 -9.0 -7.0 -6.7 -5.9
Greece -10.8 -9.6 -6.3 -4.1 -3.2
Ireland -10.6 -8.9 -7.6 -7.5 -4.9
Portugal -9.9 -4.4 -6.4 -5.5 -4.0
Slovenia -5.9 -6.4 -4.0 -7.9 -2.6
Cyprus -5.3 -6.3 -6.3 -6.7 -7.5
Source: IMF and Slovenian Ministry of Finance.
IIF RESEARCH NOTE
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The Euro Area Debt Crisis: Whats Next?
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launched because of failures to reduce debt as well as de&cits, and the Macroeconomic
Imbalance Procedure, which requires steps to correct a broader range of imbalances than
&scal ones.
Institutionally, the 500 billion European Stability Mechanism (ESM) has been established
and the ECB has become much more active and effective in managing liquidity problems (via
LTROs) or diminishing Euro-exit tail risk (via the OMT). Nevertheless, not much progress has
been made, or is likely, in mutualizing of sovereign and bank liabilities in the Euro Area
member states. Debt mutualization is needed to effectively sever destabilizing linkages
between weak sovereign and bank balance sheets that have been at the root of much of the
crisis. Without mutualization, &scally weak government will remain vulnerable to renewed
banking stresses in the future.
This study analyzes both the "glass half-full" and "glass half-empty" views and offers
thoughts about next steps.
PROGRESS HAS BEEN MADE BY MEMBER STATES
Since 2008, many problem countries in the Euro Area periphery have made strenuous efforts
to reduce the macroeconomic imbalances that had brought them under &nancial market
pressures. And since currency devaluation is no longer possible as an adjustment policy
instrument by virtue of membership in the Euro Area, they have had to make extra efforts
through "internal devaluation" to regain competitiveness lost during the initial years of the
monetary union. In addition, they have begun to implement structural reforms to improve the
potential for growth. Overall, progress has been most impressive in reducing &scal and
external imbalances, tangible but uneven in improving competitiveness and spotty in
advancing structural reforms.
Under pressure from &nancial markets and fellow Euro Area members, those countries
experiencing &nancing strains or loss of market access have adopted stringent &scal
consolidation measures. From 2009 through 2013, structural primary &scal de&cits (adjusted
for cyclical effects and one-offs) have been reduced by 4% of GDP in Italy, 6-7% in Spain,
Table 3
Changes in Structural Primary Fiscal Balances, 2010-20141
% GDP
2010 2011 2012 2013 2014
Italy 0.4 0.5 2.6 0.9 0.2
Spain 1.4 0.4 2.4 1.6 0.8
Greece 6.9 4.8 3.5 2.8 -0.2
Portugal -0.1 3.6 2.9 0.7 1.5
Slovenia -0.5 0.4 2.2 2.1 0.1
Ireland 2.7 1.5 1.5 1.9 1.6
Cyprus 0.4 0.7 3.0 0.3 0.3
Weighted Average2 1.2 0.9 2.5 1.3 0.5 1 General government. 2 By nominal GDP
Source: IMF and Slovenian Ministry of Finance
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Ireland and Portugal and 18% in Greece (Table 3, previous page). Fiscal consolidation
programs have been front loaded, relying heavily on tax increases and spending cuts with
larger &scal multipliers than initially assumed, the combination of which contributed to
sharper than expected recessions.
Collapsing domestic demand, in turn, led to a signi&cant increase in unemployment rates,
especially among the young. Labor shedding, especially among lower-productivity sectors
such as construction, helped boost labor productivity signi&cantly in Ireland, Spain and
Portugal. Together with more limited declines in nominal wages, increases in productivity
have yielded declines in relative unit labor costs (RULCs), the broadest measure of external
competitiveness. In Ireland, Greece, Portugal and Spain, these decreases have corrected
75-90% of earlier increases in RULCs from the beginning of monetary union through peaks
in 2008 or 2009 (Charts 3 and 4). In Italy, by contrast, improvements have been more
limited, with Q2 RULCs just 2.5% less than the late 2009 peak and still 14% higher than at
the start of the monetary union in 1999.
The combination of collapsing domestic demand reducing imports and improvement in
competitiveness stimulating exports has brought about impressive improvements in current
account positions. The smallest shift since 2008 will be in Italy, which should run a small
surplus this year, a swing of just over 3 percentage points of GDP from de&cit in 2008.
Greece should see a surplus this year, compared with a 13% of GDP de&cit in 2008. Ireland,
Spain and Portugal may see surpluses of 3-4% in 2014, which represent shifts equal to 10,
13 and 15 percentage points of GDP, respectively, from 2008.
The drivers of current account improvement have differed among countries: Declines in
domestic demand were a major factor in all the major countries. Export growth has been key
in Ireland, Spain and Portugal, although much less than headline &gures suggest because of
signi&cant shares of imported export inputs. Italy will register only about half the 3-4% annual
increases in export volumes these three countries have recorded since 2008. Greece, by
contrast, has yet to return exports to their 2008 level.
Source: Eurostat. Derived from labor productivity and nominal unit labor costs.
Source: Eurostat.
60
70
80
90
100
110
120
1999 2001 2003 2005 2007 2009 2011 2013
IrelandGreeceSpainItalyPortugal
Chart 3
Relative Unit Labor Costs
2005 = 100
-15
-10
-5
0
5
10
15
09Q1 10Q1 11Q1 12Q1 13Q1
Spain
Ireland
Italy
Portugal
Greece
Chart 4
Hourly Compensation
12-month change, percent
IIF RESEARCH NOTE
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With &scal de&cits considerably reduced, the current account surpluses Ireland, Portugal and
Spain will run this year and next means each should post surpluses of private savings over
investments on the order of 9% of GDP or more. Much of this will go to repaying private
sector debt owed foreign lenders by companies and banks. The last, in turn, may continue
being repaid by companies and households. The remainder should be available for use to
&nance at least part of smaller &scal de&cits, at least in Spain. With higher levels of private
sector debt, Ireland and Portugal will need to rely more on foreign lenders for &scal de&cit
&nancing, with or without further of&cial &nancial support in the form of contingent credits or
disbursing loans.
The consequence of the adjustment has been a sharp and protracted recession, with
shrinkage in GDP of 25% in the case of Greece and record high unemployment (Charts 5
and 6). This has caused social tension and weakened political support for persevering with
structural reform. And this is where there is much un&nished business. Important initial
progress has been made implementing labor market reforms (making it somewhat easier to
layoff full time workers and easier to hire part time workers) and pension reforms (extending
minimum retirement age and period of contribution and reducing bene&ts, partly to offset the
loss of pension contribution in1ows as employment has fallen). Portugal, notably, has also
made progress privatizing state owned enterprises. Much more needs to be done on reform,
all the same, to improve 1exibility and dynamism and enhance each economys potential
growth. Otherwise, the limited recoveries currently in prospect will simply not be suf&cient to
make a dent in the extremely high levels of unemployment, building up risks for the future.
OUTPUT IS NEARING BOTTOM
The good news on the economic front is that eight quarters of recession in the Euro Area
periphery seems to be coming to an end. Renewed growth in export volumes slowed the
contraction in aggregate output for seven periphery countries to a seasonally adjusted 0.1%
80
85
90
95
100
105
110
115
2007 2008 2009 2010 2011 2012 2013 2014
Ireland
Greece
Spain
Italy
Portugal
Chart 5
Real GDP Growth, 2007-2014
2005=100
0
5
10
15
20
25
30
2007 2008 2009 2010 2011 2012 2013
Italy Ireland
Spain Italy
Portugal Greece
Chart 6
Unemployment Rate
percent, seasonally adjusted
Spain, Italy, Ireland, Portugal, Greece, Cyprus and Slovenia
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in Q2 from 0.5% in Q1 and 0.9% in Q4 2012. Exports of goods and services rose 3.3% after
declining 2.4 % in Q1. This helped to compensate for continued weakness in domestic
spending.
Growth returned in Portugal and Ireland, while recessions slowed in Greece, Italy and Spain
(Table 4, page 7). Buoyed by temporary factors, Q2 growth in Portugal was the highest in
the Euro Area at 1.1%. In Ireland, renewed export growth enabled real GDP to increase
0.4%, the &rst advance after three consecutive quarters of decline caused by further
decreases in domestic demand and expiring pharmaceutical patents. Rebounding Spanish
exports boosted the year-on-year increase to impressive double digits while slowing the
contraction in quarterly real GDP to a minimal 0.1%. Renewed growth in Italian exports
slowed the contraction in Italys real GDP to 0.3% despite a larger decrease in domestic
demand in Q2 than Q1.
Following a soft Q1, exports in the periphery improved markedly in Q2. Spanish exports rose
6% in seasonally-adjusted terms after decreasing nearly 4% the previous quarter, making a
signi&cant increase likely this year as a whole (Chart 7). Improved competitiveness has
helped, as has success in increasing shipments to emerging markets, stronger growth in
which has helped offset more sluggish demand in developed markets, something Portugal
and Greece have been able to do as well (Chart 8). Bolstered by rising shipments of
automobiles and automobile components, Spanish exports also have also bene&tted from
strong competitiveness gains, with relative unit labor costs down 15% from the pre-crisis
peak and 8% lower in Q2 than two years earlier. Similar or larger gains in competiveness
improvements have been registered by Greece, Ireland and Portugal from pre-crisis levels
and compared with 2011. Italy recouped much less of considerably smaller earlier
competitiveness losses through Q3 of last year and has seen much of those gains unwound
in recent quarters as the euro has strengthened vis--vis trading partner countries.
Other factors contributed to the stronger Q2 performance. Irish exports were supported by
recovering demand in the U.K., Irelands largest export market. Portuguese exports were
Source: Eurostat Ratio of exports of goods to emerging market economies vs advanced economies.
Source: Direction of Trade Statistics.
80
90
100
110
120
130
140
150
2008 2009 2010 2011 2012 2013 2014
Ireland Greece
Spain Italy
Portugal
Chart 7
Export Volume
2005 = 100
60
80
100
120
140
160
180
2008 2009 2010 2011 2012 2013
Greece
Ireland
Italy
Portugal
Spain
Chart 8
Exports to Developing Countries
2010 = 100, 12-month moving average
IIF RESEARCH NOTE
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Table 4
Real GDP, by Expenditure
% change vs. previous quarter vs. year earlier
12Q1 12Q2 12Q3 12Q4 13Q1 13Q2 12Q1 12Q2 12Q3 12Q4 13Q1 13Q2
Italy Real GDP -1.1 -0.6 -0.4 -0.9 -0.6 -0.3 -1.4 -3.0 -2.9 -2.8 -2.8 -2.6
Domestic Demand -2.0 -0.9 -1.1 -1.4 -0.5 -0.7 -4.4 -5.8 -5.6 -5.1 -4.1 -4.0
Private Consumption -1.8 -0.6 -1.4 -0.8 -0.5 -0.4 -3.5 -4.1 -4.8 -4.2 -3.2 -3.7
Govt Consumption -2.0 -0.5 -0.4 0.1 0.2 0.1 -2.5 -2.6 -2.1 -3.4 -0.5 0.2
Fixed Investment -3.8 -1.7 -1.1 -1.8 -2.9 -0.3 -7.0 -9.6 -9.0 -7.6 -7.6 -6.1
Exports 0.2 -0.2 0.9 0.1 -1.4 0.6 3.6 1.2 1.1 2.1 -1.4 0.3
Imports -2.6 -1.1 -1.5 -1.6 -0.9 -0.8 -7.3 -8.3 -8.0 -5.9 -5.8 -4.6
Spain Real GDP -0.4 -0.5 -0.4 -0.8 -0.4 -0.1 -1.3 -1.7 -1.7 -1.9 -2.7 -1.7
Domestic Demand -0.5 -1.4 -1.0 -1.8 -0.6 -0.3 -3.4 -3.7 -4.5 -4.8 -4.9 -3.7
Private Consumption 0.2 -1.1 -0.7 -2.0 -0.5 0.0 -2.0 -2.5 -3.3 -3.5 -4.7 -3.2
Govt Consumption -1.8 0.0 -3.0 -0.3 0.0 0.9 -5.4 -3.8 -5.2 -4.8 -3.4 -1.6
Fixed Investment -1.7 -3.3 0.2 -3.0 -1.5 -2.1 -6.0 -7.0 -7.2 -7.7 -7.5 -6.6
Exports -3.1 0.6 6.5 0.6 -3.8 6.0 -1.4 -0.7 3.9 6.7 2.6 11.2
Imports -3.3 -2.2 4.6 -2.6 -4.5 5.9 -8.0 -7.4 -4.4 -2.9 -4.5 4.9
Greece Real GDP -1.5 -1.0 -1.8 -1.6 -0.5 -0.3 -6.7 -6.4 -6.7 -5.7 -5.6 -3.8
Domestic Demand -2.3 -1.6 -2.6 -1.6 -2.1 -1.9 -11.0 -9.2 -11.4 -6.6 -6.8 -7.5
Private Consumption -1.4 -1.7 -2.6 -3.3 -1.9 0.4 -9.5 -8.6 -8.6 -9.6 -8.7 -6.3
Govt Consumption -2.7 -3.0 -2.4 0.1 -1.7 -3.1 1.4 -1.8 -10.2 -5.8 -8.8 -6.1
Fixed Investment -5.0 -4.5 -3.3 -2.8 -3.9 -2.9 -22.8 -21.5 -21.5 -10.3 -11.4 -11.0
Exports 1.4 -3.3 0.7 -1.5 0.1 0.6 4.1 -3.0 -4.2 -4.8 -2.5 0.9
Imports -3.1 -0.8 -7.0 2.8 -2.7 -5.2 -14.9 -12.9 -18.7 -8.1 -7.7 -11.8
Portugal Real GDP -0.1 -1.0 -0.8 -1.9 -0.4 1.1 -0.8 -4.0 -2.5 -5.4 -4.9 -2.5
Domestic Demand -0.5 -2.7 0.0 -1.2 -2.1 0.8 -5.4 -9.3 -6.0 -5.9 -6.4 -3.0
Private Consumption -1.9 -1.0 -0.3 -1.9 -0.7 0.4 -5.0 -5.7 -5.7 -5.3 -4.0 -2.6
Govt Consumption -1.3 -0.9 -1.6 -0.4 -0.9 0.0 2.4 -10.5 0.6 -9.9 -6.0 -4.3
Fixed Investment 2.0 -10.4 0.4 -4.4 -2.7 -0.1 -13.0 -17.3 -14.4 -12.2 -15.7 -6.8
Exports 2.0 -1.3 0.5 -1.0 2.6 5.2 7.9 3.6 1.7 -0.2 0.3 7.4
Imports 0.9 -5.9 2.7 0.9 -1.8 4.5 -5.7 -11.1 -7.7 -1.6 -4.0 6.5
Ireland Real GDP -0.5 0.5 -0.8 -0.2 -0.6 0.4 1.8 0.4 -0.5 -1.0 -1.0 -1.2
Domestic Demand 1.3 -2.4 1.6 -0.5 -0.6 -2.0 -2.2 -4.0 0.1 -0.1 -2.0 -1.8
Private Consumption -0.6 0.6 1.1 -0.3 -2.5 0.7 -2.4 -1.6 1.7 0.9 -1.1 -1.3
Govt Consumption 0.2 -1.6 0.1 -0.3 -0.2 -1.0 -2.8 -4.8 -3.0 -2.0 -1.7 -1.7
Fixed Investment 17.1 -23.1 13.3 -1.4 -6.4 -3.4 4.6 -16.0 10.0 1.3 -20.0 0.4
Exports 1.7 -0.7 -0.3 0.6 -3.5 4.3 3.3 1.3 0.4 1.3 -4.1 1.0
Imports 5.1 -5.7 3.4 -0.9 -0.6 0.7 -0.1 -3.0 2.0 1.4 -4.0 2.6
Slovenia Real GDP -0.5 -1.3 -0.4 -1.0 -0.5 -0.3 -0.2 -3.5 -3.0 -3.3 -4.6 -1.7
Domestic Demand -1.0 -3.6 -1.9 -1.8 -0.8 0.2 -2.6 -6.5 -8.5 -8.5 -8.0 -3.5
Private Consumption -1.6 -2.0 -1.4 -0.6 -0.5 -0.5 -1.2 -5.1 -6.8 -5.8 -5.2 -2.1
Govt Consumption -0.4 -0.3 -0.9 -0.8 -0.1 -1.2 -0.2 -0.6 -1.8 -2.4 -1.8 -3.1
Fixed Investment -4.9 -1.3 -1.5 -2.7 1.1 -1.2 -6.2 -6.5 -7.3 -12.3 -3.3 -3.0
Exports -0.9 1.6 -0.1 0.3 1.3 -0.6 1.7 -0.3 0.1 0.8 1.7 2.0
Imports -2.5 -0.7 -2.8 0.1 2.4 -0.7 -1.4 -4.1 -7.1 -6.0 -2.3 0.0
Cyprus Real GDP -0.3 -1.0 -0.8 -1.5 -1.7 -1.8 -1.6 -2.7 -1.9 -3.6 -5.0 -5.9
Domestic Demand -1.2 -2.9 0.4 -4.1 -3.9 -5.3 -6.1 -6.6 -6.5 -8.0 -8.9 -11.5
Private Consumption -1.0 -1.6 -1.4 -1.0 -1.2 -2.4 -1.0 -2.7 -3.9 -4.4 -5.3 -6.3
Govt Consumption 0.6 -1.0 -2.0 -1.3 -1.5 0.0 2.7 0.1 -4.7 -3.4 -6.1 -4.9
Fixed Investment -6.2 -8.6 -3.6 -10.9 -4.0 -10.2 -19.7 -24.2 -21.8 -26.3 -24.6 -25.7
Exports 0.8 3.1 -2.1 -2.0 -2.1 0.3 -0.2 3.7 5.1 -0.1 -8.2 -7.2
Imports -1.2 -1.1 0.3 -7.3 -6.9 -7.3 -10.5 -5.0 -4.3 -9.2 -16.8 -18.9
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boosted by the stream of new re&nery capacity. Spain, Portugal, Greece and Italy were all
able to bene&t from improving tourism, from a very low base in Greeces case, a
development that is likely to have continued in Q3.
Stronger export performances were accompanied by further declines in domestic demand
during Q2. Across the periphery as a whole, domestic spending fell 0.6%, only marginally
less than in Q1. Private consumption contracted further but by less than in Q1 as modest
upturns were recorded in Ireland, Portugal and Greece, and household spending ceased
falling in Spain. Further declines occurred in Italy and Slovenia and a larger drop was
registered in Cyprus. Fixed investment fell everywhere as output lagged potential, leaving
signi&cant amounts of unused capacity in industry and services. Year-on-year declines
exceeded double digits in Greece, Portugal and Cyprus and ran at 6-7% in Spain and Italy.
Declines were much smaller in Slovenia and in Ireland, where aircraft deliveries for Irish
carriers and leased 1eets have buoyed capital outlays and imports. Low levels of household
investment remain a drag on investment across the periphery.
Smaller declines in private consumption and increases in several countries mainly re1ect
moderating declines in employment or the onset of modest upturns. In aggregate, private
consumption declined 0.2% across the periphery, much less than the decreases of 0.7%
and 1.5% registered in Q1 and Q2. Renewed employment gains in Ireland since mid-2012
and recent stabilization in Spain and Greece have been accompanied by further declines
elsewhere, however. Except in Cyprus, unemployment rates have ticked down from highs
early this year and in 2012 that reached 27% in Spain and Greece, 18% in Portugal, 15% in
Ireland and 13% in Italy. Surveys show that consumer sentiment has improved, mainly in
comparison with 2012, but remains at weak levels.
Household spending looks likely to remain constrained by further downward adjustments to
wages and efforts to pay down debt. Downward 1exibility in wages has increased, thanks
mainly to recent reforms to wage setting mechanisms in Spain, Portugal and Greece. Lower
wages in these countries are helping to improve competitiveness but at the cost of further
Source: European Commission Source: ECB
-20
-15
-10
-5
0
5
10
15
20
1999 2001 2003 2005 2007 2009 2011
Ireland Greece
Spain Italy
Portugal Slovenia
Cyprus
Chart 10
Household Savings Rates, 1999-2012
net saving as percent of net disposable income
0
40
80
120
160
200
2008 2009 2010 2011 2012 2013
Spain Ireland
Portugal Italy
Greece
Chart 9
Household Debt
percent of disposable income
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declines in household incomes. These declines are larger in real disposable terms, given
downward rigidities in consumer prices and increases in indirect taxes. Ireland seems the
sole exception as regards wages, given modest increases in average weekly earnings in Q1
and Q2.
Household debt has been reduced in Ireland, Spain and Portugal but remains at elevated
high levels (Chart 9, previous page). Household saving rates, as a result, look likely to remain
mostly positive as deleveraging continues (Chart 10, previous page). Including corporate
borrowing, private sector debt has been little changed since 2010, suggesting that corporate
deleveraging will continue to weigh on hiring and wages.
PROSPECTS ARE UNCERTAIN WITH STILL LARGE DOWNSIDE RISKS
Whether contraction will shift to expansion among the periphery economies after midyear
remains to be seen. Improvements in sentiment indicators, together with further increases in
exports and retail sales suggest growth may have continued in Ireland and Portugal and that
a small positive &gure might be registered in Spain as well (Chart 11). Growth may be more
dif&cult elsewhere. Much will depend on foreign demand, both within the Euro Area and
further abroad. Further increases in export orders through August point to an ongoing
expansion of exports in Q3 and perhaps Q4 as well.
Domestic demand looks set to remain fragile, however. Retail sales &gures have been mixed.
In Q2, declines in turnover volume slowed in Ireland, while increases were recorded in
Greece, Ireland, Italy and Spain. Data through August show growth in Ireland, Portugal and
Spain. Car registrations appear to have picked up as well, rising in Greece, Portugal and
Ireland in the three months leading to August. In Ireland, however, this seems to re1ect
mainly the retiming of registration dates, which caused buyers to defer car purchases from
earlier in the year. In Spain, Italy and Cyprus, by contrast, new car registrations have
contracted further.
Source: DG ECFIN. Source: DG ECFIN.
70
80
90
100
Portugal
Greece
Spain
Italy
Chart 11
Economic Sentiment Indicator
2010 = 100, seasonally adjusted
2012 2013
-90
-80
-70
-60
-50
-40
-30
-20
-10
0
10
2009 2010 2011 2012 2013
Greece Portugal
Spain Italy
Chart 12
Manufacturing Orders
2010 = 100, seasonally adjusted
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Industrial production data give fewer positive signs, with output falling in July from Q2 levels
or remaining 1at. August data were better, however. Manufacturing orders registered upticks
in both July and August. Construction data for July registered increases in Spain, Italy and
Ireland but from a weak Q2 (Chart 12, previous page).
Against this backdrop of renewed export expansion and still weak domestic spending,
growth prospects remain constrained. Two factors that will continue to weigh on growth
going forward remain &scal consolidation and the high cost and tougher terms for bank
credit. Though stirring now, surveys suggest that borrowing demand has remain depressed
given uncertain business prospects, heavy existing debts and high borrowing costs
compared with the Euro Area core.
Fiscal adjustment efforts have continued in 2013 but at a more moderate magnitude than in
2012 (Table 3, page 3). A further easing of the pace of consolidation is planned in 2014, but
adjustment looks set to continue everywhere, even in Italy, where additional tightening
seems likely to be needed to make up for less consolidation this year than was originally
planned.
For the periphery as a whole, structural primary balances will tighten this year by half the
2.5% of GDP registered in 2012. The more moderate &gure will mainly re1ect smaller
adjustments in Italy and Spain, but also in Portugal, Slovenia and Greece. Only in Ireland is
underlying &scal adjustment seen as intensifying compared with 2012. This re1ects mainly
the full implementation of measures to control healthcare outlays that were only partly put in
place in 2012.
Further &scal adjustment may be partly offset this year in Italy by repayments of public
spending arrears to suppliers, which should amount to 1.2% of GDP and the same amount
again in 2014. Spain repaid a larger 2.6% of GDP in arrears owed suppliers by regional and
local administrations last year and will repay another 0.8% of GDP in 2013.
How expansionary these payments will be is unclear. Those arguing they will be, which
include the IMF in its most recent assessment of Italy, presume that the cash spent will ease
binding &nancial constraints faced by suppliers that have been tightened by the arrears. A
signi&cant part of the increases in banks NPLs in Italy and Spain in recent years is
understood, however, to have been triggered by public sector spending arrears. Repaying
these arrears would have little direct stimulative effect were suppliers to use them to come
current on past due loans owed banks. Indirect effects should be positive, of course, were
banks able to lend more to others and at lower margins thanks to reduced NPLs.
A further complication is that the spending that gave rise to these arrears has been included
in accruals-basis spending and de&cits each year bills were incurred but not paid. If arrears
repayments are expansionary, there would presumably have been an equivalent
contractionary effect when the arrears were incurred. Adjusting past spending to take arrears
into account might make sense, then, if outstanding amounts of arrears have changed
signi&cantly. Inadequate reporting of arrears makes it dif&cult to know the true story, but
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accounts payable, which include payments that are not overdue, have been little changed in
Italy since 2009 (Table 5). Survey data on late payments, moreover, indicate little change in
payments delays since 2010 (Table 6). Accounts payable did rise considerably in Spain in
2011, increasing by 3.1% of GDP that year, before decreasing in 2012 roughly in line with
arrears repayments. Adjusting Spains structural primary &scal balance in line with these
developments, however, gives the impression that Spains &scal stance eased in 2011 by a
dramatic 3.5% of GDP, was broadly neutral last year and is tightening again in 2013 by 3.4%
of GDP (Table 7). This seems hard to square with contractions in domestic demand that
accelerated from 2% in 2011 to about 4% a year in both 2012 and 2013.
However much these arrears repayments might offset &scal tightening, they add further to
government debt. Spain, as a result, will see its general government debt ratio rise to 92%
this year and keep increasing, according to the IMF, to a peak of 106% in 2017-2018.
Despite the largest primary surplus in the Euro Area except for Germany, Italy will see its
general government debt top 132% of GDP by the end of 2013. With an overall &scal de&cit
wider than 7% of GDP, Irelands government debt will increase to 123% of GDP this year.
Table 7
Change in Underlying Fiscal Positions, Spain and Italy, 2011-2014
% GDP
2011 2012 2013 2014
Spain
Structural primary balance change 0.4 2.4 1.6 0.8
Arrears payment change -3.1 2.6 -1.8 -0.8
Net -3.5 -0.2 3.4 0.0
Italy
Structural primary balance change 0.5 2.6 0.9 0.2
Arrears payment change -0.1 0.0 1.2 0.0
Net 0.6 2.6 -0.3 0.2
Memoranda:
Arrears payments
Spain -3.1 2.6 0.8 0.0
Italy -0.1 0.0 1.2 1.2
Domestic Demand
Spain -1.9 -3.9 -3.8 -1.6
Italy 0 -5.3 -2.4 0.3
Table 5
% GDP
Italy Spain Greece Portugal Ireland
2009 5.2 7.6 10.4 3.9 3.7
2010 5.2 8.9 10.1 4.9 3.5
2011 5.3 12.0 8.9 4.4 3.3
2012 5.3 9.3 11.4 3.8 4.0
Source: Eurostat
General Government: Accounts Payable
Table 6
General Government: Late Payments
days late
Italy Spain Greece Portugal Ireland
2009 52 51 70 72 15
2010 86 65 65 84 13
2011 90 66 108 82 14
2012 90 80 114 79 13
Source: Intrum Justicia
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Portugals debt ratio will exceed 127%, and Greeces ratio will exceed 175% of GDP.
Included in all these ratios will be borrowing to fund cash reserve positions varying from 10-
15 percentage points of GDP (Table 8).
What effect the further adjustments in the other countries will have on GDP remains to be
seen. Most of last years adjustment in Italy took the form of tax increases, which are likely to
have had smaller near-term multipliers than the spending cuts likely to predominate this year.
Fiscal stances will remain contractionary in any event, even if less so than in 2012. The same
will be true again in 2014, except in Italy and Cyprus.
Reductions in bank funding costs since last year due to the advent of the ECBs Outright
Monetary Transactions and progress on banking union have done little to resuscitate bank
lending. Credit to nongovernment borrowers fell 5.9% from a year earlier for the periphery as
a whole in July, compared with 3.4% in December 2012 (Chart 13). Lending to non&nancial
corporations decreased by 8.3% while that to households fell 2.7%. Lending to corporations
has declined at an increasing rate since December, thanks to larger reductions in Spain and
Italy. These more than offset slower reductions in Portugal and Greece. Lending to
households, by contrast, is declining at a slower pace, thanks to moderating declines in
Spain, Portugal and Greece and a modest increase again in Ireland, which re1ects new
Table 8
General Government Debt, 2010-2014
% GDP
2010 2011 2012 2013 2014
Italy 119.3 120.8 127.0 132.9 132.8
Spain 61.0 69.0 84.0 92.0 98.0
Greece 148.0 170.0 157.0 176.0 174.0
Ireland 91.2 104.1 117.4 123.3 121.0
Portugal 93.2 108.0 123.6 122.9 124.2
Slovenia 38.6 46.9 52.7 67.3 69.0
Cyprus 61.3 71.1 85.8 114.1 123.0
Source: ECB. Source: ECB.
-15
-10
-5
0
5
10
2009 2010 2011 2012 2013
ItalySpainIrelandPortugalGreece
Chart 13
Credit to Nongovernment
12-month change, percent
0
1
2
3
4
5
6
7
8
9
2010 2011 2012 2013
Germany Ireland
Greece Spain
Italy Portugal
Chart 14
Corporate Lending Rates: up to 1 Year/ 1 Million
percent
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mortgage borrowing.
Credit contraction continues against a backdrop of still weak but improving borrowing
demand, according to ECB surveys of banks and borrowers. Both surveys point to some
recent increases after long periods of decline. The same surveys register some easing in
bank credit standards, again after long periods of tightening. Reported differences between
interest rates on agreed loans have narrowed to 200-300 bps for &rms in Spain and Italy
over those for German &rms and 400-500 bps for &rms in Portugal and Ireland (Chart 14,
previous page). Actual spreads on offered loans are understood to be considerably wider,
however, at 450-600 bps, taking into account the smaller share of higher-interest, lower
quality credits agreed in the periphery and the larger share of lending with sovereign
guarantees.
Funding cost differences persists, moreover, with most banks paying no less for funding
than their sovereigns at different points along the yield curve. Lending margins, in addition,
continue to re1ect rising volumes of NPLs.
PROGRESS HAS ALSO BEEN MADE AT THE EU LEVEL
The crisis has prompted a substantial improvement in the EU economic governance
structures, crisis management and resolution mechanisms, including the role of the ECB,
and steps toward a European Banking Union.
The EU economic governance structure is now composed of three elements:
The European Semester of economic policy coordination, to help keep EU economies in
sync with each other by avoiding large macro-economic imbalances, bring &scal de&cits
below 3% of GDP and advance needed reforms.
The "Six-Pack" legislation and the Fiscal Compact, which strengthens the Stability and
Growth Pact (SGP) and introduces enhanced surveillance procedures.
The "Two-Pack" legislation to synchronize the budget process whereby Euro Area
member states have to submit their draft budgets to the European Commission by
October 15 of each year for review and comments before sending the budgets to their
national parliaments. The "Two-Pack" also sets out explicit rules and procedures for
enhanced surveillance of member states under stress (in excessive de&cit procedures,
assistance programs, precautionary or disbursing, or the process of exiting such
programs).
The objective of these economic governance structures and mechanisms is to enhance the
coordination and discipline of economic and &scal policies among Euro Area member states
so as to avoid a buildup of macroeconomic imbalances that could trigger &nancial crises.
One obvious omission is a symmetric adjustment among countries incurring large and
persistent current account surpluses, which leaves the burden of adjustment remains with
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de&cit countries. This asymmetric approach to adjustment will unfortunately reinforce the
de1ationary nature of the adjustment process experienced by crisis countries, making it
more dif&cult to &nd ways to foster growth strong enough to deal with the unemployment
challenge.
CRISIS RESOLUTION STRUCTURES HAVE BEEN STRENGTHENED
For crisis management and resolution, the main achievement has been the establishment of
the European Stability Mechanism (ESM) with 500 billion in authorized lending capacity,
about 60 billion of which has been approved to be available for direct bank recapitalization
if required conditions are met. Generally, the ESM can offer a requesting member state a full-
line assistance and adjustment program (as in the current four program countries), a
precautionary credit line (which could allow the ESM to buy a certain amount of the country's
government bonds issued on the primary markets), and a &nancial sector stabilization
program (like that in Spain where the government was authorized to borrow 100 billion from
the ESM and drew down 41.5 billion to recapitalize Spanish banks).
Complementing the important roles of the ESM, the ECB has re&ned its crisis resolution
toolkit. The ECB purchased government bonds to stabilize disorderly market conditions (the
Securities Market Program during 2010-11), extended LTROs to supply substantial amounts
of medium-term liquidity to the banking system to overcome market risk aversion and
liquidity crunches, and created Outright Market Transactions (OMT), which gives the ECB the
ability to purchase government bonds on secondary markets without ex ante limits. OMT
purchases are possible, however, only for countries with full bond market access and only if
the requesting member state has concluded a memorandum of understanding
encompassing agreed conditionality, which is needed to secure a precautionary ESM credit
line. Ireland is the &rst country aiming to qualify for such a facility when it exits the current
program at the end of this year. Essentially, the OMT has signi&cantly reduced the tail risk of
Euro exit or collapse, ushering in as a result a period of calm only the past year.
BANKING UNION HAS ADVANCED
At the EU summit on 29 June 2012, policy makers agreed to develop a banking union with
the goal of breaking the vicious linkage between the weak balance sheets of the sovereign
and banking sectors, which has been at the root of the virulent Euro Area debt crisis. Of the
three components of a banking union, a Single Supervisory Mechanism (SSM) is nearing
completion, a Single Resolution Mechanism (SRM) is making progress, but a Single Deposit
Guarantee Scheme (SDGS) has been put on the back burner.
After approval by the European Parliament, the ECB will take over the direct supervision of
the top 130 banks in the Euro Area. National supervisors will remain directly responsible for
the remainder of the 6,000 or so banks, but will have to abide by ECB regulations, guidelines
and general instructions and be subject to the ECB's broad oversight mandate over the
functioning of the SSM. The current schedule calls for the ECB to assume formal supervisory
responsibility by late 2014, probably around October. Before that can happen, however, the
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ECB will conduct an Asset Quality Review (AQR) early next year to assure itself of the health
of the balance sheets of banks coming under its supervision and that any capital
de&ciencies identi&ed by the AQR are recti&ed.
It is here that some uncertainty still exists. Ideally, backup arrangements for recapitalization
should be in place before a rigorous bank stress test or asset quality review is undertaken
so that there is no uncertainty as to how banks found to be in need of additional capital will
be dealt with. This has been the key lesson from the US bank stress test that took place in
the context of the TARP program back in 2009. At present, there is no such formal backup
arrangement in place for the ECB AQR, and the debate about having one is still ongoing.
According to media reports, though, an ad hoc arrangement seems to be taking shape.
A bank found to have capital less than a minimum desired level would reportedly be given a
certain number of months to raise capital in the markets. If the capital raising exercise fails
to provide the needed amount of additional capital, the bank will then be determined to
require state aid, causing recently strengthened EU rules to kick in. Those rules call for
shareholders to suffer losses and junior debt to be converted to equity before a bank can
receive state capital support. If this bail-in of shareholders and junior creditors is insuf&cient
to meet the capital requirement, the country in question will then have to use its own &scal
resources to recapitalize the bank. If the government cannot do this on its own, it can
request a Financial Sector Stabilization program from the ESM as Spain has done
meaning the government will responsible for the new debt.
To make this palatable to &scally-constrained governments, it looks like adjustments for
recapitalization outlays will continue to be made by the European Commission when
assessing whether or not a member state is complying with country-speci&c
recommendations handed down by the European Council and speci&c obligations under
the excessive de&cit procedure. Whether markets will be similarly forgiving about debt levels
increased by recapitalization outlays is less clear. It seems reasonable to believe that little or
no distinction will be made in the future, as seems the case now, among the different
reasons debt was incurred. Spain will be seen as having debt equal to 92% of GDP at the
end of next year, rather than 89% net of last years bank recapitalization or 83% net of bank
recap and cash reserves, if those prove to be the correct numbers at that point in time. Italy
will be seen as having debt equal to 133%, even though a small part of that re1ects
obligations taken to support Greece, Portugal, Ireland, Spain and Cyprus via Europes
various &nancial support mechanisms.
MORE NEEDS TO BE DONE ON BANK RESOLUTION
There are two related work streams on resolution: the Bank Restructuring and Resolution
Directive (BRRD), agreed by the European Council in June 2013, and the Single Resolution
Mechanism (SRM), proposed by the European Commission in July.
The BRRD is currently going through the European trialogue, a consultation process
between the European Commission, the European Parliament and the European Council,
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and is scheduled to be taken up by the European Parliament early next year. Even if the
directive is approved by the parliament and member states, it will not help with the needed
capital backup arrangement for the ECB AQR since its key provision, requiring the bailing in
of all uninsured creditors and depositors, will not come into effect until 2018.
In the SRM debate, the Legal Service of the European Council has stated that the
establishment of a Single Resolution Authority is consistent with Article 114 of the Treaty on
the Functioning of the European Union but that safeguards are needed to protect the &scal
sovereignty of member states. On this basis, it is likely that a Single Resolution Authority
would be launched, but it is not clear how and by which entity (the Commission, ECOFIN,
new Single Resolution Board, etc.) the authority ultimately will be exercised. Moreover, the
second part of the legal opinion has lent support to countries opposed to setting up a
Single Resolution Fund on a European basis. Such resolution funds are likely to remain
national and be &nanced by contributions from industry. Recent proposals talk call for a
0.8% levy on insured deposits over 10 years.
FURTHER PROGRESS IS NEEDED AT BOTH THE NATIONAL AND EU LEVELS
Overall, the availability of the OMT and ESM has signi&cantly reduced the tail risk of a Euro
exit or collapse. In addition, current account surpluses, primary budget surpluses and
decreased foreign holdings of sovereign debt have reduced individual countries' vulnerability
to external &nancial pressures as well as contagion risk. Despite signi&cant progress at both
the European and national levels, prospects for the Euro Area remain clouded by three
fundamental problems:
Lack of suf&cient growth in the foreseeable future to reduce record high unemployment,
risking rising social and political tension.
Despite improved EU economic governance, macroeconomic adjustment will remain
asymmetric with the burden falling on de&cit countries and no formal obligation for
surplus countries. This will continue to impart a de1ationary bias to efforts to reduce
macroeconomic imbalances.
No mutualization of Euro Area sovereign or bank liabilities. This means the potentially
vicious linkage between the sovereign and bank balance sheets will linger, not having
been severed, with ongoing risks that it may reemerge.
Against the backdrop of increased sovereign debt and high levels of corporate and
household debt, much of the Euro Area periphery will remain vulnerable to shocks for the
foreseeable future.
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EUROPEAN BANKING UNION: KEY DATES
Date Banking Union Program Countries Other Events
Oct. 2013 Council to adopt SSM
Oct. 2013 Trialogue negotiations on BRRD to
commence
EoY 2013 Agreement on BRRD to be reached
EoY 2013 Political agreement on SRM to be
reached
Dec. 2013 Program for Ireland runs out
Feb. 2014 Parliament to approve BRRD and DGS
Mar. 2014 Council to adopt BRRD and DGS
Mar. 2014 Parliament to approve SRM
Q1 2014 AQR to be conducted by ECB
Apr. 2014 Council to adopt SRM
Q2 2014 Stress test to be conducted by EBA
May-14 Elections to the European Parliament
Jul. 2014 Program for Portugal runs out
Q3 2014 New European Commission takes of&ce
Oct. 2014 ECB takes over responsibility as
supervisor
Oct. 2014 ESM mandated to directly capitalize
banks
Dec. 2014 Program for Greece runs out
2015 BRRD, SRM, and DGS become effective
Mar. 2016 Program for Cyprus runs out
2018 Bail-in rules become formally effective