1. Sovereign Risk and the Euro
Lorenzo Bini Smaghi
Member of the Executive Board
European Central Bank
London Business School
9 February 2011

2. Introduction
The economic and financial crisis – the worst
since WWII – has produced an unprecedented
increase in public deficits and debts in all
advanced economies
The ability of these countries to take the
necessary actions to bring the public debt under
control is being increasingly challenged, also by
financial markets
The challenge has started in the euro area
1

3. Government deficits have increased everywhere
General government deficit
(as a percentage of GDP)
14
2007 2009
12
10
8
6
4
2
0
Euro area United Japan United
States Kingdom
Source: IMF WEO October 2010
2

4. And so has public debt
General government gross debt
(as a percentage of GDP)
250
2007 2015
200
150
100
50
0
Euro area United Japan United
States Kingdom
Source: IMF WEO October 2010
3

5. Stabilisation of the debt in 2013
General governm gross debt
ent
(as a percentage of GDP)
120
100
80
60
Euro area (IMF)
40
United States (IMF)
20
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: IMF WEO October 2010
4

6. Within the euro area the dispersion is large
General government deficit
(as a percentage of GDP)
15
2007 2009 Euro area 2009
12
9
6
3
0
-3
Germany
Luxembourg
Slovakia
Cyprus
Belgium
Italy
Slovenia
Greece
Austria
Netherlands
Estonia
France
Malta
Portugal
Ireland
Spain
Finland
Source: European Commission's economic forecast autumn 2010
5

7. Also in terms of debt
General government gross debt
(as a percentage of GDP)
180
2007 2012 Euro area 2012
150
120
90
60
30
0
Luxembourg
Slovenia
Netherlands
Germany
Ireland
Finland
Slovakia
Belgium
Portugal
France
Greece
Italy
Cyprus
Estonia
Spain
Austria
Malta
Source: European Commission - Autumn 2010 Forecast
6

8. And ageing is bound to make things worse
Projected change in age-related government expenditure, 2007-2060
(percentage points of GDP)
20
16
12
8
Euro area
4
0
Italy
Luxembourg
Germany
Cyprus
Slovakia
France
Belgium
Finland
Slovenia
UK
Portugal
Ireland
Greece
Malta
Austria
Estonia
Netherlands
Spain
Source: European Commission Ageing Report 2009
NB: Some countries have, in the meantime, introduced pension and/or health care reform which should reduce long-term increases in age-
related spending
7

9. Three ways to reduce the debt burden
A: Fiscal adjustment
B: Inflation
C: Default / Restructuring
…or a combination of the above
8

10. In the euro area inflation is ruled out
The Treaty requires the ECB to ensure price
stability
Monetary financing is prohibited
…and markets trust it
9

11. Inflation expectations remain well anchored
Five-year forward break-even inflation rate five years ahead
3.50 Euro area US UK
3.25
3.00
2.75
2.50
2.25
2.00
1.75
Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11
Sources: Reuters, ECB, Federal Reserve Board staff calculations, Bank of England
10

12. Also in surveys of professional forecasters
Inflation expectations six to ten years ahead
(annual percentage change)
3.5 3.5
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
2004 2006 2008 2010
EA United Kingdom United States
Source: Consensus Economics
11

13. This leaves only two ways
Plan A: Fiscal adjustment
Plan B: Default / Restructuring
12

14. Euro area countries have opted for Plan A
All euro area countries have programmes to
reduce the deficit/GDP to below 3% by 2012-2013
Greece and Ireland are implementing EU/IMF
adjustment programmes
IMF, EU and EU countries are providing Greece
and Ireland with unprecedented financial
assistance
EU countries have created the EFSF and changed
the Treaty to create the ESM in 2013
13

15. Markets/Academics/Commentators have doubts
The reasoning is the following:
1. The required fiscal adjustment is too costly
2. It cannot be politically sustained
3. EA solidarity will not hold
4. Therefore the only solution left is “Plan B”:
- (partial) default/restructuring
- Exit/split the euro
14

16. Markets have reflected these doubts
5-yr Sovereign CDS Spreads
(basis points)
1250
Germany
France
1000 Italy
Spain
Greece
Ireland
750 Portugal
500
250
0
Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11
Source: CMA DataVision via Datastream
15

17. Also affecting confidence in the euro
Net EUR Pos itions (LHS)
Euro EUR/USD Rate (RHS)
140 1.72
120 1.66
100 1.60
80 1.54
60 1.48
40 1.42
20 1.36
0 1.30
-20 1.24
-40 1.18
-60 1.12
-80 1.06
-100 1.00
-120 0.94
Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 A pr 10 Jul 10 Oct 10 Jan 11
Source: Commodity Futures Trading Commission (CFTC)
16

18. What’s missing in the reasoning?
Plan A is considered “too costly” but there is no
assessment of the costs of Plan B
In fact, Plan B is itself extremely costly, in
economic and political terms
Plan B can be more costly than Plan A:
- For the country itself
- For the other euro area countries
17

19. A closer look at Plan B
Plan B has been implemented only in developing
countries
Over the last 20 years, 19 countries out of 120
IMF programmes had debt restructuring:
1998 Ukraine, Russia, Pakistan, Venezuela
1999 Gabon, Indonesia, Pakistan, Ecuador
2000 Ukraine, Peru
2001 Argentina, Cote d'Ivoire
2002 Moldova, Seychelles, Gabon
2003 Dominican Republic, Paraguay, Uruguay
2004 Grenada
2005 Dominican Republic
2006 Belize
18

20. The experience shows
Plan B has large reputation / penalty costs
• Loss of market access
• Higher future borrowing costs
• Trade sanctions by creditor countries
Broader costs to the domestic economy
• Output losses
19

21. High borrowing costs and contagion
Evolution of the EMBIG spreads around crisis episodes (in basis points)
8000 3000
Argentina Brazil (rhs)
Uruguay (rhs)
7000
2500
6000
2000
5000
4000 1500
3000
1000
2000
500
1000
0 0
Source: Haver Analytics. 2001 2002 2003 2004
20

22. EMEs’ experience is not a good guide
The experience of the emerging market
economies (e.g. Brady plan) cannot be directly
applied to the current situation in advanced
economies
Default in EMEs was typically the result of a
foreign exchange crisis, which increased the
burden of the foreign debt in an unsustainable
way
Fiscal adjustment was unsustainable as it fuelled
exchange rate depreciation, which increased the
burden of the debt
21

23. EMEs’ experience is not a good guide (2)
The default/restructuring of the debt in
developing countries mainly affected foreign
creditors
When domestic creditors were involved, very
restrictive measures were implemented through
administrative and capital controls (e.g. corralito
in Argentina)
22

24. Restructuring/Default in advanced economies
Affects domestic residents’ wealth:
- directly through the holdings of
government debt by the private sector
- indirectly, through the role played by
government guarantees in the financial
sector
Produces strong contagion in other countries
23

25. Residents hold a large share of government debt
Euro area: holdings of government debt by residents and non-residents (end 2009)
(share of total debt)
1
0.9
0.8
0.7
0.6
Debt held by non-residents of the Member State
0.5
0.4
Debt held by residents of the same Member States
0.3
0.2
0.1
0
Source: ECB
24

26. Impact on the domestic financial system
A restructuring of sovereign debt has a direct
effect on the solvency of domestic financial
institutions inter alia through:
- direct holding of government debt
- access to collateralised credit
- government guarantees
25

27. As shown by the strong correlations: Greece
1500
Sovereign CDS
1250 Alpha Bank
EFG Eurobank Ergasias SA
National Bank of Greece
1000 Piraeus Bank
750
500
250
0
Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11
Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points.
Source: CMA DataVision via Datastream
26

28. Ireland
1500 5000
Sovereign CDS
Allied Irish Banks 4500
Bank of Ireland
1200 Irish Life 4000
Anglo Irish Bank (rhs)
3500
900 3000
2500
600 2000
1500
300 1000
500
0 0
Jan.09 Jul.09 Jan.10 Jul.10 Jan.11
Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points.
Source: CMA DataVision via Datastream
27

29. Portugal
1000
Sovereign CDS
Banco Comr. Portugues
800 Banco Espirito Santo
Caixa Geral de Depositos SA
Banco BPI SA
600
400
200
0
Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11
Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points.
Source: CMA DataVision via Datastream
28

30. Spain
600 Sovereign CDS Santander
BBVA Banco Popular Espanol SA
Caixa d'Estalvis de Cataluny Caja de Ahorros y Monte de Piedad
500
La Caja de Ahorros y Pension
400
300
200
100
0
Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11
Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points.
Source: CMA DataVision via Datastream
29

31. Effects on the banking system
A sovereign default/restructuring produces
major losses for domestic banks and fuels a bank
run by depositors, which triggers:
- Administrative measures, capital controls
- Restructuring of bank liabilities (bonds,
deposits..)
- Credit crunch
30

32. Effects on the real economy
Very sharp contraction, through:
- Direct wealth effects
- Credit crunch
- Non market measures
Social/political repercussions difficult to assess
(it’s not by chance that default/restructuring has occurred
mainly in non-democratic systems)
31

33. Contagion
Default/restructuring in one country tends to
produce immediate contagion effects in other
countries
This would impact on financial stability in the
euro area as a whole
32

34. Contagion
2 1st Principal Component
Cross-sect. average of standardized CDS
1.5
1
0.5
0
-0.5
-1
-1.5
Aug08 Nov08 Feb09 May09 Aug09 Nov09 Feb10 May10 Aug10 Nov10
Source: Datastream and ECB calculations
Note: basis points, last observation 27 Jan 2011. Extracted from daily data on 5-year euro area sovereign CDS. CDS
series and the Principal Component are standardized.
33

35. Would exiting the euro make it easier?
The fear of exiting the euro would accelerate the
bank run by domestic residents (to withdraw euro)
The domestic banking system would lose access to
euro area financial market and to ECB refinancing,
and would have to reduce in parallel its assets
The redenomination of financial instruments in
new (devalued) currency would trigger cross-
border litigation but possibly also within the
country
The country would lose access to EU facilities and
funds
34

36. Is there an “optimal timing”?
When primary balance is achieved, and thus the
government does not need to tap the market
The negative impact of Plan B is not lower while most of the costs
of Plan A have been paid (especially politically)
When markets are better prepared (now?)
The experience of Lehman Brothers’ collapse, which was anticipated
for some time, shows that markets are never fully prepared for such
a systemic event
35

37. To sum up
Plan B implies:
Restructuring  Wealth effect  Demand shock
Impact on the banking system  Investment
 Lower capital stock  Supply shock
Plan A implies:
Increase in primary surplus  Demand shock
36

38. Plan A
37

39. Plan A
Plan A is made on the basis of an assessment
that the country is solvent
Plan A consists of:
1. Fiscal and structural adjustment in the
member state to ensure debt
sustainability
2. Reform of the governance of euro area
to safeguard stability in the euro area
38

40. Assessing solvency
The solvency of a sovereign is different from
that of a company or a financial institution
Solvency of a sovereign depends on
ability/willingness to implement the adjustment
programme, against any alternative scenario
In particular, the ability/willingness to:
- tax (personal, corporate, special..)
- cut expenditure
- sell assets
39

41. Debt sustainability analysis
The adjustment programme defines a primary
budget surplus which would stabilise and reduce
over time the debt/GDP, on the basis of:
- the interest rate level
- growth
- the level of debt
40

42. Debt stability conditions
Primary balances needed to stabilise
debt-to-GDP ratio
Spain Portugal Ireland Greece
Debt-to-GDP ratio projected for 2012* 73.0 92.4 114.3 156.0
r-g
2 1.5 1.8 2.3 3.1
4 2.9 3.7 4.6 6.2
6 4.4 5.5 6.9 9.4
*European Commission autumn 2010 forecast
Primary balances needed to stabilise the debt-to-GDP ratio (at the level projected by the European Commission for
2012) in the long-run (steady state) under different assumptions for the interest rate-growth differential
41

43. The adjustment is substantial: Greece
Greece: projected general government debt and primary balance under
current EU/IMF programme (percentage of GDP)
15 160
10
120
5
0 80
-5 Primary balance (% of GDP) (lhs)
General government debt (rhs)
Real GDP growth (percent) (lhs) 40
-10
-15 0
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Source: IMF - Second review under the Stand-By Arrangement
42

44. And in Ireland
Ireland: projected general government debt and primary balance under
current EU/IMF programme (percentage of GDP)
15 160
10
120
5
0 80
-5 Primary balance (% of GDP) (lhs)
General government debt (rhs) 40
Real GDP growth (percent) (lhs)
-10
-15 0
2009
2010
2011
2012
2013
2014
2015
Source: IMF - Staff Report - Request for an extended arrangement
The primary balance figure for 2010 has been corrected for the one-off impact of government support to Irish banks
43

45. But not unprecedented
General government primary balance
(as a percentage of GDP)
Ireland
10 140
5 120
0 100
-5 80
-10 60
1981
1982
1983
1984
1985
1986
1987
1988
1989
prim a ry ba la nc e
re a l e ffe c tive e xc ha nge ra te (1980=100)
Sources: OECD, IMF
44

46. The interest rate level
The interest rate on the programme is aligned
with IMF rules and procedures
Interest rate ± 6% can ensure debt sustainability
What is key is the rate at which countries have
borrowed, from the market or through the
IMF/EU programme
If successful, the Program can be lengthened
(standard procedure in the IMF)
EFSF could be made more effective, e.g. linking
the interest rate to performance (while remaining
non-concessional)
45

47. The debt level
The higher the debt level, the higher the primary
surplus required to stabilise the debt
However, a primary surplus is needed in most
cases
In the case of Greece, the primary surplus
required to stabilise and reduce the debt after
2013 is ± 6%
If the debt were cut by one-third, the primary
surplus would still be relevant
46

48. Debt stability conditions (repeat)
Primary balances needed to stabilise
debt-to-GDP ratio
Spain Portugal Ireland Greece
Debt-to-GDP ratio projected for 2012* 73.0 92.4 114.3 156.0
r-g
2 1.5 1.8 2.3 3.1
4 2.9 3.7 4.6 6.2
6 4.4 5.5 6.9 9.4
*European Commission autumn 2010 forecast
Primary balances needed to stabilise the debt-to-GDP ratio (at the level projected by the European Commission for
2012) in the long run (steady state) under different assumptions for the interest rate-growth differential
47

49. Restoring sustainability
The previous slide shows that if the primary
surplus needed to achieve sustainability is
considered too high because the market interest
rate is high, there are two ways to restore
sustainability:
- reduce the interest rate burden (and
lengthen the maturity), while keeping it
non-concessional
- haircut on debt
For (official) creditors the first solution is
preferable because it involves no capital loss
48

50. Market ways to reduce the debt burden
Under discussion: buy back at market prices
(lower than nominal), by the member state or
through the EFSF, subject to strict conditionality
Win-win situation:
- reduces the debt burden
- provides market liquidity
- short-term investors can sell (at a loss)
49

51. Restoring pre-crisis growth will be difficult
Real GDP Real GDP per capita
(average growth 1999-2008) (average growth 1999-2008)
6.0 4.0
5.0 3.5
3.0
4.0
2.5
3.0 2.0
1.5
2.0
1.0
1.0
0.5
0.0 0.0
Germany
Portugal
Germany
Portugal
Kingdom
Ireland
Greece
United
Euro area
Japan
Kingdom
Ireland
Greece
United
Japan
Euro area
Spain
Spain
States
States
United
United
Source: European Commission’s economic forecast autumn 2010
Note: Real GDP per capita refers to gross domestic product at 2000 market prices per head of population.
50

52. But growth is key
Restore competitiveness
- mainly through domestic adjustment
Lack of exchange rate flexibility
- not an excuse
Structural reforms are essential
51

53. Devaluation is no panacea
Trade openness across euro area countries
(exports plus imports in % of GDP, nominal)
180 350
160
300
140
250
120
100 200
80 150
60
100
40
50
20
0 0
Italy
Germany
Belgium
Ireland
Slovakia
Slovenia
Cyprus
Portugal
Finland
Spain
Austria
Malta
France
Greece
Netherlands
Euro area
Luxembourg
Source: European Commission
52

54. Structural reforms start to be implemented
Greece
Competition and productivity
– Deregulation of transport and energy sectors
– Opening up of closed professions
– Implementation of Services Directive
– Restructuring of state-owned enterprises and bringing
in of private management
53

55. Labour market flexibility and labour supply
– Reduction of employment protection
– Facilitating use of part-time work/flexible work
arrangements
– Reform of the arbitration system
Pension reform
– Extensive reform to improving long-run sustainability
– Simplification of fragmented system, with universal,
binding rules on contributions and corresponding
entitlements
– Increase in retirement age to 65 and contributory
period for full pension from 35 to 40 years
54

56. Ireland
Financial system:
• Stabilise and downsize the banking sector
• Improve solvency and funding of viable banks
• Quick resolution for non-viable banks
• Increase confidence in viable banks by fully
recognising losses in loan portfolios
• Burden-sharing by holders of subordinated debt
Product and labour markets
• Reduction of the minimum wage
• Reform of the unemployment benefits system
• Deregulation of sheltered sectors of the economy
55

57. Portugal
50 structural measures announced mid-December
2010 to be legislated by end-March 2011,
including:
• Fostering the export sector and investment in R&D with
tax incentives
• Reducing administrative burdens of the export sector
• Strengthening wage flexibility and reducing overall
employment protection
• Improving the rental market
• Reducing the size of informal economy
56

58. Spain
Product markets
• End 2009: transposition of Services Directive
• Early 2010: streamlining of procedures for business
creation
Labour market
• June 2010: improvements to some aspects of hiring
system and collective bargaining, improving firms’
flexibility
57

59. Spain
Pension reform
• January 2011: approval of draft pension reform bill,
agreed with social partners, including gradual
increase in the retirement age (from 65 to 67) and
increase in contributory period for full pension
(from 15 to 25 years)
Financial system
• Mid 2010: restructuring of the “cajas de ahorro”,
reform of legal framework, extension of options for
issuing equity capital
58

60. The impact on competitiveness is starting
Compensation per employee
(Annual % changes)
Germany Greece Ireland Portugal Spain
7
6
5
4
3
2
1
0
-1
-2
Average 1999-2008 2010 2011 2012
Source: European Commission (Autumn 2010 forecast).
59

61. European governance has evolved
In less than one year:
Financial support for Greece (April 2010)
Creation of the EFSF (May 2010)
Reform of the SGP (October 2010)
Change in the Treaty for ESM (Dec 2010)
“Comprehensive Package” (March 2011)
If not sufficient…“We will do what is needed”
60

62. Why so slow?
Fiscal adjustment and governance reform are
costly in the short term, from an economic and
political view point
Governments tend to take the political cost only
when they can explain to their constituencies that
the alternative (default, euro instability) is much
more costly
The evidence that the alternative is more costly
emerges only under the pressure of the markets
61

63. Action has been delayed
Greece
Spread over German 10-year government bond yield
(2009-2010; daily data; in basis points)
1000
900 22 February 2010
EC/ECB mission
800
700
600
500
400
300
200
100
0 11 May 2010
Rescue plan
-100
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10
Sources: Bloomberg, Thomson Reuters Datastream and ECB calculations.
Data: Bond yield spreads vis-à-vis the German 10-year government bond, end-of-day data.
62

64. Action has been delayed
Ireland
Spread over German 10-year government bond yield
(2010; daily data; in basis points)
700
28 August 2010
Dow ngrading by S&P
600
11 May 2010
Rescue plan
500
400
300
28 Nov 2010
200 Announcement of the
IMF/EU program
100
07 Dec 2010
Presentation of 2011 budget
0
-100
Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10
Sources: Bloomberg, Thomson Reuters Datastream and ECB calculations.
Data: Bond yield spreads vis-à-vis the German 10-year government bond, end-of-day data.
63

65. Conclusions
Plan A is painful, but most likely it is less costly
than the alternative:
- for the debtor countries
- for the creditor countries
There are ways to make Plan A less costly, “more
effective”, conditional on a positive adjustment
track
Need to avoid moral hazard
64

66. Conclusions (2)
Euro area governments are committed to Plan A
Plan A will deliver stronger fundamentals over
the medium term for the euro area and for the
member countries
65