Despite a €110bn bail-out programme that the European Union and the International Monetary Fund arranged in early May, Greek debt yields remain elevated. Ten-year Greek debt yielded around 11.5 per cent on December 13, 2010, 8.5 percentage points over comparable German obligations.
The Greek bail-out has been followed by a surge in yields on Irish, Portuguese and Spanish debt as investors shunned those obligations as well. In understanding this “debt contagion,” it is useful to examine the characteristics of the region’s debt crisis, as well as compare it with the experience of Latin American economies through most of the 1980s. Today, many of the once debt-ridden countries such as Brazil are growing rapidly, have ample foreign exchange reserves, and have become significant creditors to other countries. How did this transformation occur?
The euphoria following the formation of the euro zone led some lenders to believe that there was no greater sovereign risk in Greece than in Germany, significantly increasing exposure to the weaker economies. Similarly, in the 1970s, foreign banks believed global capital market integration had eliminated Latin American country risk. Symptomatic of the era was the oft-quoted statement by the then chairman of Citicorp, Walter Wriston: “Countries don’t go bust.”
I followed the situation closely as a country risk analyst as loans made at floating interest rates became unserviceable after global interest rates doubled after 1979. In August 1982, Mexico was the first to declare that it could not make principal and interest payments as scheduled. Brazil, Argentina and most of the region followed. The IMF and the US Treasury attempted to defuse the debt contagion by imposing austerity and adding to the countries’ debt. However, the situation worsened with sharp devaluations and a deep recession. The ratio of Mexico’s net public debt to GDP surged from 34 per cent in 1981 to 81 per cent by 1986.
The situation started to improve only when Nicholas Brady, US Treasury Secretary, offered a plan in March 1989 for creditors to accept“haircuts”, either through a principal reduction but maintaining market interest rates, or by keeping the face value of the loans but substantially lowering interest rates. Mexico repaid the “Brady Bonds” in full in 2003, some 15 years ahead of schedule.
The Latin American crisis was a solvency issue rather than a liquidity issue. A significant portion of the loans the nations received in the 1970s was used to finance wasteful consumption, or eventually landed in Miami and New York based banks due to capital flight. They were no longer available to service debt. We also learned that these countries could not generate sustainable economic growth, or create jobs, until the debt levels were reduced.
Both these conclusions are relevant to resolving problems that southern Europe and Ireland face today, and call for a similar programme to reduce the level of debt. Irish real estate developers borrowed at low interest rates because of the perception that euro zone membership eliminated risk of default.
The developers, and the Irish banks which lent to them, can no longer service debt since building values have crashed. With Ireland due to pay a relatively high average interest rate of 5.8 per cent on the new funds, its debt is projected to rise from 99 per cent of GDP this year, to 108 per cent in 2013. The budget measures will likely lead to negative growth in 2011 following three successive years of GDP declines.
In the case of Greece, the €110bn programme announced in May requires it to lower the public sector budget deficit from over 15 per cent of GDP in 2009 to less than 9 per cent this year. The unemployment rate will rise to almost 15 per cent by 2012 according to the IMF, and could eventually jump to 20 per cent.
The Latin American experience also suggests that there will be adverse implications for European debt and equity markets. The deterioration in debt ratios will discourage voluntary lending to the affected euro zone countries and, in the absence of functioning capital markets, those governments will become permanent supplicants for official aid. Poor economic growth prospects will dampen equity market performance as well since an increasing percentage of savings will be destined toward debt service rather than domestic investments. The vicious cycle of austerity, declining GDP and worsening debt ratios means that there will be no selfcorrecting cure for the malaise in debt and equity markets.
In the absence of debt reduction, the 2010s could become a “lost decade” for some euro zone countries, much as the 1980s turned out to be for Latin America. (Financial Times)