Just as Brussels is finally enjoying a spell of summer sun, there’s more good news for debt-crisis watchers who stayed behind in the European Union’s headquarters: The Peterson Institute for International Economics says the debt loads of Italy and Spain are (most likely) sustainable.
In a new working paper, William R. Cline—a sovereign-debt crisis veteran going back all the way to Latin America’s troubles in the 1980s–calculates different trajectories for the debt loads of the two countries whose financial fate is seen as central to the survival of the euro. The interesting thing about the paper is that it not only examines three typical scenarios (good, baseline, bad) and applies them to five variables (the level of growth, primary surplus, interest rates, bank recapitalizations, and privatization receipts), but also assesses the probability of several of these variables going bad (or good) at the same time. In other words, Mr. Cline calibrated the effect of, say, low privatization receipts on a government’s primary surplus or the interest rates it’s likely to pay on its bonds.
His conclusion–which should delight policymakers in Rome, Madrid, and Brussels alike–is that the most likely outcome by the end of the decade is that “both Spain and Italy remain solvent” and that they won’t need a debt restructuring á la Greece or, even worse, leave the euro zone.
The “probability weighted average,” i.e. the best bet, for Spain is that its debt will be no higher than 92% of gross domestic product by 2020. That’s up quite a bit from the 81% it is expected to hit by the end of the year and slightly worse than the 89% under Mr. Cline’s baseline scenario, but still at a level that is generally seen as manageable for a large, developed economy. On top of that, there’s a 75% chance that the debt load will be below 99% of GDP by 2020. For Italy, the best bet is a debt that declines to at least 109% of GDP by 2020 from 123% this year, with a 75% probability that it will go down to at least 116%.
Now, forecasting debt levels eight years into the future is in itself a tricky exercise. The goal of Greece’s debt restructuring earlier this year was to bring the country’s debt load to a “sustainable” 120% of GDP by 2020. Even back in March some EU officials warned privately that that kind of calculation was more of a political spiel designed to convince parliaments in countries like Germany or the Netherlands to once again open their wallets for Greece than a sound basis for economic policy making. Less than six months on they were proven right–international debt inspectors are currently trying to determine how much the political uncertainty of two national elections have set the country behind in hitting the 120% target, while the International Monetary Fund is arguing that for Greece, really, a level of 100% of GDP is much more suitable.
The biggest challenge with these calculations is of course determining how to fill in the variables, i.e. what’s the good, baseline or bad scenario for growth or interest rates. And it is perhaps here were Mr. Cline’s analysis is most vulnerable. For Spain, for instance, the “good” scenario for bank recapitalizations is that Madrid will have to pick up exactly €0 of the cost of recapitalizing its banks—that would only happen if either the stakes the government acquires in struggling lenders turn out to be unexpectedly valuable or the country succeeds in moving the entire recapitalization costs off its own books and onto those of the euro-zone bailout fund. We explained why either of these two scenarios are unlikely here and here.
The baseline scenario expects bank recapitalizations to add only some €5 billion to government debt (mostly thanks to the European Stability Mechanism taking direct stakes in the saved lenders rather than routing the money through the government, as Mr. Cline explained in an interview). Even under the bad scenario the bank bailouts add “only” €50 billion to the debt load (that’s assuming that the cost cannot be transferred to the ESM). Considering that the euro zone has promised Spain as much as €100 billion and some analysts fear that low growth could push the bailout bill even beyond that, it’s easy to imagine a worse scenario. (Sidenote: the bank recapitalization section in the Spain scenario table on p.15 of the paper also includes €36 billion in debts that the Spanish government may have to take on from crisis-hit regions—a footnote that Mr. Cline says was accidentally dropped in the final version.)
But there are conclusions in the paper that go beyond the exact variables used for the different scenarios. For instance, Mr. Cline’s calculations show that for both Spain and Italy higher interest rates—and even lower growth–have a smaller effect on debt levels than missing budget targets. For Spain, more-expensive bank bailouts set off a similar dynamic: the “bad”(€50 billion) recapitalization scenario drives the baseline debt load from 89% of GDP to 94% by 2020; the full €100 billion, meanwhile, would take it up to 99%, even if all other variables stay in the baseline.
The good news from that if of course that governments may have more influence on their primary deficits—and even the cost of bank bailouts for national governments amid “direct” bank recapitalizations from the ESM–than on interest rates and growth. Or as Mr. Cline summed it up in an email: “The good outcome depends on Spain doing its part on the primary surplus and the euro zone doing its part on the banking union.”
If that thesis holds up, Mr. Cline’s analysis may herald more good news than Brussels weather, where the probability of sustainable summer sunshine is close to zero.
By Gabriele Steinhauser
The Wall Street Journal