Eurozone Sovereign Debt: All Quiet on the Southern Front

After a wild ride in 2011-2012, interest rates have settled down on European sovereign debt. For now.

Yields on long-term government bonds, Jan 2009 to Nov 2013. Data source: Eurostat.

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Greek yields fell sharply following the PSI agreement in March 2012, a de facto default that ended up reducing the value of Greek’s debt by 20%. But as a result of ongoing deficits and plunging GDP, the ratio of debt to GDP for Greece is now almost back up to where it was in at the end of 2011. In the mean time, debt/GDP has continued its uninterrupted climb for Portugal, Ireland, Italy, and Spain.


General government debt as a percent of GDP, 2000:Q1-2013:Q2. Data source: Eurostat.

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On the other hand, these countries have seen sharp improvements in their current account, having gone in a very short period from large deficits to outright surpluses. Unfortunately, this seems not so much due to currency depreciation or wage and price adjustments restoring competitiveness as it has to the collapse in aggregate spending (on both home and foreign goods) associated with the sharp economic downturns in these countries.


Historical and projected current account surplus as a percent of GDP, annual, 2000-2013. Data source: IMF.

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Still, the improved current accounts mean less borrowing from abroad and reduced vulnerability to shifting moods of international credit markets. My recent paper with Greenlaw, Hooper, and Mishkin(and much previous research before us) identified the debt-to-GDP ratio and current-account deficits as two key factors that influence a country’s vulnerability to sudden spikes in borrowing cost. One distinctive feature we found in the data was a strong nonlinear interaction between the current-account deficit and debt loads. Our paper used a 5-year average of the current-account/GDP ratio as the variable that interacts with the current debt load to predict the interest rate on a country’s long-term sovereign debt. I was curious to see what our estimates would imply if we assumed that the recent improvements in the current account turn out to be permanent.

The table below summarizes how debt, the current-account surplus, and interest rate on government debt have changed since 2012 for these 5 European countries. The final column gives the amount by which the 10-year yield on government debt would be predicted to fall if debt/GDP changed by the amount indicated in columns (2) and (3) and the change in the current-account surplus given in columns (4) and (5) is assumed to be permanent. Much of the observed drop in yields could be explained by the elimination of big current-account deficits.


Debt as a percent of GDP in 2011 and 2013:Q2, current-account surplus as a percent of GDP over 2007-2011 and projected for 2013, interest rate on 10-year sovereign bonds in 2012 and November 2013, actual change in yields, and predicted change in yields based on equation (18) in Greenlaw, Hamilton, Hooper, and Mishkin (2013).
debt/GDP current-account/GDP interest rate actual predicted
2011 2013:Q2 2007-2011 2013 (proj) 2012 Nov 2013 change change
(1) (2) (3) (4) (5) (6) (7) (8)
Greece 170.6 169.1 -12.1 -0.3 22.9 8.2 14.7 11.2
Portugal 108.0 131.4 -10.2 0.1 11.0 6.0 5.0 4.2
Ireland 106.5 125.7 -2.2 3.4 6.0 3.5 2.5 1.8
Spain 69.1 92.3 -6.5 1.1 5.9 4.1 1.8 1.1
Italy 120.8 133.3 -2.5 0.3 5.5 4.1 1.4 0.9


An improving current-account balance means less borrowing from abroad. So who is funding the growing sovereign debt? The answer appears to be domestic banks. The Telegraph’s Ambrose Evans-Pritchard leads us to page 33 of this report from the German central bank which reports that Spanish monetary financial institutions increased their holdings of Spanish government debt by € 134 billion between November 2011 and September 2013. That’s an 81% increase and accounts for 65% of the total increase in Spanish sovereign debt over the period. Italian banks increased their holdings by € 175 billion, a 73% increase which accounts for more than 100% of the increase in Italian sovereign debt.


Sovereign debt held by domestic monetary financial institutions. Source: Bundesbank.

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And where did the banks get the funds to lend to the government? From the ECB, whose outstanding loans to Spanish and Italian banks come close to half a trillion euros.


Outstanding ECB LTRO loans to institutions from selected countries in billions of euros. Source: BNP Paribus.

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This is a fine deal for the banks, borrowing from the ECB at a lower rate than they can earn on the sovereign debt. But it does not change the underlying reality. Greece’s debt load of 170% of GDP and interest rate in excess of 8% means that its taxpayers must surrender 14% of the country’s total income every year just to make interest payments on the debt. Portugal needs to sacrifice 8% every year. Neither is going to happen; further defaults seem unavoidable.

But if the ECB does not keep renewing the LTRO loans, rates would spike back up and we’d replay last year’s excitement in financial markets.

This can will be kicked down the road.

This piece is cross-posted from Econbrowser with permission.