The markets are not convinced that the distressed European Economic and Monetary Union states of Greece, Ireland and Portugal can avoid default or restructuring on their sovereign debt. Indeed, they are pricing Greek debt for imminent default because they cannot see how the peripheral EMU states can meet the fiscal austerity targets set by the EU/IMF in return for their bailout packages.
It is true that the task facing the three distressed states to stabilise their sovereign debt ratios by the end of the bailout funding in 2014 is immense. Even after one year of fiscal stringency, Greece still needs to turn its primary budget balance from a deficit of 5% of GDP in 2010 to a surplus of 5% by 2014 if Greek debt is to be stabilised at a huge 160% of GDP.
But let us assume that the distressed states stick to their fiscal tasks despite political opposition at home to spending cuts, tax increases and reductions in public services and jobs. Then the problem of achieving the fiscal targets and stabilising debt ratios depends on economic growth.
| The required export growth |
Forecast nominal growth rates for the distressed EMU states are pretty low for the next few years, with Ireland expected to expand the most, faster than Spain, the other endangered peripheral state. Where will this growth come from?
Domestic demand will be nonexistent for years. So it is a fair assumption that any growth has to be mainly from net exports or trade. And here is the conundrum. Nominal GDP growth has to come from (net) exports. Export growth relies on improved competitiveness. Improved competitiveness in a single-currency area can only be achieved by domestic deflation. But deflation increases the break-even growth rate of nominal GDP required to stabilise debt. So achieving sufficient export growth raises the hurdle of nominal GDP growth needed.
The higher the proportion of GDP that exports account for in an economy, the lower the rate of export growth needed to meet the nominal GDP growth target. As exports are equivalent to 100% of Ireland’s GDP, but only 28% in Portugal and 20% in Greece, the required export growth rate for Ireland is only 8% a year; but for Portugal it’s 21% a year and for Greece 28%.
Only Ireland has restored its level of exports to pre-crisis levels.
Improving competitiveness is key to raising export growth rates. The real effective exchange rate of each country is a measure of competitiveness. That’s when domestic costs and prices fall relative to trading partners’. Ireland has been the leader in doing that among the peripheral EMU states.
Ireland, like the Baltic states, has done so by reducing its unit labour costs in real terms. To improve competitiveness within a single-currency area, the only option is to undergo internal devaluation. Wage rates and prices must fall relative to trading partners. Again, Ireland has achieved this with a large absolute fall in unit labour costs.
The peripheral EMU states also need to reduce dependence on foreign funding of sovereign debt. All distressed sovereigns, particularly those with a banking-engendered crisis and high foreign leverage, must reduce that leverage through a rise in the domestic savings rate, so that the current account becomes positive.
This is essential to the achievement of debt sustainability, as a positive external balance reduces vulnerability to foreign ownership of debt. Which of the three sovereigns can achieve that?
| Change in real effective exchange rate |
| End-2008 to date |
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| Source: Datastream, Independent Strategy |
Before the crisis, Ireland had a much higher national savings rate than Greece or Portugal. And even after the crisis, its savings rate was much higher than the others. It ran a small current account deficit before the crisis and now it has a surplus. Ireland is far more likely to generate enough growth from exports by 2014 to stabilise and reduce its debt burden than either Portugal or Greece. But it’s not a done deal. Ireland’s economy is already highly competitive. Now its deflation has to re-converge with eurozone inflation, reducing the burden on nominal GDP. The risk of trading partners’ economies rolling over in the second half of this year is a threat to all the EMU peripherals – more so to Ireland given its high exposure to exports as a proportion of GDP.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com