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What’s next for the Eurozone
Vanguard commentary
November 2010
Executive summary. The Eurozone continues to work through its
sovereign debt issues, but a great deal of concern remains regarding the
long-term economic health of the bloc. In this commentary, we review the
current situation, present possible scenarios for the peripheral European
economies, and weigh in on the much-discussed idea of a euro breakup. In
our view, the most likely outcome is one in which the European currency
union “muddles through” its problems without coming apart. A
restructuring of Greece’s sovereign debt is still quite possible, given the
country’s unsustainable debt dynamics.
Abbreviations:
ECB = European Central Bank.
EMU = Economic and Currency Union.
EU = European Union.
GDP = Gross domestic product.
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IMF = International Monetary Fund.
bp = basis point (1/100 percentage point).
Authors
Jonathan Lemco, Ph.D.
Roger Aliaga-Díaz, Ph.D.
Charles J. Thomas
Since the beginning of 2010, much of the global
financial system has experienced tremendous
uncertainty regarding the outlook for the economies
and government debt of peripheral Eurozone
members, notably Greece, Portugal, Ireland, and, to a
lesser extent, Spain and Italy. The global recession of
2008–2009 exacerbated long-term structural issues in
these countries: public sectors that were excessively
large in relation to the overall economy, unsustainable
social entitlement programs, and fundamental
misalignments in wage and price levels relative to
more competitive members of the currency union.
Things came to a head in late April and early May
with a global retreat from the debt of the peripheral
countries, causing spreads on sovereign yields and
credit default swaps (CDS) to soar (see Figure 1).
Since then, supranational authorities and policymakers in the Eurozone and elsewhere have
engineered major responses. Figure 2 summarizes
the various bailouts, standby programs, and policy
actions addressing the crises.
Figure 1.
Short-term outlook: Deep fiscal cuts
with implications for growth
The governments of the peripheral economies have
also shown notable commitment to solving their fiscal
imbalances. Fiscal austerity programs have been
announced and implemented across the Eurozone.
However, the timing of these events has serious
near-term implications for the ongoing European
economic recovery. Instead of spending and engaging
in fiscal stimulus to support economic activity,
governments across the Eurozone are being forced to
reduce spending and cut stimulus programs, creating
negative shocks to spending and growth.
In our view, the combined impact of these
simultaneous austerity measures is likely to
reverberate across the entire euro area in the short
run. As shown in Figure 3, the overall fiscal
adjustment is large, even if austerity measures are
spread out over four years. The consensus growth
The Eurozone sovereign debt crisis: Rising costs of default insurance
The credit default swap spread can be viewed as the relative cost of insuring a debt security against a default or restructuring event.
This chart shows CDS spreads for the five peripheral countries versus Germany, considered one of the soundest issuers in the
region. The wide spread for Greece illustrates rapidly eroding confidence in the country’s ability to repay bondholders.
Spreads of 5-year sovereign CDS relative to Germany: January 1, 2009–October 29, 2010
1,200
1,000
Basis points
800
600
400
200
0
Jan. 2009
April 2009
Greece
July 2009
Portugal
Source: Thomson Reuters via Thomson Datastream.
2
Oct. 2009
Ireland
Jan. 2010
Spain
Italy
April 2010
July 2010
Oct. 2010
Figure 2.
Key responses to the Eurozone debt crisis
Response
Amount
Description
Bailout of Greece’s government
€ 110 billion
€ 80 billion from Eurozone members and € 30 billion from IMF.
Extension of EU balance-of-payment facility
€ 60 billion
Originally € 50 billion, extended to € 110 billion in May 2010;
the loan program is now available to more EU members.
European Financial Stability Facility (EFSF)
€ 440 billion
EFSF can make loans funded by floating debt that is guaranteed
by Eurozone member states.
IMF standby funding
€ 250 billion
Applicant states must agree to IMF conditions.
ECB bond purchases
Approximately
€ 60 billion
The bank makes secondary-market purchases of sovereign debt
issued by peripheral Eurozone nations.
Bank stress tests and recapitalization
Not known.
Banks were stress-tested for a worst-case scenario. Those failing
to pass were given access to government funding, in addition to
potential funding from the EFSF if needed.
Source: Vanguard.
Figure 3.
Fiscal retrenchment in the Eurozone
These key figures show the need for fiscal adjustment in the Eurozone. The deficit reduction targets are listed in each country’s
Growth and Stability Program, a document that EU members must submit annually. The targets are based on cyclically adjusted
GDP, meaning that the economic recovery is already built into assumptions about government revenue. Germany and France, the
largest members of the Eurozone economy, also have fiscal retrenchment targets to meet, meaning that the overall adjustment for
the region is substantial.
Germany
Country’s share of
European Union GDP
2009 budget deficit
(% of GDP)
26.8%
3.3%
Debt-to-GDP ratio
(debt as % of GDP)
Deficit reduction target
through 2013 (% of GDP)
73%
3.3%
France
21.4
7.9
78
5.0
Italy
16.9
5.3
116
2.6
Spain
11.7
11.4
53
8.4
2.6
12.9
115
10.7
Greece
Portugal
1.8
9.3
76
5.5
Ireland
1.8
11.5
65
9.0
—
6.6
Weighted average
81%
4.7%
Sources: Vanguard calculations, based on data from the World Economic Outlook Database, the International Monetary Fund, and EU members’ Growth and Stability
Programs for 2010.
estimates for the euro area are 1.7% for 2010 and
1.5%1 for 2011; however, with a fiscal shock of such
magnitude the downside risks to that forecast are
high. A serious slowdown in the region in the first
half of 2011 is highly likely and could even include a
GDP contraction (see Figure 4, on page 4, for a
summary of alternative short-term scenarios).
Reinforcing this view is the fact that Eurozone
members are highly dependent on one another for
trade, extending the potential impact of any fiscal
retrenchment across Europe. The leading economy in
the area, Germany, depends on other EMU members
to consume roughly 40% of its exports.
If such a slowdown occurs, investors should expect
a lax monetary policy and ECB quantitative support
lasting longer than in the United States. Inflation
may stay subdued, as deflation pressures in the
peripheral countries pull the Eurozone inflation
average downward.
1 Official IMF projections for real GDP growth, as of October 2010. This forecast partially reflects the impact of expected fiscal adjustments.
3
Short-term horizon (2011)
Figure 4.
Alternative short- and long-term scenarios for the Eurozone
Probability
Scenario
Market implications
High
1. Fiscal austerity and economic slowdown.
Simultaneous fiscal austerity programs create
a drag on growth across the euro area, likely
with some divergence between strong
members such as Germany and the weaker
peripheral economies.
• Elevated market volatility; investors should
expect to see some divergence in the equity
markets, as stronger Eurozone members may
escape recession.
2. Fiscal austerity with an export boom. A
strong global economy and a weak euro pull up
Germany’s export sector, with spillover effects
in growth over the rest of the Eurozone. For
the spillover effects to be meaningful,
Germany would need to rebalance its current
account and stimulate domestic spending.
• Upside surprise causes equity markets to
boom ahead of the export-led recovery.
1. Muddling through. EMU members recognize
that breaking up the currency union would not
serve their best interests. The peripheral
economies manage their fiscal troubles,
enduring several years of restrained growth,
and the Eurozone emerges as a stronger
market with more structural balance among
its members.
• Subdued inflation, moderate growth, and fiscal
austerity prevent a sharp rise in bond yields.
2. Muddling through, with a Greek
restructuring. Greece, starting with a much
higher level of debt than the other peripheral
countries, restructures its debt within three
years, most likely applying haircuts to
bondholders. EU regulators will play a
significant role in determining the likelihood
of this outcome.
• Markets distinguish between Greece and the
other countries, and remain convinced that the
latter will stay solvent over the long term.
3. A break-up of the Eurozone. The global
economic outlook worsens considerably, and
renewed pressures on the governments of the
other peripheral economies result in one or
more members leaving the currency union. For
this to happen, conditions must have
deteriorated so far that the transition costs of
leaving the euro (financial market turmoil,
banking system stress, etc.) are already being
realized.
• Necessary conditions for this scenario include
a global double-dip recession, probably
accompanied by a spike in global equity market
correlations, a retreat from risk, and the kind of
massive flight to quality we saw in 2008 and
early 2009.
Medium
to low
Medium- and long-term horizon (2012 and beyond)
High
Medium
to high
Low
Source: Vanguard.
4
• The ECB keeps interest rates low for some
time, as both inflation and growth remain
subdued in the near term.
• Expectation of currency appreciation may draw
more capital inflow, adding momentum to the
rally.
• Spreads of sovereign debt of peripheral
members over German bunds narrow from
current levels, but remain permanently wider
than before the crisis.
• CDS spreads for Greece rise above 1,100 bps
while they remain low for other peripheral
economies.
• The break-up of the Eurozone sends shock
waves to the rest of the global financial
system owing to banking system interconnectedness and generalized investor panic.
Why is a breakup highly unlikely?
Unless global economic conditions worsen
significantly, EMU members are not likely to pull
the currency union apart. The trade-offs would be
too painful for both the stronger members, such
as Germany, and the peripheral economies.
For Germany, a move back to a national currency
would hurt its main engine of economic growth.
After the EMU breakup, Germany’s fundamentals
(high productivity and low inflation) would drive
appreciation of its currency, hurting the nation’s
export sector.
More importantly, by abandoning the euro Germany
would wreak havoc on its own financial system.
German bank assets in peripheral euro countries
(both private and sovereign debt) amount to 6% of
the total assets in the system and to 150% of its
Tier 1 capital (a core measure of banks’ strength).
The initial sharp appreciation of the local currency
In our view, recent price drops in European equities
mean that Europe’s markets have for the most part
priced in this short-term scenario. Going forward, we
might see some divergence in the Eurozone equity
markets, as the EMU’s stronger members may
escape recession while the bloc as a whole
experiences anemic growth on average. A welldiversified approach within the EMU may prove
valuable to investors.
Long-term outlook: Muddling through
Given the gloomy near-term prospects for the
Eurozone as well as the long-term structural
challenges, talk about the “inevitable” breakup of
the EMU has persisted throughout the sovereign
debt crisis. That the currency union itself is partly to
blame for the crisis contributes to this view. The
introduction of the euro allowed for inexpensive
capital to flow to the less competitive members of
the currency bloc; this amounted to a “free ride” on
Germany’s credibility. Access to cheap credit caused
construction booms, property bubbles, and excessive
government spending in the peripheral countries.
that would likely follow a breakup would create
massive dislocation in the balance sheets of
German banks. Their foreign portfolios would drop
in value (in local terms) and the losses could render
many banks insolvent, which in turn could trigger a
bank panic.
Alternatively, some of the weaker EMU members
might be tempted to leave the union to cause a
competitive devaluation of their currency.
However, here too the financial fallout would be
devastating, as the move would likely throw these
countries’ own banking systems into chaos. Upon
the announcement, the local currency would
immediately depreciate. Banks in the peripheral
Eurozone countries are typically funded externally
(in euros) and lend to local businesses in local
currency, so the prospects of a sharp currency
depreciation would trigger an instant bank run and
financial panic.
Our view is that a breakup of the EMU would not be
in any member nation’s best interest (see the sidebar
above for details on the immediate costs to members
that abandon the union). A more likely scenario is that
the fiscal commitments and bailout measures will
persuade financial markets that the peripheral euro
governments are on a long-term path to solvency.
Thus, the fiscal reforms will be painful in the short
term, but in the end will prove beneficial for the EMU.
For the peripheral countries, the pain will be
especially great, but the likely reward of enduring the
current economic slowdown and expected deflation is
that they will become more competitive through
lower labor costs and lower prices (this is the
so-called “internal devaluation”). Figure 5, on page 6,
shows the potential deflation adjustment needed in
each of the peripheral economies to get back to parity
with Germany. Some countries, such as Portugal and
Ireland, have already started to deflate; others, like
Greece, still have a long way to go.
For Greece, the fiscal austerity and deflation
adjustments may prove overwhelming to the
economy. As tax revenues fall with economic activity,
5
Figure 5.
Cumulative inflation gap, 1999–2010
Prices and labor costs have risen much faster in the five peripheral countries than in Germany. This chart indicates the extent of
deflation needed to restore their competitiveness relative to the German marketplace.
The need for deflation: Price and labor costs in peripheral countries relative to Germany
25%
20
15
10
5
0
1999
2000
Greece
2001
2002
Portugal
2003
Ireland
2004
2005
Spain
2006
2007
2008
2009
2010
Italy
Sources: Eurostat and various national sources via Thomson Datastream.
Figure 6.
Implied probabilities of default priced in by the sovereign CDS market
Expectations of a debt restructuring reflected in 5-year CDS premiums, January 1, 2010–October 29, 2010
Probability of a 25%
haircut within 5 years
1,200
90%
1,000
88%
74% Did not opt out
85%
18% Partial opt-out
82%
8% Full opt-out
77%
Basis points
800
600
72%
65%
400
57% Europe
10-year excess returns:
10-year excess returns:
47% U.S.
10-year excess returns: Global
34%
1-year excess returns: Europe
19% U.S.
1-year excess returns:
1-year excess returns: Global
Oct. 2010
200
0
Jan. 2010
April 2010
July 2010
0.25
Greece
Portugal
Ireland
Spain
Italy
0.20
Note: The chart shows implied default probabilities that are consistent with levels of sovereign CDS premiums based on a 5-year probability valuation model. Probabilities
are calculated as the break-even rate, for each level of CDS spread, at which investors are indifferent between two options—investing in the euro risk-free rate and investing
in a Greek 5-year bond plus a sovereign CDS on that security, assuming a 25% haircut on the sovereign bond within 5 years.
0.15
Sources: Vanguard, based on Thomson Reuters via Thomson Datastream.
0.10
6
0.05
the debt burden becomes heavier and approaches
unsustainable levels. Greece is in much worse shape
than any of the other peripheral countries, because it
is starting from much higher debt levels (a 115% debtto-GDP ratio) and needs a considerably larger deflation
adjustment. To date, Greece is the only EMU member
that has required a rescue to avoid default.
Currently, market consensus expectations imply that
Greece is highly likely to restructure its debt within the
next five years. Figure 6 displays the probabilities of
default priced in by Greece’s sovereign CDS market
since the beginning of 2010. Currently, CDS spreads
of nearly 800 basis points imply roughly an 80%
probability that Greece’s creditors will take a 25%
“haircut” (creditors receive 75 cents on the euro).
Going forward, spreads above 1,100 bps are
something to watch for, as this would imply that
investors are almost certain of a default event.
Although market-based forecasts are often inaccurate,
current CDS market expectations are not
unreasonable, given the information available today.
Greece’s bailout funding is estimated to cover
scheduled repayment obligations through about 2012.
After that, the Greek government will need to return to
the debt markets for additional funding. The bailout last
May did not materially change the unsustainable longterm trajectory of Greece’s debt relative to its GDP.
Thus, under current economic growth projections, the
country will still look insolvent to the markets two
years from now. With projections showing that interest
rates on Greece’s outstanding debt will be well above
its economic growth rate for years to come, even the
deep cuts in budget deficits will not be enough to stop
government debt from swelling to more than 150% of
GDP. At those levels, interest service will take about
10% of the Greek national income, with 80% of that
interest going to foreign creditors.
Given the country’s weak economy and uncertain
growth prospects, it may be too late for Greece to
rely solely on belt-tightening as a way out. To be fair,
the Greek government has delivered key reforms in
its pension system and in its highly regulated labor
market; however, the growth dividends of structural
reforms like these usually arrive only in the long
term. Thus, there is fundamentally a mismatch
between the long-term payoff of the reforms and the
medium-term funding that Greece will need after
bailout funding runs out. The IMF and the European
Commission are studying the possibility of extending
the current bailout programs to help address this
gap.2 The odds of a Greek restructuring event depend
on whether relief arrives from the IMF, other
Eurozone members, or both. Regardless of the
eventual outcome, the bailout last May has likely
bought time for the markets to distinguish the rest of
the peripheral economies from Greece as contagion
fears subside (see the related sidebar on page 8).
If it were to happen, a restructuring of Greece’s
sovereign debt would most likely entail a swap
of bonds for new ones with maturity extensions,
and very possibly the imposition of haircuts on
bondholders, as the CDS market is forecasting. As
noted earlier, current CDS valuation suggests a high
probability of a 25% haircut within the next few years.
Figure 8, on page 9, compares that rate with recent
examples of sovereign debt restructurings,3 and
shows that a 25% Greek haircut would be roughly in
line with that of Belize in 2006 and less than half of
what bondholders experienced in Argentina, the Ivory
Coast, and Russia in the 1990s and early 2000s.
As of this commentary’s publication, Ireland was
facing increasing pressure from its bond markets due
to continuing problems in its largely concentrated
banking system. Unlike the response to the crisis in
Greece, this time around the euro area has preexisting
mechanisms for short-term response (i.e., the EU-IMF
financial stabilization programs). However, the longterm implications of these developments for Ireland
are still unclear.
2 As of the publication date of this commentary, EU regulators had tentatively agreed to a proposal backed by Germany and France to amend the Treaty of
Lisbon. The current proposal would establish a permanent fund to aid member states facing financing difficulties, with access to the fund potentially
involving penalties such as forced restructuring and a loss of voting rights in the EU. Passage of the proposed amendment is not certain and will likely involve
significant debate among member states, as the entire EU will be involved in negotiations, pulling non-euro member states such as the United Kingdom into
the process.
3 See Moody’s Sovereign Default and Recovery Rates 1983–2006, June 2007. http://ksuweb.kennesaw.edu/~dtang/CRM/Moodys_SovereignDefault.pdf
7
Figure 7.
Latin American sovereign debt crisis, 1998–2002
Yield spreads relative to U.S. Treasury securities
5,000
Period of Russia/Asia
debt crises
IMF bailout, conditional
on austerity measures
Basis points
4,000
IMF ceases funding;
Argentina defaults
3,000
2,000
1,000
0
1998
1999
Argentina
Mexico
2000
Brazil
2001
2002
Chile
Note: Spreads display the yields of each country’s corresponding JPMorgan Emerging Market Bond Country Index relative to the yields of U.S. Treasuries of similar maturity.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly
in an index.
Sources: JPMorgan via Thomson Datastream, Vanguard.
Can contagion fears subside while Greece restructures?
Given that Greece is much worse off than the other
peripheral Eurozone states, can we expect spreads for
other countries’ debt to diverge from Greece (and
tighten) as the Greek government approaches the end
of the bailout funding? Based on the experience of
Latin America in the late 1990s and early 2000s, this
expectation appears reasonable. Figure 7 displays
sovereign spreads relative to U.S. Treasuries in the
years leading up to Argentina’s default on its debt.
While the initial shock in 1998 from the Russian ruble
crisis (and the other financial crises in Emerging Asia)
caused spreads for several Latin American issuers to
spike, the IMF bailout of Argentina gave the markets
time to distinguish the varying degrees of credit quality
within the region: Mexico, Chile, and even Brazil
proved to be on a more solvent path versus Argentina,
which was clearly headed to insolvency. As a result,
when Argentina did default on its debt in late 2001,
spreads on the other countries actually tightened.
74% Did not opt out
18% Partial opt-out
We think a similar situation would probably arise in 8% Full opt-out
the event of a Greek restructuring, with markets
distinguishing Greece from Ireland, Italy, Portugal,
and Spain. If this is the case, any default event from
10-year excess returns: Euro
Greece should be met with modest (not significant)
10-year excess returns: U.S.
volatility in the spreads of the other countries’ debt.
10-year excess returns: Glob
1-year excess returns: Euro
1-year excess returns: U.S.
1-year excess returns: Glob
Chile
Mexico
Brazil
Argentina
5000
4000
3000
Chile
Mexico
Brazil
Argentin
2000
8
1000
Figure 8.
Haircuts during past sovereign restructuring events
Estimated reduction in par value for bondholders (%)
0
Russia
(1998)
Ecuador
(1999)
Pakistan Ivory Coast
(1999)
(2000)
Ukraine
(2000)
Argentina
(2001)
Moldova
(2002)
Uruguay
(2003)
Grenada
(2004)
Dominican
Republic
(2005)
Belize
(2006)
Greece (?)
estimated
−20
−40
−60
Value-weighted
average: –45%
−80
−100%
Note: The estimate for Greece is based on analysis similar to that described in Figure 6, using CDS premiums as of October 2010. The implied probability of a 25% Greek
haircut within five years is about 80%.
Sources: Moody’s Investors Service, Vanguard.
Toward a more balanced Eurozone
Despite the reaction of financial markets and the
widespread fears of contagion, the most likely
outcome is one in which the EMU muddles through
its fiscal issues, with the peripheral members
undergoing several years of constrained growth due
to fiscal retrenchment and deflationary rebalancing.
Because Greece is starting with far worse conditions
than the other economies, a scenario involving either
additional bailout funding or a restructuring event
appears probable.
The short-term economic outlook is bleak, and the
long-term rebalancing needed within the bloc is
challenging. However, in our view, there would be
little benefit in ending the currency union, given the
trade efficiencies that a single currency provides and
the financial disruption that would result from
returning to a system of national currencies. In
addition, member nations may have much to gain
from working through the current problems. In the
long term, the painful reforms will likely prove
beneficial, with the European currency union
74% Did not opt
out
emerging as a more balanced, competitive
economy.
18% Partial opt-out
8% Full opt-out
10-year excess returns: Europe
10-year excess returns: U.S.
10-year excess returns: Global
1-year excess returns: Europe
1-year excess returns: U.S.
1-year excess returns: Global
Notes
on risk: All investments are subject to risk. Investments in bonds are subject to interest rate, credit,
0
and inflation risk. Foreign investing involves additional risks including currency fluctuations and political
uncertainty. Stocks of companies in emerging markets are generally more risky than stocks of companies in
-20
developed countries. Past performance is no guarantee of future returns. The performance of an index is
not an exact representation of any particular investment, as you cannot invest directly in an index.
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