FYI | Jan 29 2010
By Andrew Nelson
If you’ve switched on a TV or picked up a paper lately, you’d know that the eurozone’s public finances are under a lot of scrutiny these days. While it may not be wise to lump in the good countries with the bad, it would be prudent to know who the mischief makers are, as these countries are staring down the barrel of a sharp rise in sovereign risk if they don’t get their ducks in a row, and soon.
This is especially the case in countries that have traditionally demonstrated poor budget management, like Greece and Portugal, and to a lesser degree, Italy. However, economies such as Spain and Ireland, which have gone though some severe cyclical corrections on the tail end of housing bubbles, are also looking at trouble on the horizon.
Economists from Credit Agricole point out that in Ireland and Spain, the deterioration of government finances and the build-up of public debt are fairly recent phenomena. In fact, as late as 2007 the budget situation in both of these countries was fairly healthy, with an average GDP surplus of 0.25% and 1.49%, which compares favourably with an average eurozone deficit of 1.85%.
However, in southern Europe, there is a long history of governmental struggle with public finances. Italy and Greece have traditionally been highly indebted countries where public deficits are mainly structural in nature. This is primarily due to a lack of public spending effectiveness and poor budgetary management. Thus, Greece, Italy and Portugal have also had considerably higher structural deficits than the eurozone average.
Italy, Greece and Ireland saw veritable boom times in 2000-2005, while Portugal’s most recent time in the sun was 1995-2000. But the problem was that none of these five countries used their years of strong growth as an opportunity to reform their public finances while they had the chance. Because of this, the last ten years or more in Italy and Greece have been a time where public debt ratios surpassed 100% of GDP, while interest charges, which are admittedly lower than pre-erurozone years, still siphoned off over 5% of GDP each year.
During the boom times, Portugal, Spain and Ireland were able to maintain significantly lower levels of public debt, but now these are the countries that have experienced the worst deterioration in their public finances since the start of the global financial crisis.
The team from Credit Agricole thinks the pressures on public finances in all of the above mentioned countries are unlikely to get any better in the foreseeable future. The team predicts that government deficits and debt will undoubtedly grow in 2010, while the output gap will remain sharply negative.
However, the team also thinks it would be incorrect to lump all of these countries into the same basket, thus Credit Agricole has looked at a combination of factors to determine a sort of ranking system.
The team says their ranking system can be best explained by the level of primary deficit and of public debt forecast for 2010. Italy comes out with the lowest risk because of the low primary deficit forecast this year, which is only 0.6% of GDP. Conversely, Greece has the highest risk, as it combines a high initial primary deficit and public debt, at 125% of GDP.
There is an even bigger cloud looming on the horizon, though, and that is the increasingly strong impact of population ageing on state spending. Given the proportion of older people in the European population is steadily growing, CA believes the situation of public finances will inevitably continue to deteriorate in both the near and long term.
Citing European Commission projections, the team predicts that population ageing will severely impact public finances by decreasing government revenues and increasing spending, most notably on healthcare and pensions. Credit Agricole notes this is particularly the case for countries in southern Europe, where demographic changes are even more apparent and pensions particularly generous.
Major reforms have been implemented in Italy and Portugal to cope with these problems, but in Spain and even more so in Greece, little has been done to soften the impact of the demographic shock. In fact, by 2060 age-related expenditure will increase most in Greece, then Spain, while if current reforms are properly implemented, the rise in spending will be less pronounced in Portugal and Italy.
Yet the team thinks it is Ireland that will have to make the biggest fiscal effort given the recent and very severe deterioration in its structural primary deficit. Greece will also have to make a very substantial fiscal effort, due to the scale of its age-related spending, with ageing alone implying an additional fiscal effort of 7.7 points of GDP by 2060.
On the other hand, Italy has the lowest risk according to Credit Agricole, with the age-related related issues less of a problem because of a better overall fiscal situation and recent work towards structural reforms.
So what is the overall ranking between these bottom five of Europe?
In the short and, more importantly, the long term, Credit Agricole finds that Greece is by far the riskiest country. With a cocktail of high public debt, a severely degraded budgetary position and major demographic concerns.
Ireland and Spain come next, although the recent deterioration in their public finances is at least taking place in an environment where initial public debt levels are lower.
Portugal is facing problems that are more short-term in nature, with the longer term, age-related risks looking less problematic. However, the team notes that the structural weaknesses surrounding the Portuguese economy will continue to impact on public finances over the longer term.
That leaves us with Italy, which Credit Agricole sees as being the country with the lowest public finance related risk thanks to the fiscal efforts made in recent years combined with structural pension reforms.
