Already, pressure from the markets has claimed two victims in the euro zone. The first victim was Greece, which had no alternative but to accept a joint aid package of 110 billion euros from the European Union and the International Monetary Fund last April. The next victim was Ireland, which accepted some 85 billion euros from the same two institutions in late November.
Investors started to worry about the fiscal condition of those countries, and the possibility that they would be unable to repay their debt obligations. Markets began to ask them to provide higher and higher interest rates to compensate for the higher risk of buying their sovereign debt. Their rates wound up being so high, the financing costs became unbearable for Greece and Ireland, and market financing practically came to a halt. The only way to get the money they needed in order to keep making their payments was to accept assistance from the European Union and the IMF.
However, the euro zone’s problems don’t end there. Now analysts are focusing on the financial condition of Portugal and Spain, two other countries that run some of the highest budget deficits in the euro zone. On November 15, Eurostat, the EU’s statistical agency, reported that Spain’s public-sector deficit was 11.1% of its Gross Domestic Product in 2009, and Portugal’s was 9.3%. That’s far above the 3% requirement that the EU has set as the acceptable limit for the sustainability of its member-states’ finances.
When it comes to public-sector debt, Portugal’s rose to 76.1% of its GDP in 2009, up from 65.3% the previous year. Spain’s increased from 39.8% of its GDP in 2008 to 53.2% in 2009, the equivalent of 560.587 billion euros. According to the criteria of the European Economic and Monetary Union, the public debt of each nation should not exceed 60% of its Gross Domestic Product.
Strengths and Weaknesses
“The main problems of the Portuguese economy stem from its high foreign deficit,” notes José da Silva Costa, professor of economics at the University of Porto in Portugal. The slow growth rate of its economy is not compatible with its level of domestic spending, he adds. “The public debt, and the level of spending by families and companies, reflect a situation in which domestic spending is not sufficient to satisfy the financing needs of the Portuguese economy.” As a result, he believes that the strengthening of public finances in Portugal will have to be accompanied by a decline in consumer spending and a reorientation of the funds available for companies that operate in the exporting sector. The recovery of the Portuguese economy will depend, to a great extent, on “the expansion of exports in coming years; and that, in turn, depends on the competitiveness of Portuguese companies and the economic progress of Portugal’s key trading partners.”
“Portugal is in a very bad situation,” says Rafael Pampillón, professor of economics at the IE Business School in Madrid. “The economy is stagnant and has been in this situation for the last 10 years. Now it suffers an unemployment rate that is considered very high for the country — about 10%.” Pampillón adds that Portugal has undergone a major crisis, and it has not carried out the structural reforms needed for its economy. “For many years, it lived with imbalances that have continued to get higher and higher, by resorting to the trick of devaluing the escudo. But now it can now use this gimmick with the euro, so the situation is complicated. One of its most outstanding weaknesses is its very low level competitiveness, with very little investment in research and development,” he notes.
As for Spain, Da Silva Costa believes that “Spanish banks have more problems than Portuguese banks have, and the Spanish economy also has problems of competitiveness.” Nevertheless, he thinks it is a good thing that “the Spanish government has adopted fiscal strengthening measures more rapidly than Portugal has.”
For his part, Esteban García Canal, professor of corporate management at the University of Oviedo, believes that the Spanish economy is stronger than that of Greece, Ireland or Portugal. “This strength is rooted in the presence of Spanish multinational corporations that are leaders in the global rankings of many industrial sectors as well as other multinationals of more modest size, which have good prospects for the future.” For García Canal, “this is a distinctive characteristic of the Spanish economy that says a lot about its potential.”
Will They Meet Their Goals?
On November 29, the European Commission published its economic forecasts for Spain and Portugal, but that didn’t calm the markets. The EU’s executive branch estimates that both countries will be unable to meet their goals for reducing their deficits.
The European Commission estimates that Spain’s economy will grow by only 0.7% in 2011. That’s almost half of the government’s forecast of 1.3%, so Spain will not be able to fulfill its goal of cutting its public-sector deficit to 6%. Instead, its deficit will remain at 6.4%, according to the EC. The Spanish government has committed itself to reducing its deficit from 11.1% in 2009 to the 3% figure authorized by the European Commission, by 2013. Spain hopes to gradually reduce its deficit from 9.3% in 2010, to 6% in 2011, and then to 4.4% by 2012. But the European Commission doesn’t back those figures; it forecasts a deficit of 5.5% within two years.
The Commission also believes that the forecasts for Portugal are wrong. According to its calculations, that country’s deficit will drop from 9.3% in 2009 to 4.9% in 2011, compared with the 4.6% forecast made by the government in Lisbon.
With this as a background, fears shot up at the beginning of December that Portugal and Spain would be unable to pay their debts. According to Bloomberg News, Spain’s risk premium – measured by the differential between the ten-year Spanish bond and the equivalent German bond – was 298.2 basis points, the highest differential since the introduction of the euro. Markets started to require Spain’s ten-year bonds to provide a return of 5.6%. At the same time, Credit Default Swaps — insurance against non-payment of the debt — also registered record highs above 370 basis points. That means that the cost of guaranteeing 10 million euros of five-year Spanish debt was 370,000 euros. The differential in the return between ten-year Portuguese debt and ten-year German debt broke above 390 basis points, and the credit default swaps went above 480 basis points.
On December 9, Barclays Bank in London published its report on markets and economic forecasts for 2011. The British institution described the situation in Spain as one of the key focal points for investors. Barclays economist Simon Hayes noted, “Spain is a solvent country from the viewpoint of the fundamentals of its economy and its public debt.” However, he added, “If investors continue to be nervous, and the cost of Spanish sovereign bonds reaches 7%, the situation could be explosive, and then it could be necessary to rescue the country.”
The Repercussions of Contagion
Given the current situation in the sovereign debt market, some very influential analysts take for granted that a process of contagion has already been produced, spreading the problems of Ireland and Greece to Portugal. Nouriel Roubini, the New York University professor who forecast the global financial crisis, told Bloomberg TV on December 2, “The contagion has already spread to Portugal.” Assuming that this is a fact, the question is whether Portugal will ultimately have to receive assistance.
For Da Silva Costa, the issue of whether or not Portugal requires assistance will depend to a great extent on the political response that the major economies of the euro zone have regarding the sovereign debt crisis. “Portugal does not have any major problems in the banking sector because there wasn’t any speculative bubble in the Portuguese real estate market. So long as interest rates remain at feasible levels for the Portuguese economy, the country will be capable of responding to the crisis without help from the Financial Stabilization Fund and the IMF.” In his opinion, if interest rates return to the levels of recent years, IMF assistance will be inevitable. “Portugal depends on what is happening in economies such as Spain and Italy. If the perceived risk regarding Spain and Italy is high, and the euro zone’s measures for avoiding risk are more energetic, Portugal will not have to rely on help from the Financial Stabilization Fund and the IMF,” he says.
For his part, Pampillón is certain that Portugal “will have to ask for help from the European Union and the IMF because Portugal’s economy is not growing, and it suffers from significant over-indebtedness in its public sector.” He believes that “without economic growth, they can’t generate the necessary tax revenues that will enable it to deal with its debt payments. They need to realize that one of the keys to the problem is the country’s growth.”
If Portugal ultimately has to receive aid, the spotlight would be fall directly on Spain. “My perception is that the rescue of Portugal would make Spain the center of attention, and would create a problem in the euro zone that is truly difficult to solve. I am afraid that the cost of a Spanish rescue would be so large that it would cast doubt on the euro,” notes Da Silva Costa. “In places such as Spain, if the contagion were to become worse than it already is, there would be problems because there aren’t enough institutional resources for rescuing Spain, following [the rescue of] the smaller countries,” he says.
According to Da Silva Costa, 90 billion euros in assistance is an acceptable amount; that is what Portugal would receive from a guarantee fund of 750 billion created by the European Union and the IMF. “The problem is that Portugal drags down Spain, because rescuing a country of these dimensions would require 300 billion euros, an amount that is too large, and which would involve certain difficulties,” calculates Pampillón. “If Spain fails, other countries such as Italy and Belgium would collapse right behind it. However, I don’t believe that the ECB [European Central Bank] is going to let Spain collapse. No one in Europe is interested in rescuing Spain. Spain is too big to collapse.”
Last spring, the IMF and Europe offered Greece loans of 110 billion euros. The EU’s budget for the other troubled euro-zone countries could include 60 billion euros of debt. In addition, a guaranteed mechanism for the 16 countries could bring in another 440 billion, while the IMF could contribute another 250 billion. In Europe as a whole, a maximum of 750 billion euros would be available for lending to countries in trouble.
Reforms Build Confidence
In an effort to calm markets and relieve pressure on its debt, Portugal approved its most austere budget in decades on November 26. The Portuguese government will cut salaries of its officials by 5% in 2011. It will increase its value-added tax from 21% to 23%, freeze pensions and increase tax burdens imposed on corporations and ordinary citizens. It will cut all of its social subsidies, and generally restrain public sector investments and spending.
For its part, the Spanish government has decided to lower salaries for public-sector employees by an average of 5% for 2010, and then freeze them in 2011, when it will also suspend increases in pension payments and eliminate some social assistance programs such as grants given when children are born — the so-called “baby checks.” In addition, to reduce the deficit, the Spanish government increased its VAT (Value Added Tax) in July to 18%, from an earlier level of 16%. One of the measures approved in order to calm markets was to establish January 28 as the date when the executive branch will approve its pension reform program.
EstebanGarcia Canalbelieves that markets should pay more attention to the entrepreneurial potential of the Spanish economy than they have been. Whether or not that happens will depend on deepening the country’s structural reforms (of its labor market, financial system, public spending, etc.). “These reforms have already been started, but they have to be developed, and they will enable our multinational companies to continue to contribute to the growth of our economy. It is the only way to restore the confidence that has been lost,” he says.
What needs to be done to prevent the market from losing even more confidence and putting more pressure on Spanish debt? After all, such a development would only increase the country’s financing costs even more. Pampillón says Spain needs to carry out more reforms — wider and deeper ones than those previously undertaken. “You cannot let yourself be controlled by the market,” says Pampillón. “You have to demonstrate that the country will be able to grow in a sustainable way in the future.
"The pending important reforms that need to be carried out include healthcare reform, which needs to be sustainable with the introduction of co-payments. It is very important to reform the energy market, reduce subsidies to renewable energy, and commit the country to cheaper forms of energy such as nuclear power. It is also vital to approve regulations for limiting and controlling spending by autonomous [local Spanish] ‘community’ governments. And finally, the labor reforms made a few months ago have to be deepened by introducing the deregulation of collective bargaining,” he notes.