Deciphering the G10 sovereign debt crisis: a macroeconomic perspective

Posted on 14. mar, 2010 by Jean Jacques Ohana in Weekly Focus | Commentaires fermés

When a country runs a current account deficit, the private sector and the public sector cannot deleverage at the same time. Let us explain this simple fact.

There is an economic equilibrium relating current account balance, budget balance and private sector balance:

Private Balance + Budget Balance = Current Account Balance

where we denote Private Balance = Private Saving – Investment.

The Budget Balance represents the difference between taxes and public spending while the Current Account Balance represents the sum of the trade balance (exports minus imports) and the net factor income balance (interests, dividends…).

This relationship provides a crucial insight on the way a country may reduce its public debt. If the Current Account Balance is maintained negative, the only way for a country to increase the Budget Balance consists in increasing private debt.

This essential fact implies that Sovereign Solvency issues are at least tridimensional: budget deficit, current account deficit and outstanding debt. We can represent G10 Government’s 5 Years CDS (as of 5 March 2010) and the three economic explanatory variables:

Sources : Bloomberg, IMF, European Union Commission Estimates

Actually, Current Account is more explanatory of CDS Spread than any other variable. The correlation between Current Account and Budget Balance exceeds 75%. Indeed, when a country is a net importer, it can finance its current account deficit either by public deficit or negative private balance (in the form of private debt or foreign investment).

As a matter of fact, Greece has financed its current account deficit through public and private debts. Spain, by contrast, used to fund its current account deficit through private debt under the form of real estate investment in particular. When the recession knocked at the door, they had no other possibility than substitute public debt for private debt as the private sector started deleveraging and foreign investors stopped investing in the country.

The chart below represents the countries most exposed to external funding due to the lethal combination of a sustained negative current account and a negative budget balance. It clearly shows that Spain, Portugal and Greece are in a dead-end as regards their public debt burden, as their current account deficit will necessarily be funded by more of an already high public debt as long as the private sector deleverages.

These countries have been consistently running current account deficits at any EUR/USD exchange rate, as illustrated by the chart below:

Hence, they won’t be able to run a current account surplus in the future because their economy is not equipped to generate an exports-driven growth. China, Brazil, India and Germany have set up mercantilist policies enabling them to run consistently high current account surplus. They are unlikely to give up global market shares without a fight.

Let’s calculate the private sector indebtedness corresponding to the budget effort required by the European Commission (supposed to be reached in 2013) for the vulnerable countries, assuming the current account is unchanged:

It is absurd to assume that the private sector will increase its spending and indebtedness in a context of economic crisis and fiscal retrenchments. The only way out  for Greece, Spain and Portugal is therefore improving their current account balance.

In fact, they are three alternative solutions to do so:

  • The overall balance of the Eurozone can shift toward surplus
  • Countries with a fiscal deficit can be temporarily excluded from the Euro Zone so that they can devaluate their domestic currencies or accept a reset of their domestic exchange rate against the euro.
  • These countries can go through a major deflationary shock.

The first remedy, which implies a Euro devaluation, may be difficult to swallow for Germany and for Europe’s trade partners. The last two remedies amount to a real exchange rate depreciation, a necessary condition to restore the competitiveness and in turn reduce the current account deficit in countries with large fiscal deficits. Deflation implies a transitory depression phase where the private sector suffers from lower wages and falling business revenues under higher taxes and cuts in government spending. Demonstrations in Greece are a sign that the populations might not be ready to withstand the long-lasting slump that is looming in countries with high external and fiscal deficits.

Deflation, which lowers companies’ output and employees’ wages and increases the ratio of debt to asset value, undermines the capacity of indebted businesses and households to repay their debt and entails the risk of spiraling credit defaults on banks’ loans to the private sector.  On top of that, banks generally hold a large amount of ”toxic” Treasury bonds issued by their insolvent governments. Therefore,  their assets are subject to a twofold depreciation threat. The following chart, relating Spanish Banks CDS to Spain’s Sovereign Debt CDS, shows that sovereign solvency issues are the Achilles’ heel of the whole financial system.

In the short term, the Euro Zone should consider easing its rigid monetary and assistance rules (euro devaluation, set up of a rescue plan at the European level). In the long term, the Euro Zone has to acknowledge the fact that Greece, Spain and Portugal cannot reduce their structural current account deficit unless exporting countries reduce their surplus. As Martin Wolf put it in his inspirational FT article Germany’s eurozone crisis nightmare, “Germany must become less German if the eurozone is to become more so”.

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