SPIEGEL ONLINE

SPIEGEL ONLINE

07/14/2011 06:08 PM

Debt Quicksand

Europe Fights the Growing Currency Crisis

By Carlo Angerer, and

For a while, Europe's common currency crisis seemed to be cooling down. But this week Italy joined other debt-ridden euro-zone countries in the crosshairs of the financial markets. Europe's indebted nations are fighting to get their houses in order -- with some success.

In spite of massive cash transfusions and bailout packages, the euro-zone has started trembling again over its weakest members. The future of the common currency is, again, at stake. Ireland and Portugal will receive billions of euros in support, and a second bailout for Greece is in the works. And just as European politicians were starting to think about their summer vacations, Italy's public debt has slipped into focus.

It looks almost as if speculators are working slowly through a list of European governments, namely the indebted ones known under the notorious acronym PIIGS -- Portugal, Ireland, Italy, Greece and Spain (which may be up next). What's certain, though, is that all five governments will be under close observation by financial markets as long as the EU comes up with nothing but short-term fixes.

The common impression of a single big debt crisis in Europe, though, is deceptive. The euro zone's problems are wildly different from one indebted nation to another, so the dangers vary. Governments have also fought for some time against financial collapse, and in some ways they've started to win.

How did debt problems start in Portugal, Ireland, Italy, Greece and Spain? How will the countries dig themselves out, and how well? This overview breaks down the debt crisis from nation to nation.

How did the crisis start?

Portugal has massive structural problems in its economy. As late as the '90s it had a flourishing textile industry, mainly due to low-wage policies. From 2004 on, things went downhill: Portugal lost more and more investors to new EU members in eastern Europe, which also had low wages to offer. Since then the Portuguese economy has hardly grown. The industrial sector is shrinking, and unemployement has risen. The government is highly in debt.

What has been achieved?

In the spring, Portugal slipped under the protection of the EU's rescue mechanism, narrowly skirting bankruptcy. In return for loan guarantees to the tune of €78 billion, Portugal has to quickly make good on what the EU and IMF consider to be missed payments from the last 30 years. The government has imposed austerity on pensions and official salaries; it's reforming the public sector and selling its last state assets, including the public water works and the energy group EDP.

By 2013 the state budget deficit will have to be reduced from 9 to 3 percent. But a new government is still getting started with reforms under Prime Minister Pedro Passos Coelho, who was just elected in June.

What are the obstacles?

Prime Minister Coelho has predicted "two horrible years" for the almost 11 million citizens of Portugal. He knows government reforms are extremely ambitious and will demand a lot from the population. According to forecasts so far, the country will languish in recession through 2012, and unemployment figures may top 13 percent (setting new records). There's considerable fear that new growth will stall. But no one in Portugal wants to consider that. "We simply can't fail," said President Aníbal Cavaco recently.

How did the crisis start?

With extremely low interest rates, tax incentives and lax bank regulations in the 1990s, Ireland's government spurred a real-estate boom that saw home prices quadruple within just a decade. But when the global real estate market collapsed, mortgage-backed securities at Irish banks lost most of their value. In autumn 2008 the country's financial institutions were on the verge of collapse. The government took on junk bonds and pumped capital into banks until the state itself became financially strapped with debt exceeding 100 percent of the gross domestic product (GDP). Last November the country could no longer function without financial aid, and asked the European Union and the International Monetary Fund for money.

What has been achieved?

The European safety net saved Ireland. But Dublin still had to impose drastic austerity measures in exchange for loan guarantees worth some €80 billion. The government must also reduce its deficit to three percent of GDP (a level set by the Maastricht Treaty) by 2014. The financial restructuring has already had some positive effect -- the economy is improving thanks to booming exports. In the first quarter of this year it grew by 1.3 percent, the highest gain since 2007. Economists are already discussing potential dates for the country to leave the European Financial Stabilization Mechanism (EFSM).

What are the obstacles?

Unemployment is high and wages have tanked -- not a good indicator for domestic economic activity. State finances also remain wobbly. Because the government continues to back domestic banks, its solvency is tied to their fates. But they are still dragging billions of euros in real estate loans, which increases the interest that Ireland must pay for government bonds. Meanwhile on July 12 rating agency Moody's downgraded the country's bond ratings to junk status.

How did the crisis start?

Neither a real estate nor banking crisis sparked the financial emergency in Italy. Instead, poor budgetary management racked up enormous debts. Just as it did in the mid-'90s, the euro zone's third-largest economy carries a mountain of debt that equals more than 120 percent of its GDP. That's twice as much debt as Brussels will allow. Only in Greece is the situation worse.

What has been achieved?

New debts must remain under the European average and fall bellow the Maastricht Treaty's criteria of three percent of GDP by 2012. To reach this goal the Italian government plans to save some €40 billion over the next few years. The cabinet has sanctioned the savings measures, but final approval awaits a parliamentary vote. There is much to suggest that Rome can overcome this crisis more effectively than other southern European governments. The economy is still quite productive, the savings rate is comparatively high and its bond market is the third-largest in the world.

What are the obstacles?

Doubts have risen over whether the planned austerity measures will be implemented. There are also rumors that their main steward, Finance Minister Giulio Tremonti, may leave his post. Risk premiums for Italian government bonds have therefore reached record levels, which could endanger the country's banks, a number of which have invested in domestic bonds. Rome would be forced to prop up some of these institutions -- but government coffers are empty. Speculators have started to bet the country will become insolvent.

How did the crisis start?

Greece was the first EU nation to stumble after the global financial and economic crisis of 2008-2009. It had to be protected in 2010 with a multi-billion-euro safety package. The catalyst for the crisis was gigantic government debt, which towers over the rest of Europe's at 160 percent of the nation's gross domestic product. The country lost investor confidence and has managed to borrow money only at horrendous interest.

Behind the debts lie deep structural problems. Compared to other euro-zone members, Greece's economy was never particularly strong. When it joined the euro zone, moreover, borrowing became less expensive, and cheap loans heated up domestic consumption. Since Greece exported so little to start with, a large trade deficit developed -- a huge imbalance between outgoing payments and incoming goods.

What has been achieved?

Greece has steered a severe course of government savings since the crisis began. Several multi-billion euro austerity packages have lowered the nation's new indebtedness from about 15 percent in 2009 to 9.5 percent in 2011. Thanks to a new statistics office, these numbers are now considered realistic. In the past Greece regularly spruced up data about its state finances.

George Papandreou's Socialist government has tightened the belts of long-privileged state officials, and the whole population will face higher taxes. The rich will also have to reach for their wallets. Greece's notoriously inefficient tax officials will do more to find millionaires who are trying to hide income.

What are the obstacles?

Greece's largest problem hasn't changed since the start of the crisis: Government debt is still at record levels and promises to rise. One reason is the enormous interest due on older debt, but another is a downturn in the Greek economy. The outlook for significant growth is dim, so calls for long-term economic stimulus have risen. The Athens government will set its hopes on privatization, which alone would make up €50 billion of the latest €78 billion savings package. But it's doubtful whether state assets in their current condition can be sold at reasonable prices.

Political protest against further cutbacks has proved to be a growing problem. Some opposition has taken to the streets, where many thousands of protesters have mobilized recently. But Papandreou's chief political opponent, Antonis Samaris, and his conservative party Nea Dimokratia, have staunchly refused to support to the government's austerity packages -- though they bear as much of the blame for the nation's current misery as Papandreou's Socialists.

In light of the changing situation, a restructuring of Greek debt seems ever more likely. In that case creditors would be asked to prolong their loans or reduce their claims. A more radical debt-reduction plan now has prominent supporters like Martin Blessing, head of Commerzbank. The problem with all restructuring models is that ratings agencies intend to view them as default by another name. In that event not only Greek bond issues, but also bonds in the other PIIGS nations will be more difficult to sell.

How did the crisis start?

In 2008, Spain was rudely awakened from its dream of an economic boom. The rapid economic growth in the middle of the last decade was based on an overheated construction sector that was fueled by extremely low interest rates. When the housing bubble burst in the wake of the financial crisis, hundreds of thousands of Spaniards lost their homes and over a million lost their jobs. Tourism also slumped as a result of the global economic crisis. The country slid into a severe recession.

What has been achieved?

The Socialist government of Prime Minister José Luis Zapatero tried to steer Spain out of the crisis with the help of unprecedented reforms -- partly passed under pressure from the International Monetary Fund. The retirement age was raised and the rigid labor market reformed. There are some initial signs of recovery: Exports and tourism are getting back on track. The government is also making progress in the key economic indicators. In 2010 the budget deficit shrank more than expected. Zapatero recently said he expects faster growth in the second half of 2011.

What are the obstacles?

The biggest problem remains a record unemployment rate of over 20 percent. Among young people the rate even tops 40 percent. The IMF recently warned that Spain needs to make greater efforts to reform the labor market. Spain's young people have also pressured Zapatero -- for weeks -- by protesting the government's policies in public squares. Zapatero faces the next major obstacle at the end of July: The country needs to raise about €16 billion in the capital markets to pay off old debts. Recently, however, risk premiums on Spanish government bonds have once again risen significantly.

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