EU's 'Club Med' provides vital clues to wider economic climate


Italians and Cypriots go to the polls at the weekend. The centre-left is likely to win in Italy, while the centre-right is all but guaranteed victory in Cyprus. Both elections provide yet more evidence that the political centre is holding even in the face of the worst economic conditions in living memory across the Mediterranean.

The new administrations in both countries, and those already well-established in office in Portugal and Spain, face daunting challenges. Most economic indicators point to continued recession. Among the many consequences of this is the risk of another sovereign default in the Mediterranean.

But let’s start with the two positives: the calming of panic in the euro zone and the Med’s recent export success.

Since the European Central Bank unveiled its Outright Monetary Transaction programme six months ago, the threat of the euro breaking apart in the near term has receded. With the new plan, the ECB answered the question as to what would happen if Italy and/or Spain came to be locked out of the bond market. The ECB backstop has thus dealt with that (liquidity) risk, thereby buying valuable time in which a recovery can take hold.

But has it bought enough time?

Whether the peripheral economies remain solvent depends more than anything else on how soon economic growth resumes. In that regard, the outlook is very worrying, but not without signs of hope.

The most important positive development has been the regaining of competitiveness in much of the south. As the chart shows, export growth has been very strong in the two Iberian economies. From the depths of the Great Recession in the first half of 2009 until the third quarter of last year, export volumes rose by 32 per cent in Spain and 29 per cent in Portugal.

Italy’s export performance has been strong but less stellar. Although volume growth over the same period was a creditable 24 per cent, exports have yet to return to pre-crisis levels.

But if advocates of front-loaded fiscal consolidation can point to this export growth as proof that their favoured policy is working, most other indicators suggest profound weakness.

Along with new taxes and spending cuts, the periphery has experienced capital flight and severe credit tightening. All of these factors together have hammered confidence, making matters worse again.

As the chart shows, domestic demand in all three economies was falling fast as of the third quarter of last year. In Italy, the contraction since the economy dipped back into recession in 2010 has actually been greater than the shrinkage that occurred in the 2008/’09 period. Domestic demand in the Portuguese economy is in freefall.

More up to date, but less detailed headline GDP data for the final quarter of 2012 shows a massive quarterly decline in Portugal. While the contractions in Italy and Spain were not as frightening, they represented accelerating decline in both economies.

What does this mean for these countries’ debt sustainability?

The most closely watched indicator of sustainability is the debt to GDP ratio, and analysts generally agree that when it rises above 120 per cent, sovereigns move into the default danger zone.

With nominal (as well as real) GDP falling and debt piles growing, that ratio is rising fast in all three economies. The latest figures show that Portugal passed the 120 per cent threshold as of the end of September last, while Italian public debt surpassed 127 per cent of GDP. Spain seems to have more headroom – debt was 77 per cent GDP – but that figure excludes tens of billions of euro spent on bailing out banks last year.

And then there is Cyprus. Its banking system collapse is of a magnitude somewhere between Ireland’s and Iceland’s. If the sovereign absorbs all the bank losses, debt will touch 150 per cent of GDP.

In drawing up the terms of Cyprus’s long-awaited bailout, the EU and IMF have a choice between an unprecedented burning of bank creditors or a second sovereign default. As they have put their credibility behind the avoidance of the latter option, their choices are very limited.

It is possible that a shock from Cyprus would not trigger renewed panic. It is conceivable that export growth in the other Meds could drag them back from the brink. That both would happen is very unlikely.

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