THE GREEK SAGA has weighed on market sentiment for more than two years, as investors questioned the troubled sovereign’s ability to repay its debt. European policymakers insisted that there was “no risk” of default, but the rhetoric proved long on hope, as the Hellenic Republic succumbed to the inevitable in recent weeks, and became the first developed country to default on its debt in six decades.
The largest sovereign default in history was greeted by investors with a mere shrug of the shoulders, a far cry from the violent reaction policymakers long feared would bring the financial system to a standstill. Simply put, the game has long since moved on, as investors relegated the Greek crisis to an uncomfortable but manageable sideshow. The more pertinent question today is who’s next.
Policymakers argue that the Greek situation is “unique and exceptional”, but such claims are certain to fall on deaf ears, given such rhetoric’s lack of credibility. Investors already have Portugal in their sights and the beleaguered country’s sovereign debt has failed to participate in the meaningful downtick in eurozone government bond yields precipitated by the first tranche of the ECB’s three-year long-term refinancing operation late last year. Portuguese policymakers have expressed confusion at the debt market’s reaction to their seemingly heroic efforts to more-or-less meet the fiscal targets set out by the troika in last year’s rescue package. Indeed, the second review document published by the IMF last December revealed that Portugal managed to reduce its fiscal deficit by more than three percentage points of GDP last year to below 6 per cent, an impressive achievement given its rapidly contracting economy.
But careful analysis suggests that the fiscal improvement is not as stellar as it might appear which will make it far more difficult to meet targets for this year and beyond. In this regard, it is of concern to see that last year’s effort would have fallen well short of target but for accounting cosmetics that masked the magnitude of the underlying adjustment.
In fact, the reported deficit would have come in almost two percentage points below the desired level, but for a last-minute transfer of banking-sector pension funds to the government social security system. This transfer accounted for almost 60 per cent of the fiscal adjustment in 2011. Removing this once-off item implies that the underlying improvement was 1.3 per cent of GDP, way less than the “fudged” reported number.
More importantly, the true fiscal position today reveals that the adjustment to meet the target for 2012 is far greater than it appears in official documentation. The deficit in 2011 – excluding the transfer of banking-sector funds – was 7.8 per cent rather than the 5.9 per cent reported, which means that the adjustment required to satisfy the 4.5 per cent target this year is more than three percentage points of GDP or 2½ times larger than the improvement implied by the unadjusted data.
The additional fiscal drag alongside an accelerating pace of domestic demand destruction and rapidly decelerating export growth means that this year’s economic contraction could well be greater than the 3.3 per cent decline in official forecasts, which will make 2012’s targets almost unattainable.
Indeed, the year-on-year decline in domestic demand accelerated from below 5 per cent in 2011’s third quarter to 9.5 per cent in the final quarter, while export growth decelerated by more than 3 per cent to below 6 per cent between the second and fourth quarters, as demand sagged in its major trading partners, most notably Spain.
Given the negative momentum, it is not difficult to construct a scenario in which the economy contracts by over 5 per cent in 2012. Given such an outcome, disappointing tax revenues alongside the strain on government expenditures could well see the fiscal deficit come in at 7 per cent in 2012, while the level of outstanding public debt could jump to more than 120 per cent of GDP. The notion that Portugal could return to the markets in the autumn of 2013 as envisaged under the rescue plan would evaporate under such a scenario, while the pressure to restructure the Portuguese sovereign’s debt would likely prove insurmountable. Unlike Greece, the Portuguese crisis originally stemmed from excessive private-sector debts that currently amount to almost 200 per cent of GDP.
The large and persistent decline in the economy is certain to make a vast number of loans unserviceable, and the eventual losses incurred by the banking system could well become public debt. In a nutshell, there could well be no option but to restructure Portugal’s sovereign debt in order to place its economy on a more sustainable path. An “orderly” debt default has been orchestrated for Greece, but the claim that it’s a “unique and exceptional” case looks empty as attention turns to Portugal. The negative momentum evident in the economy suggests that the restructuring of Portuguese sovereign debt could prove unavoidable. The euro crisis is far from over.
