Fixing the eurozone
To overcome high debt levels and lack of competitiveness
By Boston Consulting Group
The successful haircut imposed on private holders of Greek debt in early March 2012 has led some observers to conclude that the eurozone is finally on its way toward solving its debt problems.
The move followed the decision of the European Central Bank (ECB) in December 2011 to lower its core refinancing rate to 1 percent and, in cooperation with the U.S. Federal Reserve, to ease the borrowing of U.S. dollars for banks via foreign central banks. The ECB has also offered two new longer-term refinancing operations (LTROs) with three-year maturity dates. These steps have significantly reduced bank financing costs and improved the funding conditions for sovereigns in the eurozone periphery. In response to the LTRO offerings, European banks borrowed 489 billion euros in December 2011 and a record 530 billion euros in February 2012.
In parallel, European governments have agreed to several measures to restore confidence in the euro zone. In addition to the decision in March 2011 to implement a permanent European Stability Mechanism (ESM) by June 2013, these measures comprise more stringent limits for structural deficits of the member countries, the close supervision of national budgets, and additional contributions to the International Monetary Fund.
The real issue facing the eurozone is, however, dealing with two fundamental problems: unsustainably high debt levels and the lack of competitiveness of some member countries. The introduction of the ESM, the intervention of the ECB, and the reduction in Greek government debt can only buy time to address these broader issues. Any long-term solution to the eurozone crisis has to reduce the debt overhang and restore the competitiveness of some countries ― notably Portugal, Greece, Spain, and Italy.
The scope of the eurozone problem
Eurozone governments have to acknowledge the necessity to substantially reduce the current unsustainable debt burden. Assuming that a government debt-to-GDP ratio of 60 percent represents the upper limit of sustainability, there is an excess debt of 3.7 trillion euros that needs to be eliminated for the government sector alone. (As a point of reference, the current Greek haircut reduced that nation’s debt-to-GDP ratio from 160 percent to about 110 percent.)
But, of course, the eurozone countries do not just have a government debt problem. They have substantially overleveraged private sectors that are also in need of restructuring. Spain and Ireland, for instance, have a massive corporate debt problem; the Netherlands is suffering from high private-household debt. Since, unlike governments, both private households and nonfinancial corporations can reduce leverage on their own (given positive savings rates, corporate cash flows, and existing assets), we have set their debt-to-GDP sustainability threshold at 90 percent, which means that approximately 1.4 trillion euros will have to be restructured.
Reducing such a vast debt burden will take time and will require unpopular measures. The usual ways of dealing with the debt overhang won’t work in the current situation:
Saving and paying back
Neither indebted countries nor overleveraged private sectors will be able to save more in order to pay back their loans. Should many debtors pursue this path at the same time, the ensuing reduction in consumption would lead to even lower growth, higher unemployment, and correspondingly less income, making it more difficult for other debtors to save and pay back. For the private sector and government to reduce debt simultaneously would require running a trade surplus. But as long as surplus countries (China, Japan, and Germany) pursue export-led growth, and emerging markets do not import significantly more, it will be impossible for debtor countries to deleverage.
The best way to improve debt-to-GDP ratios would be to grow GDP faster. Historically, this has rarely been achieved and appears to be unlikely now. Growth prospects for developed economies are limited in a two-speed world in which growth has largely shifted to developing markets. Even with substantial structural reforms, growth opportunities are limited (the IMF estimates an additional growth potential of only about 0.5 percent for the eurozone on the basis of the “best-in-class” performance of eurozone peers). Growth will also be hampered by the aging of Western societies, with the workforce in Western Europe shrinking 2.4 percent by 2020. Finally, debt in itself makes it more difficult to grow out of debt, because it reduces the ability and willingness for additional spending and investments.
Pooling excess debt
In order to avoid default and to pursue orderly deleveraging, The Boston Consulting Group proposes that excess debt be pooled in a eurozone redemption fund that is tied to a specified repayment plan and accompanying structural reforms. Pooling excess debt and refinancing it as joint-liability issuers in the form of Eurobonds would allow over-indebted eurozone governments to secure financing at much lower interest rates. Excess government debt would be rolled in over several years as debt matures. The German Council of Economic Experts has made a sensible proposal for the structure of such a redemption fund.
A pooling of government debt is relatively straightforward. It is less obvious how a restructuring of private-sector debt would take place. Nevertheless, a restructuring is clearly necessary in some countries and in some sectors. The likely alternative is widespread insolvencies with the resulting economic and social fallout. One option would be to force banks to take a haircut on debt for borrowers above a certain level of leverage. The resulting financing necessary to recapitalize the banks could be funded from the redemption fund.
BCG proposed that the redemption fund would be tied to a 20-year fixed repayment plan for each country. Eurobonds would be issued with a matching, staggered maturity profile. The average annual cost for euro zone countries to repay the pooled debt over 20 years would be in the neighborhood of 2.4 percent of GDP (assuming slight financial repression, with nominal growth rates 1.5 percent higher than nominal interest rates). Exceptions could be granted to smaller highly indebted countries (such as Cyprus) not considered here if these countries prove unable to shoulder additional obligations.
Such repayments would be financed by raising additional taxes, earmarked for payments to the redemption fund. One option would be a wealth tax, which, compared to other types of taxes (for example, an income or value-added tax) would be less likely to negatively affect growth. Such a tax could be justified politically as the realization of already existing losses on financial assets that are currently at risk of defaulting. Of course, the longer the time horizon, the more acceptable such a tax is likely to be. Given our time frame of 20 years, the wealth tax would require a relatively moderate tax on the financial assets of private households of about 1.2 percent per year (less if nonfinancial assets were also included).
BCG’s scenarios assume the interest rate for pooled debt to be 2.75 percent, eurozone inflation to be 2.1 percent, and eurozone real growth (following structural reforms) to be 2.2 percent. Different growth rates are assumed for each country on the basis of forecasts by the Economist Intelligence Unit.
Necessary structural reforms
A substantial debt restructuring such as the plan described above is a prerequisite to enable eurozone countries to return to stable growth. Debt restructuring will need to be accompanied, however, by a comprehensive plan to increase growth and restore competitiveness of the periphery countries. This plan must include lowering unit labor costs and introducing more flexibility into labor markets.
The plan should also include a combination of higher inflation (to facilitate wage adjustments while helping to reduce real debt) and higher consumption in the northern countries. Employees in Italy, Spain, and Portugal (and also France) would have to accept wage increases below the rate of inflation, while employees in Germany and the Netherlands would enjoy real-wage increases. Reducing southern eurozone trade deficits would also require a rebalancing of global trade flows, in particular through a shift in emerging markets to more domestic consumption.
Saving the euro will be a very expensive exercise. But without such restructuring of debt and fundamental reforms, BCG foresees significant political tensions and the risk of disorderly exits of countries on the periphery of the eurozone.
The creditor countries have to accept that they will lose money under any scenario. The debt is too large to pay back. These countries do, however, have the option of choosing precisely how they will lose their money — whether through defaults and economic chaos, sizable inflation, or orderly restructuring and joint responsibility.
This article was provided by The Boston Consulting Group.