Portuguese authorities recently made a pre-emptive offer to their country’s creditors: Instead of redeeming bonds maturing in September next year, the government would stretch its repayment commitment out to October 2015. The deal was concluded on Oct. 3, and has been interpreted as a successful market test for Portugal. Ireland’s authorities have conducted similar recent operations, exchanging short-maturity paper for longer-term debt.
These transactions highlight the broader strategy of buying time. Both countries are seeking to create a longer, more manageable repayment profile for their privately held debt as they begin weaning themselves from dependence on official “bailout” funds provided by the “troika” (the European Commission, the European Central Bank (ECB) and the IMF). Private investors are acknowledging the reality that repayments will likely be drawn out, because insisting on existing terms could cause an untenable bunching of debt-service payments, with possibly unpleasant consequences.
This strategy’s success presupposes that, in the interim, economic growth will strengthen the capacity to repay debt down the line. The debt ratios for both Ireland and Portugal are expected to peak at about 120 percent of GDP next year, after which they are projected to fall. The peak ratio and the subsequent downward trajectory depend crucially on the assumed pace of economic growth.
However, growth prospects remain grim. The Portuguese economy is now expected to contract by 1 percent next year. In late June, the IMF projected modest growth, and — at the time of the “bailout” agreement in May last year — GDP next year was expected to grow by 1.25 percent.
Such successive downward forecast revisions have become commonplace. The latest estimates for Italy and Spain project a deeper contraction, prolonged into next year. Ireland is doing better, although its growth forecast has also been revised downward, to just under 0.5 percent this year and 1.4 percent next year. Moreover, Irish GNP (the income accruing to its nationals, as distinct from foreign firms operating in Ireland) continues to shrink. Each downward revision implies postponement of the date on which the debt/GDP ratio will peak.
Beyond next year, growth must depend on either the elixir of structural reforms, or a strong revival of the global economy, but a revival of economic growth in the short term is unlikely. Crucially for Europe, world trade has been virtually stagnant in recent months. Global trade and economic performance in the eurozone appear to be dragging each other down.
The potential consequences are serious. While the IMF’s primary scenario is that Irish and Portuguese debt levels will soon stop rising, it comes with a chilling litany of downside risks. The likelihood that budget deficit and debt targets will be missed is rising.
Thus, the eurozone faces three choices: Even more austerity for the heavily indebted countries; socialization of the debt across Europe; or a creative reprofiling of debt, with investors forced to accept losses sooner or later.
Austerity alone cannot do it. Some countries face the growing risk of near-perpetual belt-tightening, which would further dampen growth and thus keep debt ratios high. After all, if a country’s debt/GDP ratio is to decline without austerity, the interest rate that it pays on its debt must be lower than its GDP growth rate. If the interest rate is higher than the growth rate, austerity is required; the wider the gap, the more austerity is needed.