VoxEU Column Europe's nations and regions

The PIGS’ external debt problem

Markets are increasingly concerned that the Greek debt crisis could spread to other Eurozone countries including Portugal, Ireland, and Spain. This column notes that much of these countries' debt is held by non-residents meaning that the governments do not receive tax revenue on the interest paid, nor does the interest payment itself remain in the country. The solution lies with debt restructuring and rescheduling.

Financial markets are focused on the public finances of Portugal, Ireland, Greece, and Spain (the “GIPS”). The GIPS´ public profligacy is partly to blame for their current plight, but other factors are at play. Amid the hype, little attention is paid to the crucial difference between these nations’ public debt and their external debt.

  • Debt held by a nation’s own citizens has less pernicious consequences (Scott 2010) – the interest paid is returned to the domestic economy.
  • External debt, if used to finance non-productive expenditure, is a different matter. Non-residents receive the interest on such debt, making the nation poorer with every interest payment.

Table 1. Government debt, external debt, and Internal Investment Position at year-end 2009

Notes to Table 1: (a) IIP and net external data for Ireland excludes Ireland's International Financial Service Center assets and liabilities; (b) General Government Gross debt and balance, as defined in the updates to Stability and Growth Programme. For remaining variables, IMF IIP and External debt manuals’ definitions are used; (c) Net external debt data is calculated by adding external debt-like securities liabilities by sector and subtracting asset claims on debt-like securities by sector. It excludes direct investment claims, financial derivatives claims, and reserves; (d) Proxy for non-government net external debt. Monetary Authority is included in this category to account for varying degrees of central bank lending to the domestic banking systems of the countries in the Table.

The facts: Internal versus external debt burdens

The GIPS’s problem is that a significant share of their debt is external (see Table 1).

  • Greece, for example, has approximately 79% of government gross debt held by non-residents and has net international investment position of -82.2% of GDP. Interest payments on public debt represented nearly 40% of Greece’s already large 2009 budget deficit – and this is set to increase.
  • Italy, by contrast, does not face the same challenge. Italy’s public debt reached 115% of GDP at the end of 2009, but Italy’s net international investment position were just about -19% of GDP. So, much of Italy’s interest burden is paid to Italians, and some of it is paid back to the government as taxes. As a result, Italy’s public debt dynamics are better than those of the GIPS.

The flip side of the GIPS’ external interest payments is income and thus tax receipts in the lending nations. The governments of Germany, France, and of other creditor nations earn tax revenues on the GIPS’ interest payments, as taxes on interest-income are typically paid according to the country of residence of the lender.

In fact, external indebtedness is key to understanding the current crisis. Portugal, Ireland, and Spain have similar external debt dynamics to that of Greece. Despite netting out debt-like assets held by residents abroad, the GIPS’ average net external debt-to-GDP ratio, is approximately 30 percentage points higher than the average gross external debt-to-GNP ratio observed in the emerging market external debt crises of Table 2.

Table 2. Government debt, external debt for selected past external debt crises

Notes to Table 2: (a) Reinhart et al (2003) define a "credit event" as "a default or restructuring of the country's external debt". Here, it is considered that Southeast Asia countries experienced an adverse credit event in 1997, given corporate debt defaults and restructuring, even though sovereign defaults were averted through IMF bailouts; (b) Data is for Gross external debt to GDP in the case of Colombia, India, Indonesia, Korea, Malaysia, Philippines (1997), and Thailand. See Reinhart et al (2003) for further table notes.

Table 3. The GIPS’ combined current account, trade, and income balances

The GIPS’ combined income balance has deteriorated in recent years (Table 3). In order to reduce the net external debt-to-GDP ratio, the GIPS would need to increase net exports substantially while maintaining reasonable nominal GDP growth rates. In sum, the GIPS face challenging external debt dynamics as a result of the leakage of interest income abroad and interest compounding (Cabral 2009).

Greece’s bailout

The EU, jointly with the IMF, is about to finance Greece’s public debt while Greek officials are required to bring its budget into order, under close European Commission and IMF supervision. The rescue package is conditional on Greece’s government implementing a strict budget austerity programme (Corsetti and James 2010; Eichengreen 2010). A byproduct of the ensuing restrictive budgetary policy should be falling domestic wages and prices, which, it is argued, would help restore Greece’s external competitiveness.

Alcidi and Gros (2010) point that large fiscal adjustments have been achieved in the past by different European countries. However, there are doubts whether even under a serious austerity programme Greece will be able to stabilise the public debt (Wyplosz 2010). Though some argue debt restructuring would be necessary (Boone and Johnson 2010; Roubini and Das 2010), the president of the European Council has suggested that public debt restructuring will not be considered and the president of the European Central Bank has stated that a default on public debt is “out of the question”. However, the issue with not restructuring debt is that Greece’s external indebtedness will continue to rise and to sap domestic economic activity through the interest income leakage effect identified above. Moreover, the austerity programme will likely depress nominal GDP growth, resulting in worsening external debt dynamics. Finally, the potential for contagion effects to Portugal, Ireland, and Spain remains large (Eichengreen 2007, De Grauwe 2009, Reinhart 2010, Wyplosz 2010).

A solution for the GIPS’ debt crisis

Past precedents (Table 2) and the size of the required current-account adjustment (Table 3) suggest that the GIPS too will be unable to significantly reduce their external debt, regardless of the austerity of their budgetary policy. The GIPS’ high external indebtedness is detrimental to these nations’ public debt dynamics, through the interest income and tax revenue leakage effects identified above. For these reasons, it is probably a good idea to allow bygones to be bygones – some form of external debt restructuring is required.

Further, the current GIPS’ crisis is not a one-time event. The intra-Eurozone current account deficits and external debt buildups will reoccur. They require an enduring solution.

A significant part of the GIPS’ net external liabilities is private (Table 1). In market economies, excessive levels of private sector debt are often resolved through bankruptcy or bank resolution. Therefore, a solution should seek to support the restructuring of private sector debt, for example, through Chapter 11-type bankruptcy procedures and a new US-type European bank resolution authority (Strauss-Kahn, 2010, Nguyen and Praet 2010). These instruments would force creditors and debtors that took excessive risks to bear losses. The restructuring of the PIGS’ private sector debt would reduce these nations’ external indebtedness (Cabral 2009).

A solution ought also to address the high levels of (external) public debt. There are no good options available in this instance. Outright debt forgiveness by the governments of Eurozone creditor nations does not seem advisable, given the creditor nations’ high public debt levels and the moral hazard problems for debt holders and issuers. Public debt restructuring and debt rescheduling seems preferable since it should have an immediate effect on the GIPS’ interest income leakage abroad and on the external debt dynamics. While not ideal, it offers a better approach to reducing moral hazard. Creditors would suffer losses and debtor nations would face higher interest rates for any new debt issuance.

Finally, debt restructuring would send the right signals to credit markets, and set an important precedent for any future debt crisis in the Eurozone.

Editor's Note: The abbreviation GIPS was substituted for PIGS.


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