• Euro area debt levels are rising faster than at any peacetime rate in the aftermath of the ongoing crisis. Further, as a result of the crisis government bond yield spreads between different euro area member states have exploded.
  • We take a closer look at debt sustainability for various euro area member states. The approach chosen is to make mechanical projections until 2020 for each country and analyse the projected path for future debt levels.
  • We conclude that debt levels will rise to unsustainable levels for some countries if member states do not tighten their primary balances significantly.
  • It is not too late to avoid default. If plans put forward by Greece and Ireland are strictly adhered to, it will stop the debt-to-GDP ratio from skyrocketing. Significant spread tightening in addition to fiscal tightening could stabilize the debt ratio.
  • The Maastricht Treaty’s debt-to-GDP criterion of 60% seems unrealistic within the next 10 years for many EMU countries. Even a 100% debt-to-GDP ratio in 10 years time could prove difficult for several countries.

Euro area debt levels start on a dangerous path

Euro area debt levels are rising with faster than at any peacetime rate in the aftermath of the ongoing financial and economic crisis. Firstly, the severity of the ongoing economic crisis overall has resulted in a sharp drop in government income and an increase in expenditure (particularly rising unemployment costs). In addition to the automatic stabilisers significant fiscal easing has also occurred. Secondly, GDP growth has been negative both in real and nominal terms for most euro area countries. Finally, direct fiscal costs are resulting from government support for the financial sector. Direct fiscal costs can be partly recovered after the crisis. In Sweden, initial direct fiscal costs were nearly fully recovered following the crisis of the early 1990s. However, this is not the norm. A study of 49 financial crises undertaken by the European Commission estimates average direct fiscal costs of a banking crisis after recovery (i.e. in the first five years) at 13% of GDP but only 5.6% of GDP for crises within the euro area. The table below shows latest budget deficits, debt-to-GDP levels and forecasts for coming years provided by the European Commission (Autumn forecast 2009).

Before the crisis, most 10y government bonds traded within 10-20bp spread to Bunds (even tighter for most countries). Currently, 10y spreads to Germany are 15-35bp for AAA-countries (Finland, France, the Netherlands and Austria), 35-80bp for Belgium, Portugal, Spain and Italy, around 150bp for Ireland and more than 230bp for Greece.