Europe faces a massive bill as grapples with the aftermath of recession and the cost of economic stimulus steps, but the surge in government debt looks manageable for the 16 countries that enjoy the protection of euro zone membership.
Europe's monetary union has survived the toughest test since it was launched in 1999, and continues to shelter even its most fragile and indebted economies from fears of default.
When Moody's announced on Thursday that it might downgrade Greece, the most indebted euro zone country after Italy, the spread of 10-year Greek government bond yields above German debt rose to around 144 basis points from 136 bps a day earlier.
But the spread remained well below the past decade's peak of 299 bps, hit at the height of the economic crisis in February, and far below the spread for the most heavily indebted European countries outside the euro zone. The spread for Poland is now around 290 bps.
Much of the markets' calm over soaring debt in euro zone members is due directly to the single currency; membership of the strong euro has removed the danger of currency crises in indebted countries such as Greece.
Also, although the European Union does not guarantee the government debts of its members, markets see an implied guarantee - they think the EU would probably find some way to assist those countries if debt burdens became too heavy.
German finance minister Peer Steinbrueck fuelled that belief in February by saying: "If it came to a serious situation, all of the euro zone countries would have to help."
The result is a "ringfence" around the euro zone which is sheltering countries from some of the worst consequences of rising public debt, and is working better than many analysts predicted when the euro zone was created.
"The ringfence is here to stay ... the challenge now will be in stopping the less fiscally responsible countries from abusing the system," said Marco Annunziata, London-based chief economist at UniCredit bank.
Demand for debt
Ultra-low interest rates, a renewed appetite for risk among cash-flush investors and the possibility that tougher capital rules for banks could boost demand for sovereign debt, are also helping governments finance their immediate needs, said Philippe Mills, head of France's debt management agency.
This buys them time to work on plans to stabilise public finances in the medium term - the next five years or so.
There is little doubt that such plans will be needed. Public spending cuts and tax rises for countries such as Greece and Ireland may need to be as drastic and painful as the package that turned Sweden's public deficit from 11.2 per cent of gross domestic product in 1993 to a surplus of 3.7 per cent by 2000.
Greece's new Socialist government revealed last week that it was now expecting a deficit this year of 12.5 per cent, instead of the 6 per cent which the last government had declared. Ireland is struggling to rein in a deficit which Dublin expects to hit about 12 per cent this year, from around 7 per cent in 2008.
But Jens Hendrickson, an aide to Prime Minister Goran Persson during Sweden's debt crisis, says careful policy choices can help clear up debt mountains much faster than initially predicted. Sweden's total public debt fell from more than 80 per cent of GDP in 1994 to 53 per cent by 2000, despite a warning by the Organisation for Economic Co-operation and Development in 1994 that it risked swelling to 128 per cent.
It is possible that euro zone countries could enjoy similar improvement early next decade, partly because stricter rules for bank capital after the financial crisis could increase demand for safe, liquid investments to meet those rules, said Barclays Capital economist Laurence Boone.
New rules being suggested by Britain's Financial Services Authority could eventually raise the amount of liquid capital required of banks there from 220 billion pounds now to 600 billion, and mooted changes in the United States could lift needs from $US1.1 trillion today to as high as $US2.2 trillion within four years, Boone estimated.
"There's going to be a colossal appetite for safe, very liquid paper," she told a conference in Paris this month. "It's an appetite that's going to last ... which will allow a lot of the sovereign issue load to be absorbed."
Sweden's predicament after a banking crisis, recession and fiscal expansion at the start of the 1990s was not unlike the current situation for the most indebted European countries - though OECD officials note that debt burdens in the 1990s were lightened by falling interest rates, while euro zone rates can be expected to rise in coming years as the economy strengthens.
Italy, which had a public debt to GDP ratio of 105.8 per cent of 2008, spent more than 80 billion euros, or about 4.9 per cent of GDP, in interest payments alone, according to OECD data.
That is twice the average for the euro zone as a whole, where debt is set to rise from 66 per cent of GDP in 2007 to 77.7 per cent in 2009 and 83.8 percent in 2010, according to European Commission forecasts.
The commission expects the aggregate public deficit climb to 6.5 per cent from 0.6 per cent of GDP over the same period.
Higher in the past
Those figures are not unprecedented, however. In 1995, the euro zone public deficit was 7.6 per cent, before moderate GDP growth averaging about 2.2 per cent a year helped bring it down to 2.3 per cent in just three years, OECD data shows.
Italy, much like Japan, has lived for years with a debt in excess of 100 per cent of GDP. During the latest crisis, Italy was one of the few countries that largely refused to fight recession via costly public stimulus, and this will help limit further deterioration in its fiscal position, analysts said.
OECD economists estimate a debt of around 80 per cent of GDP can be prevented from inflating further even if a country runs a deficit of 2.7 per cent of GDP, assuming inflation is near the European Central Bank's tolerance level of 2 per cent and economic growth is 1.3 per cent per year.
The credit default swaps market, used to hedge against the possibility of defaults on debt, shows the extent to which the markets believe the ringfence provided by the euro zone will give its members sufficient time to sort out their finances.
The cost of insuring the sovereign debt of Ireland, hit hard by banking and housing market crises, is about half the cost of insuring the debt of Latvia, which is outside the euro zone but has begun the process of joining. It is less than a third the cost for Iceland, which is now considering whether to try to join the zone.
Reuters
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