>Eurozone sovereign risk: a hierarchy of countries to watch (ECONOMIC RESEARCH)

■ Financial markets are highly concerned about the risks surrounding the public finance imbalances present in a number of eurozone countries. This has been represented by the sharp increase in the government bond spreads between the countries seen as risky (Greece, Portugal, Italy, Ireland and Spain) and those of Germany, considered as the reference country.

■ However, not all the countries should be put on the same level. The situation of public finances has developed differently from one country to another. In Ireland and Spain, the deterioration in budget balances and the build-up of public debt are fairly recent phenomena. In the remaining southern European countries (Greece, Italy and Portugal), public finance difficulties go back a long way.

■ This article sets out a hierarchy of short-term and longer-term sovereign risks (related to the ageing problem). The results show that: 1) in the short term, and, more importantly, in the longer term, Greece is by far the riskiest country; 2) Ireland and Spain are also risky countries regardless of the timeframe; 3) Portugal presents large-scale short-term risks; 4) Italy is considered to be the least risky among these countries.

The eurozone’s public finances have deteriorated severely. This is especially the case in countries that in the past have shown relatively poor budget management, namely Greece and Portugal, and, to a lesser degree, Italy. It is also the case in economies that are currently experiencing very severe cyclical corrections, following a housing boom that played out against a backdrop of galloping prices and credit, notably Spain and Ireland. All of these countries will see a sharp rise in sovereign risk if they do not implement credible public finance consolidation plans in the near term.

These countries, however, should not all be viewed in the same manner. This article attempts to establish a hierarchy of sovereign risk in countries with poor public finances (Portugal, Italy, Ireland, Greece and Spain). After highlighting the source of these imbalances in the country’s public finances, we have attempted to set out a hierarchy of shortterm sovereign risks using a range of indicators: the primary budget balance ratio, the ratio of public debt to GDP, the government revenue-to-GDP ratio and the ratio of public spending to GDP. Finally, we evaluate the longer-term risks linked to an increase in age related expenditure, based on demographic projections from the European Commission. Of course the crisis is to blame, but it’s structural problems, too

The budgetary situation in eurozone countries has deteriorated sharply due to the financial crisis and the recession. A look back at how these imbalances developed helps to gauge how difficult it will be to resolve them.

In Ireland and Spain, the deterioration in government finances and the build-up of public debt are fairly recent phenomena. In 2000-2007, the budget situation in these countries was fairly healthy, with an average GDP surplus of 0.25% and 1.49%, respectively, compared with an average eurozone deficit of 1.85%.

In the other countries, notably in southern Europe, there is a long history of struggles with public finances. Italy and Greece have always been highly indebted countries whose public deficits are mainly structural in nature, due to the lack of public spending effectiveness and poor budgetary management. Greece and Portugal, and to a lesser extent Italy, have had considerably higher structural deficits than the eurozone average (see graph in report).

To read the full report: EUROZONE SOVEREIGN RISK