The Crisis in the Eurozone
II. Country cases
32. Over-indebtedness resulting from the crisis and the adoption of the euro in the context of a weak policy and regulatory environment are common themes for all European countries currently affected by the euro crisis. There are, however, considerable differences among various countries.
Ireland
33. The crisis in Ireland is essentially one of a boom and bust of a real estate bubble.
Encouraged by the fall in interest rates that went along with the adoption of the euro, banks
obtained funding from British, German and US banks, usually in the form of short-term debt,
foreign-owned bank deposits, or foreign-owned portfolio equity, to expand credit to the private
sector. Figures 11 and 12 below indicate the degree of Irish indebtedness.
Figure 11: Foreign bank claims in Ireland
Figure 12: Foreign claims on Ireland, December 2011
34. Fuelled by a rapid expansion of credit, Ireland's housing market began to expand in 2000, resulting in a boom in property investment and construction. The wealth effect from this boom spurred higher levels of consumption and helped sustain high growth rates. Boosted by the real estate boom, Ireland's banking system ballooned to five times the size of the economy, and its external debt to over 1000 percent of GDP at the end of 2010. When in the wake of the crisis funds from the US and Britain dried up, the banking system experienced a liquidity crunch, thus slowing credit to the real estate market. As borrowing became more expensive, the demand for housing started to decline, resulting in a fall in prices and an oversupply of housing. This put pressure on the balance sheets of banks many of which had relied extensively on profitable mortgage loans to boost their earnings. The authorities' extensive support as well as access to emergency support from the Central Bank was vital to address financial stability concerns. Yet, the bailout or purchase of failing banks also led to a crisis of confidence, as the government bailout package reached 20 percent of GDP and the budget deficit shot to 32 percent of GDP in 2010, leading to outflows of foreign assets. Figure 13 below shows the extent to which Ireland and other countries in the periphery experienced major withdrawals of foreign-owned funds in the course of the crisis. The crisis exposed Ireland's vulnerabilities to financial contagion.
Figure 13: Foreign-owned banking sector liabilities
35. The housing boom was also the crucial factor obfuscating the soundness of Ireland's fiscal position. On the surface, Ireland had pursued conservative fiscal policies and in fact had been running fiscal surpluses since the mid-90s, except in 2002.
However, these surpluses were increasingly driven by tax revenue boosted from the property bubble. In fact, during 2000-2007, driven largely by the revenue boom, revenue from capital taxes and stamp duties increased from 2 percent in 2000 to 4 percent
of GDP, while VAT increased by one percentage point of GDP to 7 ½ percent. At their peak in 2007, these revenues represented over a third of total current revenue, as opposed to one-fifth of current revenue in Spain and the UK, two other countries
with large asset booms. This asset-related revenue encouraged increases in structural expenditure and masked a rising structural deficit. When adjusting for the impact of asset prices, the Irish structural deficit reached 8 percent in 2007 (as opposed
to a measured surplus of 0.9 percent of GDP), spiking to 12 percent of GDP in 2008.
36. While Ireland's crisis was primarily driven by the burst of the real estate bubble, loss of competitiveness owing to the rapid rise in wages was also an important factor in explaining the crisis. Notably, the departure of Dell, a large manufacturing
employer, to Poland in early 2009 was symbolic of the loss of edge in low-end manufacturing. Ireland's share of the value of global and European manufactured exports, which had risen sharply between 1995 and 2001, fell steadily thereafter (Figure
14). Since then, however, export growth has been sustained, though at lower levels than in the 1990s, as Ireland repositioned itself as a service exporter and "knowledge hub".
Figure 14: Trade trends for Irish goods and services
| 2004 | 2005 | 2006 | 2007 | 2008 | |
| UK | 9.2 | 9.3 | 9.2 | 10.7 | 11.1 |
| US | 2.2 | 1.6 | 2.0 | 2.2 | 1.8 |
| France | 4.0 | 3.8 | 3.4 | 4.9 | 5.0 |
| Germany | 3.0 | 3.6 | 3.3 | 3.5 | 3.5 |
| Italy | 3.2 | 3.5 | 4.8 | 5.0 | 5.1 |
| Spain | 2.3 | 2.5 | 2.6 | 2.9 | 3.0 |
Iceland
37. Although not a member of the Euro Zone, Iceland's crisis followed a very similar pattern
to that of Ireland. In 2007, the banking system had ballooned to 10 times the size of the
economy, as a result of expansion abroad through direct acquisitions as well as the financing of
the expansion of international companies and Icelandic multinationals. German banks were
crucial in providing funding to Icelandic banks (see Figure 15). The rapid increase in lending fuelled bubbles in all asset classes, particularly the stock market and real estate. Inflated asset
prices and non-transparent cross financing and related party lending between banks and holding
companies helped mask poor asset quality and facilitated the financing of credit expansion by
borrowing abroad, increasing vulnerability. Moreover, like in other European countries, domestic
demand grew rapidly, fed by capital inflows and reflecting growing imbalances. Real GDP
expanded by 28 percent during 2003-07, driven by private consumption and large investments in
power-intensive industries. The spending boom was underpinned by strong growth of disposable
income, easy credit, rapid increase in housing and equity wealth, and low unemployment. At the
same time, external balances ballooned and net external indebtedness deteriorated sharply,
exceeding 110 percent of GDP while the expansion of Icelandic companies and banks abroad
bloated gross international liabilities to 625 percent of GDP in 2007.
Figure 15: Foreign bank claims in Iceland
38. In the wake of the global financial crisis in late-2008, Iceland experienced a deep financial and economic crisis of its own. Given their high leverage, Icelandic banks, which were relying on wholesale funding – primarily from German banks – were cut off from financing and a brief attempt to nationalize one of them revealed the severe problems facing the banking system which contributed to a downgrade of the sovereign. Within a short period of time, the three largest banks (Landsbanki, Glitnir and Kaupthing) collapsed. The banking crisis reflected poor asset quality and bubbles, a worsening of credit conditions, intensified financial disruptions and dislocations, and a major equity market sell-off. Confidence evaporated, the currency depreciated sharply and the exchange rate market ceased to operate, while other assets prices were in freefall. During 2009-10, real GDP and domestic demand declined cumulatively by a 10 ½ and 23 percent, respectively. Following a deterioration of the budget deficit to 8.6 percent of GDP in 2009 from a surplus of 5.4 percent of GDP in 2007, the government's fiscal position improved to a deficit of 4.6 percent of GDP in 2011. In contrast to Ireland, where the deterioration of the fiscal position reflected mostly the size of the bail-out package, Iceland's fiscal position was primarily the result of the collapse in economic activity. Iceland allowed its banking system to collapse.
Spain
39. The evolution of the crisis in Spain followed similar patterns to that of Ireland. As in Ireland, the lowering of interest rates accompanying the introduction of the euro plus the growing financial integration in Europe led to a sharp increase in lending which primarily fuelled the real estate market. While in Ireland, German banks were second to British banks in providing funding, in Spain (like in Iceland) German banks played the most important role as lender (Figure 16). When funds from German banks ceased to flow in the context of the global financial crisis and economic growth stagnated, the bubble burst, leading to an avalanche of nonperforming loans in the banking system (Figure 17), especially the 'cajas' where political meddling and profiteering from local politicians allowed loans to be extended to a segment of borrowers with questionable credit worthiness, somewhat similar to the subprime mortgage market in the United States.
Figure 16: Foreign claims on Spain, December 2011
40. While high personal indebtedness in the run-up to the bubble, mostly on account of real estate, made the economy particularly vulnerable, the loss of competitiveness resulting from the appreciation of the exchange rate due to substantial wage increases exacerbated the impact of the crisis and led to a marked increase in unemployment, especially among young people where unemployment reached more than 50 percent. The increase in unemployment partly also reflected the stringent labor laws. Even though Spanish banks were initially robust because of the stringent capital requirements and banking supervision, the burst of the real estate bubble seriously undermined their health and made a bail-out necessary. The government first bailed out Bankia in the amount of US$ 23.8 billion, and in June 2012, European partners collaborated to provide a bail-out package of US$ 145 billion for the banking system as a whole.
41. In addition to the costs of the bail-out package, the deterioration of the fiscal accounts also reflected the large stimulus administered in the aftermath of the global financial crisis. With the crisis, the incipient deterioration in the fiscal accounts
accelerated as revenue-rich real estate collapsed, automatic stabilizers kicked in and the large stimulus package took effect. In fact, the general government deficit swung from a surplus of 2 percent of GDP in 2007 to a deficit of 11.2 percent of
GDP in 2009, sparking widening spreads. Performance on the fiscal side further weakened in 2011 as a result of fiscal slippage (of about 3 percent of GDP) which greatly undermined the credibility of Spain to deliver fiscal consolidation at a time
when nervousness of financial markets had peaked because of the ongoing crisis in Greece.
Figure 17: Spanish household nonperforming Loans
Greece
42. Greece also experienced a real estate bubble and a sharp increase in household debt with
a similar genesis to that of Spain and Ireland. However, in contrast to Iceland, Ireland and Spain,
Greece pursued sharply expansionary fiscal policies, largely driven by social transfers and
increases in civil service wages, and had not been observing the Maastricht criteria (Table 6 and
Figure 3). Loose fiscal policy could be sustained for a long time because of low interest rates
on euro-denominated bonds and buoyant revenue reflecting strong, largely consumption-driven
economic activity. In the absence of structural measures to improve the competitiveness of the
economy, growth weakened and debt sustainability indicators worsened laying the ground for the
crisis of confidence of the financial markets in the solvency of Greece and the ongoing sovereign
debt crisis in the Euro Zone.
43. While the real estate bubble was important in Greece, fiscal profligacy along with failure
to implement structural reforms aimed at improving competitiveness was the critical factor in
Greece.
44. Since 2009, Greece has been unwinding imbalances, but through deeper recession and slow improvements in competitiveness. Real GDP has declined by more than 13 percent since 2009. Private investment led the downturn in 2009, while public retrenchment started only in 2010. With falling incomes and employment, private consumption took over as the main driver of the recession in 2011. Current and leading indicators suggest that domestic demand continues to contract sharply: retail trade volume shrank by around 11 percent year-on-year in the fourth quarter; industrial production declined by 11 percent year-on-year in the fourth quarter; the manufacturing PMI has fallen to close to historical lows; and industrial new orders declined by 8 percent in the fourth quarter of 2011. Competitiveness gains are not yet evident on an economywide basis. The recession and losses from government debt exposures have taken a deep toll on the banking system, undermining financial stability.
Portugal
45. The genesis of Portugal's crisis was different from that of the other countries in that it did
not reflect the burst of a real estate bubble or fiscal profligacy, but mainly a broad deterioration
of the business environment and competitiveness, seemingly accelerated by the country's
accession to the Euro Zone. In the context of the recession brought about by the global financial
crisis, this poor competitiveness resulted in unsustainable debt indicators and triggered the crisis
of confidence.
46. Prior to the crisis, Portugal had begun consolidating its finances; in fact, between 2005 07 the government succeeded in reducing the structural balance by over 3 percentage points of GDP to around 3 percent of GDP, largely by cutting compensation via public sector
administration reforms and upfront tax increases, notably via raising the standard VAT rate.
Nevertheless, the fiscal position remained weak compared to Euro Area peers in the Northern
countries. Encouraged by the sharp fall in interest rates following the adoption of the euro,
government expenditure kept rising very quickly reflecting higher social expenditure and wages
(Figure 18).
Figure 18: Portuguese public social expenditure as a percentage of GDP
47. Furthermore, as a result of this real appreciation, Portugal's competitiveness declined from its already weak level. Membership in the Euro Zone seems to have adversely affected Portugal's business environment as measured by the country's global ranking on the Economic Freedom index which declined from position 22 in 2000 to position 41 in 2005 and position 46 in 2008. Key areas affecting this deterioration in the ranking are the size of government and the regulation of credit, labor and business. While the size of the government was affected by the expansionary impact of the country's membership in the euro, the ranking on 'judicial independence' and 'impartial courts' experienced a substantial downward trend reflecting increased levels of cronyism. 'Access to money' was, however, the best rating, reflecting the membership in the Euro Zone. The poor business environment led to a substantial competitiveness gap. As a result and different from other countries whose growth performance benefited from EU membership, Portugal's growth was sluggish since the early 2000s, as the pre-euro adoption boom turned into a post-euro bust (Figure 19).
Figure 19: Portuguese productivity indicators
48. At the same time, Portugal became one of the most highly indebted countries in Europe. Government debt has risen sharply over the past decade, corporate leverage has increased, and household debt, driven by low savings, is among the highest in the Euro Area. This has been reflected in sustained large current account deficits financed mainly by bank borrowing from abroad, and a negative net international investment position of about 100 percent of GDP in 2008, one of the weakest among advanced countries. Increasing debt in the context of the crisis has fostered rising risk premia (Figure 20).
Figure 20: Portuguese debt indicators
Italy
49. While Italy's fiscal policy in recent years had been reasonably conservative – well below
the Maastricht criterion of 3 percent of GDP – its vulnerability arises from fiscal profligacy in
the past which resulted in a very high debt public burden (which was even slightly above that of
Greece's in 2009). Like Portugal, vulnerability to adverse shocks in a highly uncertain post-crisis
global environment reflects the combination of high debt, declining competitiveness and anemic
growth. While like Portugal, Italy did not have a real estate bubble, a recent study by the
European Commission showed that, from 1998 to 2008, exports of goods and services grew
more slowly in Italy than in any other member country. Standard competitiveness indicators in
Figure 21 show a rising gap since the late 1990s.
Figure 21: Italian competitiveness indicators
50. Banks proved resilient to the initial phase of the global financial crisis, as they benefited from a business model based on classical on-balance sheet lending-deposit activity, and strong customer relationships. With adequate liquidity and the absence of asset bubbles and toxic assets, this conservative business model sheltered Italian banks from the liquidity crunch at the onset of the crisis. However, the subsequent deterioration of the economy weakened banks' asset quality and profitability. Following the economic contraction, lending growth to the private sector slowed sharply, profitability declined, and asset quality deteriorated.
Concluding remarks
51. The adoption of the euro prompted fundamental changes in the Euro Zone. Convergence
of interest rates in periphery countries to the levels in core countries in combination with rising
capital inflows owing to greater financial integration set off a consumption and real estate boom
in periphery countries, leading to higher growth and increases in government revenue and
spending. The resulting real appreciation led to a loss of competitiveness in periphery countries,
adversely affecting export performance and causing current account imbalances. While the fiscal
position remained manageable before the crisis owing to rising revenue, the recession following
the global financial crisis led to the burst of the real estate bubble and a financial sector crisis and
to sharply increased budget deficits and worsened debt indicators and triggered the sovereign
debt crisis. Core countries, in particular Germany, maintained a competitive edge through wage
restraint allowing them to increase exports to periphery countries, while their banks profited
from increased lending to non-core countries. In sum, the euro exacerbated intra-European
imbalances whose unsustainability became evident in the aftermath of the global financial crisis
and triggered the current sovereign debt crisis.