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European Economics

European public finances in 2012

The euro area faces a tough 2012. Its economy is in recession; financial

conditions have deteriorated; and troubled governments and banks have

substantial financing needs, especially in the next few months. A conclusive

policy response to the crisis remains lacking.

But the ECBs latest unconventional measures are supplying liquidity, so asovereign or bank funding crisis may well be avoided. And the slowdown is, so

far, in no way comparable to the one experienced in 2008-9.

A stronger global economy and a weaker euro should support activity going

forward. And although pro-cyclical fiscal tightening should prove a drag on

growth, we dont think it is self-defeating. Quite the opposite: the euro area

should see substantial and successful fiscal consolidation this year.

In this publication, we look at these issues and analyse the public finances of

most European countries.

10 January 2012Economics Research

http://www.credit-suisse.com/researchandanalytics

Research Analysts

Yiagos Alexopoulos

+44 20 7888 7536

[email protected]

Christel Aranda-Hassel

+44 20 7888 1383

[email protected]

Steven Bryce

44 20 7883 7360

[email protected]

Violante Di Canossa

+44 20 7883 4192

[email protected]

Neville Hill

+44 20 7888 1334

[email protected]

Axel Lang

+44 20 7883 3738

[email protected]

Giovanni Zanni

+33 1 7039 0132

[email protected]

The authors of this report wish to acknowledge

the contribution made by Maxine Koster

of Koster Economics Limited.


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10 January 2012

European Economics 2

Contents

Europe in 2012: Not the end of the world? 3In fiscal austerity we trust (but dont forget other policies) 8Can austerity be self-defeating? 11Policy hurdles 14Greece 16Portugal 20Cyprus 23Ireland 26Italy 29Spain 34Belgium 38France 42Austria 46Finland 49The Netherlands 52UK 56Germany 60Sweden 64Denmark 67Summary macroeconomic data 70

Summary macroeconomic indicators 70IMFs debt sustainability analysis 73European fiscal indicators 74European monthly bond redemptions 74


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10 January 2012


Europe in 2012: Not the end of the world?

The euro area faces daunting challenges in 2012. Not the least of them, the enormous

financing needs of governments and banks in the early months of this year. That

funding challenge takes place against a backdrop of low market confidence, high

government bond yields, and an economy dipping into recession.

These challenges posed a risk that the euro area would find itself locked in a vicious cycleof tighter monetary and financial conditions, weaker growth and fiscal slippage.

Deteriorating financial conditions would worsen the downturn, limiting governments ability

to reduce their deficits, in turn precipitating a further loss of confidence in the debt of some

sovereigns in the euro area.

And the inability of policymakers to provide a clear and compelling solution to the

crisis has raised concerns that the euro area is set to slide into this vicious cycle early this

year. However, we think expectations for the euro area may have become unduly

pessimistic, and believe the risks of an imminent extremely negative outcome a deep

recession and acute financial crisis have diminished considerably in the past month.

There are a couple of reasons for this:

First of all, the evidence from the first of the ECBs three-year LTROs is that much

needed liquidity is being injected into the euro area financial system, which shouldease, but not alleviate many of the sovereign and banking funding pressures; and

Secondly, the slowdown in the euro area has, so far, been less acute than we

and other forecasters have anticipated. And the prospects for growth driven by

global developments look, in the near term, to be slightly more promising than a few

months ago.

Thats not to say that the euro area in 2012 will not be beset by periodic crises. It almost

certainly will. But there is scope for euro area developments the economy, public

finances, and financial conditions to surprise positively in the early months of this

year and the worst outcomes to be avoided. There is also scope for European politicians

to build on the summit agreement of last year and begin discussions on the possibility of

Eurobonds. But European politicians have, so far, not been characterised by their swift

and effective action.

The challenge for the euro area is clear enough. The inability of policymakers to

promptly and effectively address the distress in sovereign bond markets especially in

Italy led to a severe deterioration in financial conditions and liquidity.

For sovereigns especially Italy and Spain facing considerable financing needs this year,

that illiquidity raises the risk that they will not be able to issue sufficient amounts of

debt in coming months to finance their deficit or redeem the substantial amount of

debt maturing. As the chart below shows, between them, both Italy and Spain need to

raise around 290bn in the coming six months, with their financing needs most acute

in February, March and April. Given the illiquidity in their bond markets, as well as the high

level of yields, there is a very real risk of acute financial turbulence if thosegovernments find it increasingly hard to fund themselves.

In the very near term, another key sovereign issue for early this year will be the

implementation of private sector involvement in Greek government debt. It remains

to be seen how deep the cuts in the net present value for private sector bondholders will

be. In our view, deep and substantial private sector haircuts at this stage would more

effectively remove Greece as a source of market volatility and slowly mitigate market

concerns about the possibility of a Greek exit from the euro area.

Neville Hill

+44 20 7888 1334

[email protected]


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10 January 2012


Exhibit 1: Estimated monthly Italian and Spanish government financing needsin 2012bn per month

0

10

20

30

40

50

60

70

Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12

Spain

Italy

Source: Credit Suisse

The close association between the sovereign and its banking sector has also led to

considerable monetary distress. Inasmuch as the sovereigns face substantial funding

problems, so do the banks. As Exhibit 2 shows, there is a considerable amount of bank

debt maturing this quarter, much of it in the periphery. That funding need has been

exacerbated by deposit flight from peripheral economies. As Exhibit 3 shows, in the six

months to November 2011, bank deposits fell by 100bn.

Exhibit 2: Euro area banks bond redemptions in2012

Exhibit 3: Bank deposit growth in the periphery andGermany

bn Non-financial private sector bank deposits, 6m flow, bn

0

20

40

60

80

100

120

140

Q1 Q2 Q3 Q4

Rest of euro area

EAP5

-100

-50

0

50

100

150

200

99 00 01 02 03 04 05 06 07 08 09 10 11

Germany

EAP5

Source: Credit Suisse, Dealogic Source: Credit Suisse, Thomson Reuters DataStream

That financial distress is having palpably negative effects on the euro area economy.

Business surveys are at levels consistent with a recession, especially in the periphery, and

broad money is contracting.


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10 January 2012


So the euro area ended 2011 with an illiquid, recessionary economy. Not really one to

instil much confidence in sovereigns ability to stabilise their debt-to-GDP ratios. A

combination of high bond yields and weak growth does little for debt sustainability.

So there are plenty of good reasons to have very low expectations for the euro area

in early 2012.

But, we would caution against being too pessimistic.

We had argued that euro area government bond markets required a significant injection of

liquidity if extremely negative outcomes were to be avoided. In our view, there remains a

strong case for the ECB to embark on large scale asset purchases similar to the

quantitative easing programmes undertaken by the Federal Reserve and the Bank of

England. However, we think the ECBs recently announced unconventional policies

of unlimited three-year refinancing operations have a reasonable chance of

success. Certainly, the take-up of the first LTRO close to 500bn has increased

liquidity considerably, with a net increase of just over 200bn. That liquidity will be

increased substantially further by the reduction in reserve requirements in late January,

perhaps by slightly less than 100bn. And the second refinancing operation at the end of

February will take place after the change to collateral requirements has been implemented,

meaning that an even larger take-up may occur.

As such, its possible that these measures could cumulatively add well over 500bn of

liquidity into the euro area banking system. That should alleviate the funding pressures

for banks and could help alleviate some of the funding pressures for sovereigns.

Of course, that money need not find its way to finance governments, but we think its

unrealistically pessimistic to think that none of it will. As the chart below shows, the first

period of generous liquidity provision by the ECB in 2009 was associated with banks

increasing their holdings of government debt. We expect that there will be significant political

pressure on financial institutions in Spain and Italy to invest in their governments debt.

Exhibit 4: LTRO operations and banks' net acquisition of government debt

-200

-100

0

100

200

300

400

07 08 09 10 11 120

100

200

300

400

500

600

700

800

LTROs outstanding, bn, rhs

Banks' net acquisition of govt bonds, 12m sum, bn, lhs


Indeed, the evidence so far which, given the time of year, we shouldnt really regard as

conclusive is that domestic banks have been solid buyers of government debt. So

far, that appetite seems stronger for debt of relatively short duration . As the charts

below show, rates at the short end of the Spanish and Italian yield curves have fallen

considerably in the past month. So if those governments are prepared to skew their

issuance towards the shorter end, they should be able to borrow at rates the market could


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10 January 2012


regard as sustainable. That would reduce the near-term risk of a funding crisis for the

Spanish and Italian governments, but would come at the cost of a shortening of the

maturity of their debt stock.

Exhibit 5: Italian yield curve Exhibit 6: Spanish yield curve% %

0

1

2

3

4

5

6

7

8

3m 6m 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y

End-Nov 2011

Jan 2012

0

1

2

3

4

5

6

7

3m 6m 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y

End-Nov 2011

Jan 2012

Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service

On the basis that the ECBs policy is successful in averting a financial accident,

theres good cause to think that the euro area economy could surprise some of the

more pessimistic expectations to the upside. It seems clear that the euro area as a whole is

in mild recession. We expect output to fall by 1% between Q4 2011 and Q1 2012, and that

seems consistent with the mild quarterly declines in euro area GDP signalled by the PMI.

But, the weakness in euro area cyclical indicators is not as acute as the distress in

financial markets would have suggested. There seem to be several factors at workpreventing a more severe deterioration:

Firstly, the pass-through to the real economy from the considerable stresses in the

banking sector seems to be limited. Although there is growing evidence of banks

cutting back on lending, the corporate sector appears fairly resilient. In part, that may be

a reflection of the relatively high financial balance that sector has run since the start of

the crisis.

Secondly, the global economy appears to have started 2012 with a pick-up in

momentum. Given that the euro area tends to be a follower, rather than a leader, of

global growth trends, we think a stronger global economy will mean the euro area

recession will be short and shallow rather than long and deep.

And that positive stimulus to euro area growth should be further boosted if the

euro continues to weaken. On a trade-weighted basis, the euro is 7% below its level of

last May. Such a decline should boost GDP growth by close to 1% over a two-year

period.

Some degree of resilience in growth should mean that the cyclical deterioration in

countries public finances shouldnt be as severe either. Offsetting that, of course, is a

risk of a sharp upwards spike in the oil price. That could dampen global growth momentum

much as it did early last year.


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10 January 2012


Exhibit 7: Euro area PMI and GDP growthExhibit 8: Euro area non-financial corporate sectorfinancial balance% GDP

25

30

35

40

45

50

55

60

99 00 01 02 03 04 05 06 07 08 09 10 11 12

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

Euro area composite PMI, lhs

Euro area GDP, q/q, rhs

-4

-3

-2

-1

0

1

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Source: Credit Suisse, Thomson Reuters DataStream, Markit Economics Source: Credit Suisse, Thomson Reuters DataStream

Of course, it is worth reiterating that the prospect for the euro area in coming

months is not great. The economy is in recession and the financing needs of banks and

sovereigns are considerable. But the apparent success of the ECBs policy measures

makes us think that the risks to our euro area GDP forecast for 2012 of a contraction of

0.5% are more balanced than they have been.

Exhibit 9: The global PMI ex-euro area Exhibit 10: Euro area TWI

30

35

40

45

50

55

60

1999 2001 2003 2005 2007 2009 2011

30

35

40

45

50

55

60Euro area

Global ex-euro

80

85

90

95

100

105

110

115

99 00 01 02 03 04 05 06 07 08 09 10 11 12

Source: Credit Suisse, Markit Economics Source: Credit Suisse, Thomson Reuters DataStream


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10 January 2012


In fiscal austerity we trust (but dont forget other policies)

Deficit reduction is due to continue this year, despite the significant economic

slowdown. After a local peak at over 6% in 2009, the aggregate euro area deficit ratio has

fallen to around 4% in 2011 and we expect it to fall by a further pp in 2012 and again in

2013 leading to a deficit below 3% in 2013 and also a first fall in the debt ratio that year

after five consecutive yearly increases. These figures compare favorably with most other

developed economies.

Exhibit 11: General government budget balance Exhibit 12: General government gross debt% of GDP % of GDP

-14

-12

-10

-8

-6

-4

-2

0

2

2001 2003 2005 2007 2009 2011 2013

US

Euro area

UK

0

20

40

60

80

100

120

2001 2011 2013

US

UK

Euro area

Source: OECD, Credit Suisse, Thomson Reuters DataStream Source: OECD, Credit Suisse, Thomson Reuters DataStream

The cyclically adjusted deficit should fall by more than 1.5pp in 2012, having fallen by

just under 1.5pp in 2011, on our calculations. The structural adjustment for this year islarger than we penciled in only a few months ago. In light of worsening growth projections,

most euro area members have chosen to keep their deficit reduction profile unchanged,

taking additional fiscal measures instead.

Exhibit 13: Credit Suisses fiscal projections

As % of GDP

General government balance Structural balance Change in structural balance (pp) Debt

2010 2011E 2012E 2013E 2010E 2011E 2012E 2013E 2010E 2011E 2012E 2013E 2011E

Austria -4.4 -3.6 -3.6 -3.0 -3.5 -3.1 -2.4 -2.2 -0.5 0.4 0.7 0.3 72

Belgium -4.1 -4.2 -3.0 -2.3 -3.2 -3.8 -1.7 -1.1 1.5 -0.6 2.1 0.6 97

Finland -2.5 -1.0 -1.0 -0.5 -0.6 0.7 1.7 2.5 0.3 1.3 1.0 0.8 49

France -7.0 -5.7 -4.9 -4.0 -5.8 -4.5 -2.9 -2.1 0.4 1.3 1.6 0.7 85Germany -3.3 -1.3 -1.5 -1.0 -3.5 -2.5 -2.2 -2.2 -1.5 1.0 0.3 -0.1 82

Greece -10.6 -9.5 -6.5 -5.0 -8.7 -4.3 1.3 3.2 8.3 4.4 5.6 1.8 163

Ireland -11.6 -10.0 -8.6 -7.5 -10.0 -7.6 -4.6 -2.7 2.5 2.4 3.0 2.0 108

Italy -4.6 -3.9 -1.8 -0.5 -3.3 -2.6 0.4 1.5 0.3 0.7 3.0 1.1 120

Netherlands -5.4 -4.5 -4.1 -3.0 -3.7 -2.8 -1.4 -0.4 -0.1 0.9 1.3 1.0 64

Portugal -9.8 -4.7 -4.5 -3.0 -9.2 -6.1 -1.6 -0.3 0.5 3.1 4.4 1.3 102

Spain -9.2 -8.0 -5.4 -4.8 -7.0 -5.1 -1.1 -0.2 3.0 1.9 4.0 1.0 70

Euro area -5.6 -4.2 -3.3 -2.4 -4.6 -3.4 -1.6 -1.0 0.5 1.2 1.7 0.7 88


Giovanni Zanni

+33 1 7039 0132

[email protected]


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10 January 2012


Fiscal packages are not just about deficit cuts. It is worth noting that key measures in

recent packages also address long-term debt sustainability concerns through pension

reform, for example. As a consequence, budget improvements do not relate just to the

deficit reduction requirements of the current year, but also to the debt profile in the longer

run. Secondly, the composition or quality of the measures is important in the context

of the current recession: many measures in the adjustment programmes try to be as

growth friendly as possible, as we detail below. Finally, institutional changes are

accompanying fiscal packages, aimed at addressing enforcement related credibility issuesof the Stability and Growth Pact. In particular, constitutional balanced budget rules are

being presented and implemented in most countries in the euro area. The deadline for

implementation has been fixed for the end of this year, and countries, including Germany,

Italy and Spain, have already completed the legal process of approval or at least have

started it with a first parliamentary vote in the process.

According to the ECB, for example, The agreements following the European Council

meeting of 8-9 December 2011 are a further important step (...) a key element of the new

fiscal compact is the balanced budget rule formulated in structural terms (debt brake) in

an intergovernmental treaty at the European level, to be enshrined in national legislation

and combined with an automatic correction mechanism in the event of deviations. Other

major elements are the endorsement of quasi-automatic sanctions if budget deficits

exceed the 3% of GDP reference value and the decision to enshrine in primary law thenumerical benchmark for debt reduction for countries with general government debt in

excess of 60% of GDP.

Although probably not the final word on the matter, and in many aspects just an

incremental improvement of the current imperfect fiscal infrastructure, it is important that

the ECB is giving a strong backing to these latest modifications also in light of the role that

the ECB has to play in the context of the overall policy strategy, as we discuss below.

Key fiscal measures and strategy

A simple strategy of unconsidered deficit reduction will not be enough, and could

even prove self-defeating. Structural reforms and other measures to foster growth

are needed and in most cases are included in the packages already voted by countries of

the so-called periphery.

Most packages include a move away from labour and corporate income taxation

and into consumption (VAT) or property taxes ideally on less mobile capital (e.g.,

real estate). An interesting element is also the so called fiscal devaluation, which

generally combines an increase in VAT with lower social contributions. This is akin to a

devaluation in the sense that the VAT increase affects all products, including imported

ones, while the cut in social contributions reduces input costs for the domestic producers

only, thereby mimicking the effects of currency depreciation. Portugal is still discussing the

measure, Italy is implementing aspects of it, and even France has preannounced it will

attempt to implement a similar approach in the coming months, via the TVA sociale.

While the impact is likely to be limited, a fiscal devaluation can speed up the process of

adjustment from an initial situation characterised by real exchange rate overvaluation. In

its latest monthly bulletin, the ECB made its contribution to the debate stating that:

Reforms that shift taxation from inputs to consumption are likely to be beneficial from a

broader economic perspective. Moving away from taxes on labour income or profits and

towards consumption or property taxes could boost growth structurally in addition to the

(possibly small) effect from higher net exports. Such a reform would reduce the tax bias

against saving and promote labour supply. Moreover, the more attractive tax structure

might encourage investment, including by fostering foreign direct investment. There is

strong empirical evidence that moving towards taxing consumption or property has

a positive impact on growth.


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10 January 2012


Pension reform is also a key element of the fiscal strategy in most countries, with the

increase in the retirement age probably the most effective measure on debt dynamics and

generally with positive effects on growth. Privatisations can also help bring down public

debt (and deficit, to some extent) without a negative impact on aggregate demand, and as

such are attempted in most countries. Finally, liberalisation of closed professions, retail

trade and other services, as well as labour market reforms, are actively sought in all

peripheral countries.

Clearly, not all measures are growth neutral or growth enhancing. Several measures

are negative for growth: a freeze of pension indexation or public sector wages can only be

negative for aggregate demand, even though it improves public finances directly. Also,

Greece has cut investment spending by around 40% last year to try to reach its deficit

target, with a negative impact expected on potential growth as well. Finally, social unrest

often has consequences over and beyond the strict implications of policy decisions on

income and spending.

More importantly, other aspects of policy, and not just in the periphery, are key for

the adjustment to be successful. Core countries should boost aggregate domestic

demand, for example, and monetary policy should accompany the fiscal adjustment with

loose monetary conditions. We will discuss all these aspects more in detail in the context

of the next section, which tries to address a question we have often heard from clients in

recent months: will austerity be self-defeating?

Exhibit 14: Euro area monetary condition indicator Exhibit 15: German and Spanish domestic demandDifference between domestic demands annual growth rate and EA average

-2

-1

0

1

2

3

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Restrictive

Accommodating

-3

-2

-1

0

1

2

3

98 99 00 01 02 03 04 05 06 07 08 09 10 11

Spain

Germany

Source: Credit Suisse, Thomson Reuters DataStream Source: Credit Suisse, Thomson Reuters DataStream


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Can austerity be self-defeating?A fiscal retrenchment could be defined as self-defeating if it reduces demand so much that

the fiscal outlook of a country deteriorates instead of improving.

A deficit-increasing fiscal adjustment? It is difficult to imagine that the deficit of a

country would increase as a consequence of a tax rise and/or expenditure cuts. Such an

event would be quite extreme. Empirical evidence does not point in that direction.

Moreover, if that was the case, it would probably make sense to always expand fiscally, as

the financial expansion would fully finance itself. This type of policy fallacy has been

attempted in the US and in Europe in the past, with poor results.

True, fiscal adjustments generally have a negative impact on activity and as a

consequence a negative feedback effect on the deficit but generally not so large

as to defeat the purpose of the fiscal adjustment. Fiscal adjustments can also be

associated with a neutral or even positive impact on growth, through three channels: (i) if

they create positive confidence effects and lead to a fall in private sector savings, in

accordance with the so-called Ricardian equivalence; (ii) if the measures that cut the

deficit dont have a negative impact on GDP (e.g., a pension reform that delays retirement

most likely increases potential output; a wealth tax has empirically very little impact on

demand); (iii) if the fiscal retrenchment is accompanied (or facilitates) complementary

policies easier monetary conditions, both in terms of interest and FX rates, and looserfiscal policies in countries that do not need to adjust fiscally.

In technical terms, for austerity to be self-defeating, the fiscal multiplier which is

defined as the change in output due to an exogenous change in the fiscal deficit

respective to the relative baselines should be clearly higher than 1 and probably

close to 2. Estimates of the fiscal multiplier are numerous and far apart. Some suggest it

should be higher than 1, consistent with the classic Keynesian multiplier, for example. At

the other extreme, others argue that positive confidence effects, for example, more than

compensate for a restrictive policy (i.e., the multiplier should be negative instead). The

size of the multiplier also clearly depends on the type of measures implemented a cut in

investment expenditures would lead to a higher multiplier than, say, a tax on the extremely

wealthy or on real estate.

Empirical evidence is mixed on the subject. Although some episodes in the 1990s would

tend to support some Ricardian effect on confidence (a very low multiplier), the recent

crisis would point to the opposite conclusion. The ECB provided a review of the topic last

year (ECB monthly bulletin, June 2010) and concluded that, Looking at a broader range

of experiences, it is found that around half of the fiscal consolidations in the EU in the last

30 years have been followed by an improved output growth performance in the short term

relative to the initial starting position. [...] Fiscal consolidations have had negative but

limited short term implications for real output growth in a number of countries.Clearly,

other factors beyond the simple relation between fiscal variables and GDP affect growth

during the adjustment including other economic policies.

Most econometric models used by central banks and governments suggest that a

restrictive fiscal policy has a short-term negative impact on growth . They also

suggest, however, that the multiplier is significantly lower than 1 and that the negative

effect on GDP is only in the short term. The European Commission QUEST modelestimates a multiplier of 0.4 in year one, assuming a permanent across-the-board

adjustment in spending and taxes proportional to their respective shares in the

government budget. The negative impact on GDP disappears over the following years.

The Bank of Italy model assumes an even lower number (0.3) in its modeling of the fiscal

multiplier for Italy. Other widely used econometric models have fiscal multipliers of just

over 0.5 on average (see Fiscal multipliers, an IMF staff position note on the topic

published on 20 May 2009 for a broader list of estimates). Overall, a 0.5 coefficient

should be seen as a fair approximation in order to assess the impact of the fiscal

retrenchment in the euro area. If thats correct, then a fiscal adjustment would rarely

be self defeating in the meaning defined above.

Giovanni Zanni

+33 1 7039 0132

[email protected]


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10 January 2012


There is, however, a second interpretation for a self defeating austerity drive,

linked to the impact of fiscal retrenchment not so much on the deficit, but on the

debt ratio. Thats especially true if the debt ratio is large.

Lets take the example of Italy, with a debt ratio at 120% and a deficit at 4% in 2011. Lets

assume a cut in the deficit by 2pp of GDP that leads to a fall in GDP of 2pp relative to its

natural baseline. Lets also assume that potential growth is 3% nominal (2% inflation, 1%

real). In that case, the retrenchment would be self defeating as the debt ratio in 2012would be slightly higher than the debt ratio, which would have been obtained withoutfiscal

adjustment (Exhibit 16).

Exhibit 16: Stylized impact of austerity on the Italian debt ratio% of GDP

110%

115%

120%

125%

2011 2012 2013 2014 2015 2016 2017

No austerity

Austerity


However, two other conditions must hold for austerity to be really self-defeating:

1) The multiplier must be relatively large. In the case of Italy, it must be higher than

0.83 (i.e., the inverse of the debt ratio, 1/120%) and as we discussed above, most

studies agree on lower multipliers, of around 0.5. Moreover, given the nature of the

measures implemented in most countries in Italy (heavy on pension reform and property

taxation), it is likely that the fiscal multiplier is lower and not higher than usual.

2) More importantly, even in the case of a self-defeating multiplier, austerity

makes sense for the medium run provided the dent on GDP growth is temporary.

While some commentators (see Paul Krugmans self-defeating austerity piece, in the

New York Times, 7 July 2011) argue that GDP growth could be permanently affected by

austerity, through for example, the increase in long-term unemployment, and the reduction

of investment expenditure, most econometric models argue that in most cases the loss of

output is a one-off event (affecting the level, as opposed to the growth rate, of GDP) and

at best, leads to an increase in potential growth in the medium run (with fiscal

retrenchment leading to an efficient re-allocation of resources, pension reforms increasing

labour inputs ...).


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10 January 2012


Taking the middle view and assuming a permanent loss of GDP (in level terms) but no

consequences to the GDP growth rate in the following years, the negative impact on the

debt ratio will appear only the first year as, similar to what happens with other forms of

deleveraging1, the positive impact on the debt will show up in the following years relative to

no retrenchment scenario (Exhibit 16).

In a recent article (Can austerity be self-defeating, voxeu.org, 29 November 2011),

Daniel Gros illustrated these same points concluding that the permanent deficit cutlowers the growth rate of debt, while the permanent impact on GDP is of the path-

lowering type, not the growth-lowering type. Thus any initial increase in debt/GDP will be

reversed over time. Implementing credible austerity plans constitutes the lesser

evil for peripheral countries with high debt, even if this aggravates the cyclical

downturn in the short term.

Clearly, this does not end the job for the euro area. Other policies and other

countries should complement austerity with coordinated actions. Monetary policy

should help provide the right conditions for the fiscal adjustment to be successful. This

means low rates for longer, and actions to address the loss of confidence and high level of

uncertainty, affecting activity and spreads. European politicians, especially from core

countries, should also contribute to the latter.

There is indeed little question that the confidence channel of austerity is not working at allat the moment one might even argue that the opposite is happening right now. IMFs

chief economist has recently argued for a slower pace of fiscal adjustment, to address the

risk of too harsh procyclical policies and their negative feedback on growth also through

market rates. We share the concern, but believe that a better way of addressing the

confidence issue would be through stronger political commitments to the euro area by all

member countries governments.

Meanwhile, German fiscal policy should probably turn accommodative, while European

institutions should present a concrete and ambitious plan for new transnational

infrastructure projects to boost economic growth as well as European integration de

facto. A contribution from exchange rate depreciation should also be sought more

proactively, while addressing the social consequences of the current economic crisis

remains a key challenge, no matter how difficult it is to capture it in economic models. Wesee progress on some of these fronts, but clearly more is needed. Overall, our maybe

simplistic conclusion would be that austerity is required but needs to be

complemented by other policies of the sort mentioned above. This is the same

conclusion we reached nearly two years ago2

and we believe it remains very actual.

1 See on this Leverage up, leverage down, 12/11/2010.

2 See"How to survive in a monetary union", 29/1/2010.
https://doc.research-and-analytics.csfb.com/docView?language=ENG&source=ulg&format=PDF&document_id=867149131&serialid=Ek6K80ZncbKO6YKhOxiBclHo3JwU0p4uS0MZ7WvDofE%3dhttps://doc.research-and-analytics.csfb.com/docView?language=ENG&source=ulg&format=PDF&document_id=844357081&serialid=7kc5bOK%2bncOpYUTX53HTxgMlMi54zIhRgos%2fcTotMTw%3dhttps://doc.research-and-analytics.csfb.com/docView?language=ENG&source=ulg&format=PDF&document_id=844357081&serialid=7kc5bOK%2bncOpYUTX53HTxgMlMi54zIhRgos%2fcTotMTw%3dhttps://doc.research-and-analytics.csfb.com/docView?language=ENG&source=ulg&format=PDF&document_id=844357081&serialid=7kc5bOK%2bncOpYUTX53HTxgMlMi54zIhRgos%2fcTotMTw%3dhttps://doc.research-and-analytics.csfb.com/docView?language=ENG&source=ulg&format=PDF&document_id=844357081&serialid=7kc5bOK%2bncOpYUTX53HTxgMlMi54zIhRgos%2fcTotMTw%3dhttps://doc.research-and-analytics.csfb.com/docView?language=ENG&source=ulg&format=PDF&document_id=867149131&serialid=Ek6K80ZncbKO6YKhOxiBclHo3JwU0p4uS0MZ7WvDofE%3d


14/77

10 January 2012


Policy hurdles

Three key events will influence confidence in the euro area in the coming months.

The first concerns the final shape of the private sector involvement (PSI) in Greece's debt

restructuring; the second involves the finalisation of the firewall instruments at the EU/IMF

level; the third the broader setting of the fiscal compact, for a closer fiscal union for euro

area members. We briefly review the current status and likely innovations expected in the

coming months on all these fronts.

1. Private sector involvement (PSI): As we write, negotiations on a revised Greek PSI

are ongoing and reports suggest that an agreement on the Greek debt swap will be found

within days. The involved parties are anyway expected to come up with a proposal by the

end of January, after which private bondholders will have roughly a month to decide

whether to participate in the debt exchange. A favourable scenario would be a near

universal participation of the private bondholders, through which the Greek sovereign

would experience a 100bn reduction in its debt, as well as lower financing needs for the

following years. Alternatively, if the PSI proves unsuccessful i.e., high voluntary

participation is not secured in the debt swap Greece would have to either proceed with

an involuntary debt exchange or face the risk of default as soon as March 20, when

14.5bn of bonds come due without a PSI agreement. As a consequence, the 'hard'

deadline for any agreement is effectively March. The details of the PSI will be key informing more general expectations for the euro area, as well as for specifications of the

second support programme for Greece.

2. Firewall construction: European leaders have been trying to create a robust firewall to

avoid further contagion since the beginning of the crisis, with several amendments, steps

back and steps forward along the way and little clear success so far. The current firewall

includes:

EFSF: The EFSF was created last year on the back of the Greek crisis and has been

used so far to support, in a joint venture with the IMF, Portugal and Ireland. The tools of

the EFSF have been expanded over the past months and in October, EU leaders have

approved the possibility to leverage EFSF resources in an expanded role, yet to become

operational. At the time of writing, the EFSF has a AAA-rating and a firepower of

440bn. Leverage could happen in two ways: partially guaranteeing primary issuance ofeuro area states, and/or through the creation of a SPV, in which private investors could

participate and which would purchase bonds in the primary and secondary markets. The

loss of confidence in euro area sovereigns, as well as concerns over correlation risks

(the guarantors of the structure are essentially the same euro area countries) are limiting

the leverage potential. In addition, increasing risk of a downgrade of AAA-rated

countries, would mean that the EFSF would likely lose its AAA credit rating as well or

see its firepower further reduced. Nevertheless, the fund started a bill issuance

programme in December and it is expected to assume its expanded role by the end of

January. Operational support granted by the ECB also suggests that the EFSF remains

a pillar of the strategy at this stage.

ESM: The ESM is expected to replace the EFSF as a permanent, and more flexible,

crisis management and rescue mechanism in the euro area. It will have an effectivelending capacity of 500bn, although EU leaders agreed to assess whether this is

sufficient in March and could decide to increase it. Its introduction was brought forward

one year and it is expected to become operational this year. A positive development for

confidence would come if the ESM is operational from mid 2012, if its firing power is

increased, if it is made as flexible as possible in terms of its capacity to intervene, and

finally if indications of seniority and potential private sector involvement are further

diluted or outright abandoned.

Giovanni Zanni

+33 1 7039 0132

[email protected]


15/77

10 January 2012


IMF: The IMF is already involved through its co-participation in all rescue programmes.

On December 19 2011, euro area countries agreed to contribute with an additional

150bn via their central banks, with other countries also expressing their willingness to

participate. These resources represent an additional weapon in the arsenal against the

financial crisis, whose effect is still to be appreciated with also the firing power likely to

increase well beyond the 150bn already committed, especially if the BRICs decide to

contribute as well, as they have suggested in recent months.

3. Fiscal compact: On December 9, most EU leaders (with the notable exclusion of the

UK) agreed on a new intergovernmental treaty for tighter fiscal rules. These include a

balanced budget rule introduced in national constitutions, more automatic rules for

sanctions under the stability pact and stronger policy coordination. The agreement will be

finalised in March, and will then have to be ratified by national parliaments. It has been

decided that fifteen countries will have to approve it before it comes into force, but,

importantly, it doesn't need EU, nor euro area, unanimous participation to go ahead. This

reduces the risk that some countries might delay the process.

As we have stated in the section above, this additional binding commitment is key

as it is consistent with requests coming from the ECB. It is also likely to be crucial

for the latter, in order to use more fully its capacity, perhaps the only fully credible

and ultimate firewall against financial contagion and instability in Europe.


16/77

10 January 2012


Greece

The Greek economy contracted by 6% in 2011 worse than expectations and is

forecast to enter a fifth consecutive year of recession in 2012, with its GDP falling

by around 4%. The extreme fiscal retrenchment continues to cause a decline in domestic

demand and labour market conditions have deteriorated, with unemployment reaching

17.5% in September 2011. Significant wage cuts, higher taxes, cuts in benefits and

decreasing asset prices are reducing households purchasing power and willingness tospend. At the same time, banks exposure to Greek government bonds, deposit outflow

and an increasing number of non-performing loans have intensified pressures on the

banking system, leading to a significant credit tightening. On the positive side, exports

continue to grow at a strong pace, with balance of payments data showing a clear rebound

in tourism revenues. Nevertheless, given the limited size of export-oriented sectors, their

impact is yet insufficient to counterbalance the negative effect from depressed domestic

demand. Also, despite some correction of external imbalances since 2008, it would take at

least another couple of years to meaningfully reduce the current account deficit and see a

first reduction in external debt, we reckon.

The increased uncertainty over the sustainability of the Greek debt and over the resolution

of the euro area debt crisis has prevented investment flowing in the country. A successful

PSI and an improvement in sentiment, coupled with more effective and timelyimplementation of the needed structural reforms, should hopefully provide a floor to

economic activity in the second half of the year (and vice versa, clearly). Greek

growth could under such conditions turn marginally positive again in 2013.

Financing needs

Defining financing needs for Greece remains a complicated exercise at the moment of

writing, since a lot will depend on the negotiations over the PSI and the second EU/IMF

programme, both due to be finalised over the next few weeks, according to the latest

official declarations. While final details are not yet available, the PSI is said to envisage a

50% haircut of the notional value of all Greek government bonds held by the private sector

around 200bn and an exchange of the latter with new bonds of longer maturity. Inaddition, a second EU/IMF financing programme of up to 130bn is negotiated, with 37bn

remaining from the first EU/IMF financing programme. If the negotiations go as planned,

Greeces financing needs for the next two to three years would be significantly reduced

and fully funded by official loans, with short-term paper issuance covering any shortfall.

The Greek PSI

The private sector involvement (PSI) foresees a voluntary exchange of the bonds held by

the private sector, with new ones of different notional value, coupon and maturity. It was

originally introduced at the July 21 EU summit and it envisaged a debt swap of all privately

held bonds maturing before 2020, with new 15-30y bonds with guaranteed principal,

leading to an NPV loss of 21%. This was soon deemed insufficient and at the 26 October

EU summit, a bigger PSI was agreed. It involved a 50% face value haircut on all privately

held Greek government bonds and 30bn of cash incentives, with the aim to reach a debt-to-GDP ratio of 120% by 2020. The negotiations for the PSI proposal are ongoing, as we

write. According to reports and our understanding at the time of writing, the debt exchange

proposal would involve a face value of 100% being exchanged for 15% in cash and 35% in

new 20-30y bonds carrying a coupon of 4-5% and governed under English law. The aim

would be for near universal participation.

Greek net financing requirements for 2012 amount to around 14bn prior to PSI and

10-11bn after, on our calculations, with the difference arising from lower interest

payments. As of now, there are 34bn of bonds maturing in 2012, with March being

a key redemption month, with 14.5bn coming due.

Giovanni Zanni

+33 1 7039 0132

[email protected]

Yiagos Alexopoulos

+44 20 7888 7536

[email protected]


17/77

10 January 2012


However, the crucial month for Greece is probably the current one, due to the above

mentioned negotiations. When (if...) the PSI and the second package will be in place,

Greeces debt profile will improve substantially and its financing needs for the next

few years will be significantly reduced. Apart from the first two to three years, that

would see a full coverage of the funding needs by official loans, we calculate that a

successful PSI would mean that annual funding requirements in Greece would be low, as

a percentage of GDP, when compared to most developed countries, for a decade at least.

Exhibit 17: Financing needs for the Greekgovernment in 2012: prior PSI

Exhibit 18: Financing needs for the Greekgovernment in 2012: post PSI (CS estimations)

bn per month bn per month

43

19

4

12

4

2

9

1 10

3

0

5

10

15

20

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Bill redemptions

Bond redemptions

Monthly deficit

Monthly financing need

4

3

9

3

6

3

1

4

1 10

2

0

5

10

15

20


Bill redemptions

Bond redemptions

Monthly deficit


Exhibit 19: Prospective financing needs of Greekgovernment in coming years: prior PSI

Exhibit 20: Prospective financing needs of Greekgovernment in coming years: post PSI (CSestimations)

bn bn

0

10

20

30

40

50

60

70

2011 2012 2013 2014 2015

Deficit Existing bonds maturing

Bills stock EU/IMF loans

Billsstock

EU/IMF

loans

0

10

20

30

40

50

60

70

2011 2012 2013 2014 2015

Deficit Existing bonds maturing

Bills stock EU/IMF loans

Billsstock

EU/IMF

loans

Note: Monthly deficit estimated using seasonal patterns from government monthly cash balances in previous years. Moreover, the chart shows expiries for current bill stock, not possible futureissues. The post PSI scenario follows IMF guidelines and assumes universal participation in the PSI, with only official holdings remaining.

Source: PDMA, IMF, Credit Suisse


18/77

10 January 2012


Public finances outlook

Final figures for the 2011 budget deficit are not yet known, but given central

government data up to November, we believe that the twice revised target of 9%

might be missed again. Therefore, Greece, despite the fiscal effort this year, is likely to

show only a slight improvement compared to 2010. A deeper than expected recession,

delays in the implementation of the reforms, poorly designed measures and political and

social tensions are among the factors that contributed to this outcome. Nevertheless,despite these shortfalls, the original target for the 2012 deficit remains unchanged and it

might be even lower due to the interest savings from the PSI. The exact deficit target will

depend on the specifics of the PSI agreement, i.e., the notional of the new bonds, the

coupon rate and whether there will be a grace period or not.

At the same time, the government expects to achieve a primary surplus for the first

time after many years, after an estimated primary deficit of around 2% in 2011. In

order for this to happen, the pace of the structural reforms has to be accelerated and

additional austerity measures might be needed. So far, the austerity package includes tax

increases and special levies, such as VAT increases and extraordinary taxes on income

and property, large cuts in public sector wages and in pension entitlements. Additional

measures will likely focus on privatisations and on expenditure cuts, including public sector

layoffs in addition to reinforced tax evasion actions.

The general government debt ratio probably topped 162% of GDP at the end of 2011

according to the IMF and will decrease in 2012, to around 150%, only thanks to the

PSI (it is forecast to reach almost 190% of GDP without PSI). It is expected to continue

in its downward path thereafter, with the goal of reaching 120% of GDP by 2020. For this

to happen, the Greek economy will have to return to growth and it will have to engineer a

substantial and sustainable primary surplus in the coming years. At the same time,

privatisations and asset sales should also contribute to the reduction of the debt. With little

confidence, given developments over the past two years, that reforms can be implemented

and targets can indeed be reached, we believe it will take some time before confidence in

the country is restored, unless some new positive innovations in Greek or European

polices pop up in the coming months.

Exhibit 21: Medium-term fiscal consolidation plan IMF projections (assuminga PSI along the lines of the October 26 2011 agreement)

% of GDP 2011 2012 2013 2014 2015

General government balance -9.0 -4.7 -3.9 -1.4 -1.1

General government debt 162 151 149 141 133

Source: IMF, Credit Suisse

Risks

Greeces situation remains extremely fragile and risks abound. In terms of economic

activity, there are now few signs of strength in the economy, to say the least. If a

recovery does not materialise in the next year and delays in structural reform implementationcontinue, reaching the public finances objectives will again be very difficult.

In addition, the outcome of the PSI negotiations represents a key risk for Greece . It is

still uncertain, as we write, whether the PSI will be voluntary and if it will have wide

participation. An involuntary debt exchange will have unknown implications both for

Greece and the rest of the euro area. At the same time, the escalation of the debt crisis

to the euro area level, creates risks as to whether Greece will be in a position to

secure the needed funding from the European instruments and whether it will be able

to go ahead with the privatisations in a recessionary environment.


19/77

10 January 2012


Finally, political tensions although contained for the moment are likely, following

the forthcoming elections and the possibility that no party will secure an absolute majority.

Elections, originally planned for February 19, will most likely be postponed to April, in order

to give time to the interim government to finalise the negotiations on the PSI and the

second financing programme. The risk that a newly elected government will want to

renegotiate the agreement with the EU/IMF and pursue a different policy mix exists,

although it has been contained following the written commitment from the major political

parties. Nevertheless, the likely scenario that no party secures an absolute majority bearsthe risk that it might lead the country to prolonged political uncertainty, causing further

delays in the reforms.

Rating

Greece is rated below investment grade by

all three rating agencies. The rating

agencies have also indicated that if the

PSI goes ahead, Greece might be

downgraded to a default rating, albeit

briefly.

Exhibit 22: Greeces current ratings

Rating agency Rating Outlook

S&P CC Negative

Moodys Ca Not specified

Fitch CCC Not specified



20/77

10 January 2012


Portugal

The Portuguese economy contracted in 2011, but less severely than expected in its

EU/IMF adjustment programme. The outcome yet poor was largely supported by a

strong performance of the export sector but the upside surprise mainly occurred during

the first half of the year, before the euro area crisis escalated to a new level. There are

few reasons to be optimistic for 2012 either. We expect the economy to contract in

2012 by 2.7% after a fall of 1.3% in 2011. The worsening of the outlook mainly stemsfrom a very large fiscal retrenchment planned for this year, compounded by a sharp loss of

private agents' confidence. Additionally, exporters could experience more challenging

conditions this year and might be unable to match the very good performance of 2011.

It is worth nothing that although external imbalances have started their long overdue

correction, the Portuguese current account deficit remains large and requires several

more years of deleveraging to put the external debt of the country on asustainable debt reduction path.

Financing needs

Portuguese net financing requirements for 2012 amount to around 8bn and gross

borrowing needs excluding T-bills to around 20bn. This year, both should be taken

care of by EU/IMF funds and privatisation receipts. Thus, Portugal will not need to tap

the government bond market this year; it is also assumed it will continue to roll over T-

bills (8.5bn).

The key redemption month is June but clearly, the important dates for Portugal will be those

of the quarterly reviews of its adjustment programme when the decision on the release of the

funds by the official creditors is taken February, May, August and November.

Exhibit 23: Financing needs for the Portuguese government in 2012bn per month

34

3

2

-1

12

2

0 0

21

2

-2

0

2

4

6

8

10

12

14


Bill redemptions

Bond redemptions

Monthly deficit


Note: Monthly deficit estimated using seasonal patterns from government monthly cash balances in previous years. Moreover, the chart showsexpiries for current bill stock, not possible future issues.

Source: IGCP, IMF, European Commission, Credit Suisse

2011 financing needs were unusually high as the EU/IMF programme notably intended to

halve the outstanding amount of T-bills. In the coming years, financing needs will remain

elevated and Portugal is expected to come back to the bond market in 2013 with the

issuance of 10bn of medium-to long-term bonds.2012 will be crucial to gauge as

to whether Portugal will be able to do that at an affordable rate.

Axel Lang

+44 20 7883 3738

[email protected]

Giovanni Zanni

+33 1 7039 0132

[email protected]


21/77

10 January 2012


Exhibit 24: Prospective financing needs for Portugal in coming yearsbn

0

5

10

15

20

25

3035

40

45

2011 2012 2013 2014 2015

Bills stock

Existing bonds maturing

Deficit

Bills stock

EU/IMF

funds

Bonds issued

Note: We assume the bill stock remains constant at the end of 2011 levels.Source: IGCP, IMF, Credit Suisse

Repayment of IMF loans will only start in 2015 (0.6bn) while EFSF/EFSM loans will not

have to be repaid within the next fifteen years.


The Portuguese government has continued to show a strong commitment to meet the

deficit targets set under the EU/IMF programme. We currently estimate that the final

deficit for 2011 could be between 4.5% and 5.0% (lower than the 5.9% official target)

after 9.8% in 2010. However, excluding the transfer of commercial banks pension

funds to the social security accounts, the deficit would have been higher3. Other

additional one-off expenditure and revenue measures taken last year blur the underlying

picture and the true deficit actually ended 2011 just above 7% of GDP, according to

our calculation.

The government passed a budget worth 5.3pp of GDP of fiscal consolidation measures for

this year after 3.4pp last year to reach this years target of 4.5%. Still, the latter will

be hard to achieve in the context of a shrinking economy. However, if most of the

measures deliver the expected results, the fiscal effort beyond 2012 should not

impact growth significantly. The main measures for this year are a sharp reduction in

civil servants wages and pensions (around 10%) as well as a broadening of the tax base.

Structural reforms are advancing at a satisfactory pace according to the latest

EU/IMF review of the adjustment programme although the fiscal devaluation strategy

first envisioned has been put aside for now and is being replaced by an increase in the

regulatory working time, less bank holidays and more flexible working conditions with the

aim of lowering overall unit labour costs.

3 The fiscal slippage mainly stems from elements outside the central government which was broadly on track and are, to acertain extent, non-recurrent items such as the downward revision of concession revenues, the cost of selling the bank BPN orthe realisation of PPP and SOE costs by the local government of Madeira.


22/77

10 January 2012


Public debt should rise further this year and next, mostly driven by the fall in GDP the

country should post a primary surplus this year. The speed of economic expansion in

the following years will be key to gauge debt sustainability.

Exhibit 25: Medium-term fiscal consolidation plan government projections% of GDP

2011 2012 2013 2014 2015General government balance -4.7* -4.5 -3.0 -2.3 -1.9

General government debt 107 116 118 116 114

*CS calculation.

Source: Credit Suisse, IMF

Risks

As with other countries, a deeper than expected recession would put the deficit and

debt targets at risk. Additionally, the large number of state-owned enterprises (SOEs)

and Public-Private-Partnerships (PPPs) pose a risk of fiscal slippages as they face

acute difficulty to roll over their debts from private sources and might have to be

reintegrated in the general government perimeter. Also, commercial banks may requiremore funds than earmarked under the EU/IMF programme (12bn) although the capital

shortfall highlighted in the latest stress test only amounts to 7bn.

Political risks appear non-existent at the moment since the government has a large

majority in parliament (and the main opposition party agreed on the EU/IMF adjustment

plan). Additional measures, if required, would be passed without any problem although

social discomfort is gradually rising.

One concern to keep in mind relates to next year and beyond. If uncertainty were to

remain high and markets remained closed for the country, Portugal could face a similar

issue that Greece faced last year: the IMF would ask financing needs over the next 12

months to be fully covered before it can disburse its part of the funds. The enhanced

flexibility of the EFSF/ESM could help in that regard but ultimately, the issue to

involve the private sector in Portugal would potentially arise unless EU officials statevey clearly, again, that Greece is a unique case and more importantly, explain how they

would deal with Portugal if the need of continued official financing were to manifest itself in

the coming months.

Rating

Portugal has been downgraded several

times in 2011. S&P is now the only rating

agency that gives Portugal a credit rating

in the investment grade category. Further

downgrades are clearly a possibility and

we would expect the credit rating assignedby all three agencies to finish lower than it

is now.

Exhibit 26: Portugals current ratings


S&P BBB- Negative

Moody's Ba2 Negative

Fitch BB+ Negative



23/77

10 January 2012


Cyprus

Cyprus GDP marginally increased by 0.2% in 2011 and is expected to fall by 0.6% in

2012. The large exposure of the countrys banks to Greece, weaker external demand and

the destruction of a key power plant, which supplied half of the islands power, have

deepened the sense of economic uncertainty and have deteriorated growth prospects. At

the same time, the construction sector continues to face a decline in output, following the

burst of the real estate bubble. On the positive side, tourism is performing very well, withits revenues increasing close to pre-crisis levels, and potentially profitable gas exploration

is proceeding with no benefits, however, expected in the near future.

Tighter financial conditions and fiscal consolidation measures taken are expected to have a

negative impact on growth this year. The Cypriot economy is likely to return to growth in 2013.

Financing needs

Cypruss net financing requirements for 2012 amount to around 0.53bn and gross

borrowing needs to around 1.7bn, excluding bills (worth 1.5bn at the end of 2011). As

of now, Cyprus is effectively shut out of international sovereign bond markets.

However, it has secured a loan of 2.5bn from Russia that will help the country

finance most of its needs for 2012. The first tranche of the loan, amounting 0.6bn, was

disbursed at the end of December. Any remaining shortfall is expected to be covered by

issuance of bills and/or long-term domestic debt, giving time to the country to restore

confidence in the markets through the fiscal consolidation efforts and a resolution of the

euro area debt crisis.

Key redemption months are January and February, with a total of 1.1bn of bonds maturing.

Exhibit 27: Financing needs for the Cypriot government in 2012mn per month

820

697

218

727

256

98 111

-4 -21 -643

298

-100

100

300

500

700

900


Loans

Bill redemptions

Bond redemptions

Monthly deficit


Note: Monthly deficit estimated using seasonal patterns from government monthly cash balances in previous years. Moreover, the chart showsexpiries for current bill stock, not possible future issues.

Source: PDMO, Credit Suisse

Yiagos Alexopoulos

+44 20 7888 7536

[email protected]


24/77

10 January 2012


Exhibit 28: Prospective financing needs of Cypriot government in coming yearsbn

0

1

2

3

4

2011 2012 2013 2014

Existing loans maturing

Bills stock


Deficit

Bills

stock

Bonds

issued

Russian

loan

Note: We assume the bill stock remains constant at the end of 2011 levels.

Source: PDMO, Credit Suisse


The latest figures point to a 2011 budget deficit of around 6.5%, substantially higher

than the original forecast of 4%. This was due to some one-off factors, but also due to

delays in the implementation of corrective measures. For 2012, the government

announced two sets of measures, primarily focused on the expenditure side and

addressing wage dynamics. The measures are mostly of a structural and permanent

nature and are estimated to reduce the deficit by approximately 4% of GDP. Therefore, if

they are implemented in full, the 2012 budget deficit target of 2.8% is within reach.

The general government debt probably ended 2011 at around 66% of GDP below the

euro area average. It is expected to stabilise around this level for the next few years

before it starts falling.

Exhibit 29: Medium-term fiscal consolidation plan government projections% of GDP

2011 2012 2013 2014

General government balance -6.5 -2.8 -2.1 -2.0

General government debt 66 67 67 66

Source: Ministry of Finance, Credit Suisse

Risks

The Cypriot economy faces significant risks in 2012. Its large banking system with

its heavy exposure to Greece Greek government bond holdings and loans to Greek

residents total 29bn, or 160% of GDP is a major vulnerability, especially if there is a

deterioration in the Greek debt crisis. Having effectively lost access from international

bond markets, Cyprus might not be in a position to support its banking system in case it is

needed. In addition, the fiscal measures taken might not be enough to reduce the deficit

and restore confidence in the economy, which means that in the absence of any other

form of financing the country could be forced to ask for support from the EFSF.


25/77

10 January 2012


Rating

Cyprus has faced a series of downgrades

by all rating agencies in 2011. Its credit

rating is borderline investment grade,

however, further downgrades in the

next few months are likely. The main

reason behind these rating downgrades isthe countrys exposure to the Greek

economy.

Exhibit 30: Cyprus current ratings


S&P BBB- Negative

Moody's Baa3 Negative

Fitch BBB Negative



26/77

10 January 2012


Ireland

The outlook for the Irish economy and public finances is still highly uncertain.

Irelands economy had a promising start to 2011, with average Q1 and Q2 GDP growth of

1.6%, but was followed by a surprising large contraction of 1.9% in Q3. Nonetheless, it

seems probable that Ireland will reach its current IMF deficit/GDP target of 10.6% for

2011; the governments current forecast is 10.1%. The most recent data for the Irish 2011

central government primary deficit suggest that, after adjusting for bank recapitalisationcosts, the Irish central government primary deficit is 1.3bn better than the programme

target. Following the December budget, Ireland is in a stronger position to reach its 2012

target of 8.6%. But this will be put under serious pressure if our 2012 GDP forecast of

0.3% growth is correct.

The Irish public finances have also benefited by the decision in July to reduce

interest charges and increase the maturity profile of loans made as part of the EU

segment of the Irish bailout. As a result of these decisions, Ireland is expected to save

6.7 bn on the EFSM loans, and around 5.5bn on the EFSF loans over their lifetime. The

heads of state of government and European institutions also agreed to continue

supporting Ireland until it regained market access.

In the governments December budget, the Finance Minister gave several proposals

to reduce the deficit. On the revenue side, from the start of 2012, VAT will be increased

from 21% to 23%, and the government will introduce a housing charge, which together

should increase revenues by 720mn. On the expenditure side, the government has

planned for a broad-based series of savings, including cutting the size of the public sector

by about 6000 people. Ireland maintained its corporate tax rate at 12.5%.

The programme of bank recapitalisation, initiated following stress tests in March,

has largely been completed this year, leaving Irish banks with high tier 1 capital

levels relative to the rest of Europe. Some weakness remains in the credit union sector,

and the planned sale of the insurance arm of one Irish bank, Irish Life and Permanent, fell

through in November. This is likely to impose around 1bn worth of recapitalisation costs

on the government in early 2012.

Financing needs in 2011

The central government deficit this year is likely to be around 19bn. This includes

the 1bn recapitalisation costs mentioned above. In addition, there is a bond redemption

worth 5.6bn in March, putting the total year financing needs at 24.4bn. Total financing

from the EU/IMF programme and bilateral loans from Sweden, Denmark and the UK were

given as 23.2bn in the last IMF review. The gap in financing occurs due to the

unforeseen recapitalisation costs, but could be covered by Irish cash reserves, and the

lower than expected deficit this year.

Steven Bryce

44 20 7883 7360

[email protected]

Neville Hill

+44 20 7888 1334

[email protected]


27/77

10 January 2012


Exhibit 31: Irish government financing needs in 2012bn

0

1

4

1

2

12

12

57

-2-3

-2

-1

0

1

2

3

4

5

6

7


Bond redemptions

Monthly deficit


Note: Monthly deficit estimated using seasonal patterns from government monthly cash balances in previous years.

Source: Credit Suisse, Irish Department of Finance, NTMA

The chart below shows that financing needs were substantially elevated in 2011

compared to the forecast horizon. About 15bn of this was driven by bank

recapitalisation requirements, most of which were funded by an Irish contribution from

the national pension fund reserve and Treasury cash reserves. The chart shows that

there is a slight funding hump in 2014, driven by substantial bond redemptions, but that

this drops away in 2015. However, requirements for bond and loan repayments will be

elevated after this point.

Exhibit 32: Prospective financing needs of Irish government in coming yearsbn

0

5

10

15

20

25

30

35

40

45

50

2011 2012 2013 2014 2015

EU/IMF loan repayment

Bills stock


Deficit

EU/IMF

loan

Irish

funds

Gvnt retail

savings scheme

Note: We assume the bill stock remains constant at the end of 2011 levels. However, it is suggested that the government will potentially re-enter the short term market in 2012.

Source: Credit Suisse, IMF, Irish Department of Finance, NTMA


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10 January 2012



Forecasts suggest that the Irish government deficit is continuing on a downward path

from the exceptional levels in 2010. From a projected general government deficit of

15.6bn in 2011, the deficit is expected to fall again to 13.7bn in 2012. However, the

forecast has worsened somewhat over the year, with the 2011 deficit increasing by 0.7%

of GDP, and the 2012 deficit increasing by 1.3% of GDP compared with the outlook at

the beginning of 2011.The 2012 budget made adjustments worth 3.8bn to ensure that the deficit target in 2012

is met, with the burden lying on expenditure cuts (around 60% of the consolidation) rather

than revenue increases.

Exhibit 33: Irish public finances government projections

% GDP 2011 2012 2013 2014 2015

General government balance -10.1 -8.6 -7.5 -5 -2.9

Primary balance -6.7 -4.4 -1.9 0.8 2.8

Interest expenditure 3.3 4.2 5.6 5.8 5.7

Government gross debt 107 115 119 118 115

Source: Credit Suisse, Irish Department of Finance

Risks

There are several major risks to the outlook for Ireland. The most substantial is the

prospect for growth. Irish domestic demand is expected to make a negative contribution to

GDP growth in 2012, at close to 1%. The government forecast is for this to be offset by a

4% contribution from exports. The EU (excluding Great Britain and Northern Ireland)

comprises 42% of Irish exports according to 2010 data. As a result of this, any shock that

reduces the desire or ability of other euro area countries to import could have a substantial

pass-through effect into the Irish debt-to-GDP ratio.

Another key area of concern is the problem of mortgage arrears. Central Bank data

for September 2011 showed that 8.1% of private residential mortgage accounts were inarrears for more than 90 days, and this number has been trending upwards since 2009.

The risk that this poses to the banking sector is to some extent offset by banks relatively

strong position post-recapitalisation. However, the mortgage arrears situation is

suggestive of weaknesses in the household sector that may constrain future demand and,

of course, any future negative shock could amplify the situation further. The Keane Report

on mortgage arrears, published earlier in the year, resolutely opposed any substantial role

for debt forgiveness, and instead focused on the role that could be played by bank

forbearance.

Rating

At present, Ireland is rated BBB+ by S&P,Ba1 by Moodys and BBB+ by Fitch. The

outlooks are negative, driven by concerns

about the European situation and the feed-

through effect this could have on the Irish

public finances.

Exhibit 34: Irelands current ratings


S&P BBB+ Negative

Moodys Ba1 Negative

Fitch BBB+ Negative



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10 January 2012


Italy

The Italian economy entered recession in Q3 11 and should experience another

couple of negative quarters at least, judging from the latest business surveys and

consistent with our own forecasts. We expect real GDP to contract by around 2% from

peak to trough. Significant headwinds from tight fiscal policy and a severe confidence

crisis brought to a halt the mild recovery seen in 2010 and in the first half of 2011.

On the positive side, Italy is now on track to reach a close to balanced budget by

2013 with the measures already voted in Parliament so far. Confidence (and lower

rates) might return as a consequence of the implementation of the measures or, more

broadly, if and when Europe deals once and for all with its fundamental confidence crisis

at the political level, monetary conditions continue being more expansionary and ideally,

fiscal policy in Germany becomes looser too.

The negative shock to growth due to the large fiscal adjustment this year is partly

compensated by the quality of the measures, which include taxation of the wealthiest (with

generally a small impact on consumption), a pension reform (positive for growth, if

anything) and by a policy mix that is turning more supportive thanks to ECB decisions in

recent months and exchange rate developments. Finally, VIX developments over the past

few months, for example, suggest that broad uncertainty is receding. If that latter trend is

confirmed, growth could resume later this year. Corporate spending and exports would

drive the recovery.

A key concern is also related to the Italian banking sector. As we write, official statistics

are reporting only a mild slowdown in lending growth but banks, which have already

tightened credit standards, anticipate significantly further tightening this year. It is yet to be

seen if the measures announced by the ECB will suffice to turn things around in the

coming months.

Financing needs

Excluding bills, the Italian government faces just over 220bn of financing needs this

year, just a touch higher than 2011s issuance of 210bn. Bond redemptions account for194bn and the government deficit for just under 30bn, on our estimates.

Financing needs are higher in H1, with significant bond redemptions. As Exhibit 35

shows, in February, the Italian government will need around 60bn and around 50bn in

March and April including bills (42bn, 36bn and 35bn, respectively, excluding them).

Given tensions in financial markets and the relatively high yield on Italian bonds, a key

question is how Italy will go through next months large redemptions (26bn of a ten-year

bond at the beginning of the month and 11bn of a two-year bond at the end of the month).

The Treasury is planning to introduce retail bonds from this year, as an alternative to

alleviate some of the pressure on medium-to-long-term bond issuances. Moreover, the

government has some cash buffers available (over 23bn at the end of last year in the

cash account at the Bank of Italy, for instance), but if financial markets remain severely

impaired, Italy will have to work on some financial repression move pushing domestic

banks to fund the government or count on external help. With the IMF already in Rome,

officially to certify the implementation of reforms, it seems that things are being prepared

for a more significant involvement of that institution, if needed. It is worth noting in this

context, the recent decisions by euro area countries to increase IMFs firing power with

150bn via their central banks in December, as well as the creation of a new lending

facility. The new IMFs Precautionary and Liquidity Line (PLL), has been designed for

countries with sound economic fundamentals in a liquidity crisis and has light conditionality

attached to it. As such, we would see any involvement of the IMF to be quite different from

the one in Greece, Portugal and Ireland.

Violante Di Canossa

+44 20 7883 4192

[email protected]

Giovanni Zanni

+33 1 7039 0132

[email protected]


30/77

10 January 2012


That said, bills and bond auctions at the end of last year were encouraging. The average

yield on bills halved, to 3.2%, compared to similar auctions held in mid November, while

the yield on ten-year bond issuance dropped a little bit as well.

Exhibit 35: Italian governments funding requirement in 2012bn

15

5953 52

30

2320

25

31

20

35

0

-10

0

10

20

30

40

50

60


Bill redemptions

Bond redemptions

Monthly deficit

Monthly financing needs

Note: Monthly deficit estimated using seasonal patterns from government , monthly cash balances in previous years. Moreover, the chartshows expiries for current bill stock, not possible future issues.

Source: Credit Suisse, Tesoro.it

As for now, from 2013 onwards, the governments financing needs should

decrease significantly, thanks to stronger public finances and lower redemptions. As

Exhibit 36 shows, assuming the amount of bills is kept constant at the 2011 stock, the

Italian government will face financing needs of around 160bn next year and around

120bn in 2014.

Exhibit 36: Prospective financing needs of the Italian governmentEUR bn

0

50

100

150

200

250

300

350

400

2011 2012 2013 2014 2015

Deficit Existing bonds maturing Bills stock

Bills

stock

Bonds

issued

Note: We assume the bill stock remains constant at the end of 2011 levels.

Source: Credit Suisse, Tesoro.it


31/77

10 January 2012


Public finance outlook

The Italian parliament passed its third austerity package after the two summer measures

just before Christmas. The new package is worth around additional net 20bn (1% of

GDP), confirming the strong commitment to reach a balanced budget by 2013. Combined,

the measures are worth around net 80bn (5% of GDP) over three years. Below, we

present a table summarizing these measures.

Exhibit 37: Fiscal measures taken since mid 2011bn

2011 2012 2013 2014

Total net amount s 2.9 48.5 76.0 81.5

Extra revenues 2.8 42.2 59.0 62.7

Income tax 0.0 2.2 2.2 2.2

Reduction in tax benefits 0.0 4.0 16.0 20.0

Solidarity contribution 0.0 0.4 0.6 0.8

Tax evasion 0.0 1.3 2.6 2.6

Tax on fuel 0.0 7.0 6.6 6.7

VAT hike 0.7 4.2 4.2 4.2

Capital gain tax 0.7 4.9 7.4 4.9Energy tax and Tax on luxury goods 0.0 2.3 1.3 1.4

Games and lotteries 0.4 2.0 2.0 2.0

Tax on real estate (IMU) 0.0 11.0 11.0 11.0

Other 0.9 3.0 5.0 6.9

Lower spend ing 2.4 19.6 29.0 33.4

Transfers to local administrations 0.0 7.0 9.2 9.2

Pensions 0.0 3.5 7.1 10.0

Civil servants 0.0 0.4 2.1 2.1

Cut to ministries expenditure 1.9 8.2 7.2 6.0

Health sector 0.4 0.0 2.6 5.1

Other 0.1 0.3 0.3 0.3

Higher spend ing 2.1 9.6 4.0 4.4

Infrastructure projects 0.0 1.6 2.0 2.4

Public local transport 0.4 1.2 1.2 1.2

Other 1.7 6.8 0.8 0.9

Lower revenues 0.2 3.7 8.0 10.5

Regional tax (IRAP) 0.0 1.6 3.6 3.0

Other 0.2 2.1 4.4 7.5

Source: Credit Suisse, lavoce.info

The difference between the government and our public finance outlooks mainly lies on our

gloomier view on growth. The government is expecting a GDP contraction of around 0.5%

vs. our 1.5% forecast for this year. Despite the poorer growth outlook, 2013 should see a

close to balanced budget nevertheless. The two summer packages, the save Italy

December decree, and some additional savings from the upcoming spending review

should be sufficient to at least approach the target next year. Government gross debt,

thanks to the fairly solid structural fiscal stance, should be on a descending path from

2013 onwards.


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10 January 2012


Exhibit 38: General government fiscal forecasts Credit Suisse forecastsAs % of GDP

2010 2011 2012 2013

Government balance -4.6 -3.9 -1.8 -0.5

Gross debt 118 121 121 119


Risks

As mentioned above, a slippage in the public finance numbers due to even lower

than expected growth is a clear risk. This risk would be even more acute in a state of

the world where financial markets remained severely impaired. Italian ten-year yields at

7% are not sustainable in the medium-to-long-term. A more aggressive action from

European policymakers will be needed if confidence does not return.

Contingent liabilities are increasing, although they represent a limited source of risk, in our

view. Italian banks have already made good use of the state guarantee scheme

announced at the October Euro summit. At the end of last year, news reports suggested

that the Italian government already underwrote around 50bn of new banks issuances,

with a maturity from three months to five years. That said, the scheme is designed so that

only solvent banks should have access, with a fairly low level of risks for the government,

i

77910335 cs european public finances 2012

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