Greece and Portugal should both go gracefully

Even as the ink is drying on Portugal's European Union and International Monetary Fund bail-out agreement, evidence is mounting that last year's bail-outs of Greece and Ireland have failed. Far from improving their access to the financial markets, Greece and Ireland face record borrowing costs. Notwithstanding the slightly less draconian terms of Portugal's agreement, it will surely suffer a similar fate.
The EU will try to get away with "soft" restructurings, involving a combination of longer maturities and lower interest rates. But this will not work and by 2013 there will be no viable alternative to "hard" restructurings (default), comprising debt write-downs of 50 per cent or more. Unfortunately, in the case of Greece and Portugal at least, even this will not guarantee continued membership of the euro.

After all, interest payments on the crisis-hit countries' outstanding public debt account for a relatively small proportion of their budget deficits. Reducing the cost of servicing the outstanding stock of public debt by 50-60 per cent would make these countries' fiscal positions more sustainable. But unless the defaulting countries can engineer a return to economic growth, they will continue to struggle to tap the capital markets on anything but prohibitively expensive terms. Of the three peripheral economies, only Ireland stands a good chance of convincing investors of its solvency.

Assuming creditors write off 50 per cent of Irish and Portuguese public debt and 60 per cent of Greece's in 2013, all three countries will have public debt ratios of a manageable looking 60-65 per cent of gross domestic product. But they will still have huge budget deficits, demanding ongoing budget austerity. In Ireland's case, investors will probably calculate that the Irish economy will be strong enough to weather continued austerity. Ireland is now running a current account surplus – so the foreign balance is not a drag on its economy and the government is able to finance its budget deficit domestically. Irish exports should perform relatively strongly, holding out the promise of decent economic growth. As a result, Ireland could regain access to financial markets relatively quickly.

The picture is bleaker in the case of Greece and Portugal. Investors will be rightly sceptical of their ability to absorb the cuts needed to bring down their still very large budget short-falls. Both countries' current account deficits have narrowed somewhat, but will remain very large, depressing demand and leaving them dependent on foreign borrowing to bridge the gap between their spending and revenues. Unlike Ireland, Greece and Portugal will find it very hard to generate the stimulus from exports needed to offset the impact of continued austerity. Exports only account for around a quarter of Greek GDP and a third of Portugal's – compared with around 100 per cent in the Irish case – and both do little trade with countries outside the slow-growing EU. Added to this, both countries' businesses have experienced a huge loss of trade competitiveness within the eurozone. Investors will surely continue to deny Greece and Portugal market access, calculating (correctly) that they cannot rely on being bailed out a second time.

What will happen then? Further bail-outs of Greece and Portugal in the form of loans from the rest of the eurozone are unlikely. Everyone will by then recognise that piling more debt on top of already unsustainable levels makes little sense. This will leave two alternatives: fiscal transfers (the dreaded 'fiscal union') or the affected countries' withdrawal from the currency union. Faced with this second possibility, it is impossible to rule out a shift to some kind of transfer union. But the politics look formidably difficult. Could there be a negotiated withdrawal from the currency union? It would require action on several fronts, including emergency support for the affected countries' banks and temporary capital controls. The debts of countries leaving would have to be redenominated into their newly introduced (and massively devalued) currencies, imposing a further haircut on foreign holders of these countries' debts. It is impossible to attach a probability to all this happening. But given the obstacles to fiscal transfers between eurozone economies it would be unwise to bet too much money against it.