KBC ECONOMIC RESEARCH (GCE) SIEGFRIED TOP (02/429.59.

91) 27 MARCH 2013

Sovereign vulnerability indicator

Update April 2013

In this note, we present the quarterly update of the Sovereign Vulnerability Indicator (SVI), by which we assess which countries are most vulnerable in terms of public finances. The methodology was initially used in our December 2010 SVI-note. We then introduced an index which ranks countries according to the current situation of their public finances, the expected development over the next two years and their short-term vulnerability to confidence crises on financial markets. In our December 2012 update, we have added four new variables, which allow us to separately assess the risk of losing market access for the sovereign (a liquidity shock) and a specific financial contagion risk (a solvability shock). The financial system poses an additional threat to the sovereign, as was half-2012 clearly illustrated in the case of Spain and more recently in Cyprus. To obtain a final country-score, we normalized the variables and aggregated them. This provides a view on which countries might be most problematic and vulnerable to financial speculation. Instead of showing the aggregate score, we rank the countries by their difference to the average aggregate score, which is broadly comparable to the score of the aggregate Euro area. The countries under examination are the same as those in the former updates, now including also Malta. To facilitate comparison, we add the former position (update December 2012) of the countries between brackets. 1 Sovereign vulnerability indicator update April 2013
0.20

Difference with average aggregate score

1

0.10

0.00

-0.10

-0.20

-0.30

Corrected for the inclusion of Malta

Overview of the sub-scores per group of indicator 1. Current situation of public finances The indicators for the current situation of public finances consist of the current deficit (net lending position), the cyclically-adjusted primary balance (which excludes interest payments) and the total amount of gross debt, all as a % of GDP, and the ratio of gross government debt over tax receipts, which gives an indication how fast a country is theoretically able to reduce its debt. We used the Ameco database of the Commission to collect our data. For the U.S., we use the concept of debt held by the public, which is similar to the Eurostat gross debt ratio, but significantly lower than the European assessment of US gross debt. Table 1 shows the results for each indicator, followed by an aggregated score based on the normalized variables.
Table 1. Current situation of public finances (Q1 2013) Country Net lending Primary balance Gross Debt Debt/tax Score
0.81 0.80 0.77 0.76 0.70 0.69 0.69 0.68 0.68 0.62 0.60 0.59 0.58 0.56 0.56 0.55 0.54 0.54 0.54 0.53 0.51 0.50 0.48 0.35 0.35 0.30 0.29 0.24 0.14

1 Es toni a -0.3 -0.5 10.5 31% 2 Luxe mbourg -0.9 0.7 20.5 52% 3 Bul ga ri a -1.2 0.3 18.9 51% 4 Swe de n -1.0 1.1 37.7 72% 5 La tvi a -1.1 0.6 41.9 136% 6 De nma rk -2.7 1.7 45.6 84% 7 Ge rma ny -0.2 2.8 81.6 180% 8 Fi nl a nd -1.7 0.8 53.4 104% 9 Roma ni a -2.4 0.9 38.0 112% 10 Li thua ni a -2.7 -0.3 41.1 132% 11 Cze ch Re p. -3.1 -0.4 45.5 121% 12 Pol a nd -3.4 0.7 55.8 154% 13 Aus tri a -2.5 0.5 74.3 156% 14 I ta l y -2.0 5.2 127.1 268% 15 Hunga ry -3.6 2.2 78.6 182% 16 Ne the rl a nds -3.5 0.5 70.8 156% 17 Ma l ta -2.9 0.7 73.1 195% 18 Euro a re a (17) -2.8 1.9 93.1 205% 19 Sl ova ki a -3.3 -1.0 52.4 164% 20 Be l gi um -2.5 1.3 99.8 202% 21 Sl ove ni a -5.1 -0.5 53.7 133% 22 Fra nce -3.8 0.6 90.3 177% 23 Cyprus -4.5 1.7 86.5 231% 24 Portuga l -4.9 1.5 120.6 297% 25 Gre e ce -4.6 6.5 161.6 432% 26 Spa i n -6.7 -1.1 88.4 264% 27 U.S. -5.3 -3.0 72.5 323% 28 Uni te d Ki ngdom -7.4 -2.7 89.8 246% 29 I re l a nd -7.3 -2.2 117.2 362% -Ne t l e ndi ng: Gove rnme nt ne t l e ndi ng (ge ne ra l gove rnme nt) 2013, a s % of GDP - Pri ma ry ba l a nce : Cycl i ca l l y a djus te d pri ma ry ba l a nce , e xcl udi ng i nte re s t, 2013, a s % of GDP - Gros s de bt: Gros s gove rne me nt de bt, 2012, a s % of GDP - De bt/ta x: Gros s gove rnme nt de bt, 2012, a s % of ta x re ce i pts

Overall, public finances deteriorated in the countries under review, as economic growth disappointed and deficits remain high and debt ratios increased. The current situation of public finances looks worst in the Anglo-Saxon countries (U.S., U.K. and Ireland) and in the Southern European problem countries. This can partially be explained by the still high deficits and debt ratios in these countries, but also by the high debt over tax ratio, as the average tax rates in these countries are significantly lower, so that debt takes much longer to be (theoretically) repaid. From a positive note, Italy surged in the public finance ranking, as the net lending and structural primary balance significantly improved after the Monti reforms. 2

2. Expected evolution of public finances (2013-14) The second group of indicators covers the expected development of public finances over the next two years (2013-14), i.e. the expected budget balance (net lending) of 2014 under unchanged policy, the expected tax burden (fiscal receipts as % of GDP in 2013), the expected average GDP growth for 2013 and 2014 and the employment change since the start of 2013 up to end 2014. This latter variable adds some additional information on the expected government spending and income via taxes.
Table 2. Expected evolution of public finances (2013-14)
Country Expected net lending 2014 Tax burden Avg growth Employment change
4.1% 3.1% 1.4% 3.3% 3.7% 0.4% 1.2% 2.4% 0.5% 1.0% 0.4% 0.1% 0.9% 1.5% 0.4% 1.6% 0.9% 0.6% -0.4% -0.1% -0.7% 0.0% -0.9% -2.2% 0.5% -1.8% -3.0% -2.5% -3.0% a s % of GDP

Score
0.94 0.86 0.81 0.77 0.73 0.71 0.70 0.65 0.65 0.62 0.61 0.58 0.58 0.56 0.55 0.51 0.49 0.49 0.45 0.43 0.42 0.40 0.38 0.38 0.37 0.31 0.29 0.28 0.27

1 La tvi a -0.9 33% 4.0 2 Li thua ni a -2.2 31% 3.3 3 Es toni a 0.2 38% 3.5 4 U.S. -3.7 31% 2.2 5 Ma l ta -2.5 38% 1.8 6 Bul ga ri a -0.9 34% 1.7 7 Roma ni a -2.2 34% 2.0 8 Luxe mbourg -1.3 43% 1.0 9 Sl ova ki a -3.4 34% 2.0 10 Ire l a nd -4.2 34% 1.6 11 Ge rma ny 0.0 45% 1.3 12 Pol a nd -3.3 38% 1.7 13 Swe de n -0.4 51% 2.0 14 Aus tri a -1.8 48% 1.3 15 Cze ch Re p. -3.0 39% 0.9 16 Uni te d Ki ngdom -6.0 40% 1.4 17 Be l gi um -2.0 50% 0.9 18 Hunga ry -3.5 43% 0.6 19 Euro a re a (17) -2.7 46% 0.6 20 Fi nl a nd -1.4 54% 0.7 21 Ita l y -1.9 48% -0.1 22 De nma rk -2.8 55% 1.4 23 Ne the rl a nds -3.5 47% 0.3 24 Portuga l -2.9 42% -0.6 25 Fra nce -4.1 53% 0.7 26 Cyprus -3.8 40% -2.4 27 Gre e ce -3.5 41% -1.9 28 Sl ove ni a -4.7 45% -0.6 29 Spa i n -7.2 36% -0.3 - Expe cte d a ve ra ge gove rnme nt ne t l e ndi ng (ge ne ra l gove rnme nt) 2014, - Ta x burde n: Fi s ca l re ce i pts , 2013, a s % of GDP - Ave ra ge growth: Ave ra ge GDP growth 2013-14 - Empl oyme nt cha nge 2012-2014, i n %

Overall, the countries that score bad in the current public finance situation assessment, seem to score bad in the expected evolution too. In countries like Spain, Slovenia, Greece and Cyprus, low growth and persistently high deficits further worsen the outlook for the public finances. Core countries like the Netherlands and France also seem to be stuck in the vicious spiral of low growth and deteriorating public finances. From a positive note, the Irish outlook continues to improve, as the growth and employment prospects for this dynamic economy are much better than the average of the euro area. The three Baltic countries top our ranking, as they have excellent growth prospects, and their deficits were strongly reduced. This can be called a success, as Latvia was one of the countries that was the hardest hit by the 2008-09 recession and was granted EU/IMF support. The country has however strongly improved its competitiveness (e.g. by an internal devaluation) and is now ready to join the Euro area as of 2014. 3

3. Ease of market access of the sovereign One of the main risks resulting from the eurocrisis is the locking-out of countries from the public debt markets, or a liquidity shock. To measure the ease of access to financial markets, we first use a composite indicator: gross financing need adds maturing debt (Bloomberg data, in % of GDP) to the budget deficit in 2013 (% of GDP). The higher this ratio, the more reliant a country is on the bond market confidence in 2013. Funding needs have decreased in most countries in comparison with 2012, with Germany e.g. now having only 2/3rd of the needs they had last year. Both the lower deficit and the higher maturity of their bonds (due to the very low interest rates paid in 2011-12) have put the German debt agency in a very comfortable situation. Funding needs for Italy and Spain remain high in 2013, but debt issuances in Q1 2013 have so far outperformed the initial targets. This is mainly owing to the ECBs Outright Monetary Transactions (OMT-)programme, which has provided an implicit guarantee on government sovereign debt in the euro area. The second indicator is the percentage of total debt held abroad, or external debt, and collected from the Joint External Debt Hub (BIS, World Bank, OESO and IMF data). Since the start of the crisis, the ownership of public debt has changed significantly in the Euro area. From the one side, government bonds of countries that were perceived as more risky were sold off by foreign owners, and bought back by e.g. banks of the country itself, thus renationalized. Related to this is the variable private savings of a country, as debt was also renationalized through retail bonds (e.g. the Leterme bonds or Italys inflation-linked retail bonds). On the other side, debt of countries with a lower risk profile have seen an strong increase in external ownership of their debt (e.g. Germany, Poland, Finland and Sweden).

Graph 1: External debt in % of total debt

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Q3 2010 Q3 2012

The fourth variable, the current account balance, indicates the difference between a countrys savings and its investments. A negative current account makes a country vulnerable, as its economy then relies on external financing. Since the start of the Eurocrisis, current account deficits of the problem countries significantly declined, although this is partially a side-effect of the strong fall of imports as domestic demand contracts in these countries. Spain is even expected to have a current account surplus in 2013.

Graph 2: Large reductions of current account deficits in Southern EMU Current account balance in % of GDP
2 0 -2 -4 -6 -8 -10 -12 -14 -16 France

2004-08 2013

Italy

Spain

Portugal

Greece

Table 3. Ease of financial market access

Country

Fin.needs

External debt Current account Private savings

Score

1 Swe de n 3.6 46% 7.3 23.9% 0.81 2 Luxe mbourg 5.2 38% 6.7 23.6% 0.80 3 Ne the rl a nds 11.3 54% 8.6 25.5% 0.75 4 Ge rma ny 7.9 61% 6.0 21.1% 0.65 5 De nma rk 9.5 50% 4.1 22.4% 0.65 6 Sl ove ni a 10.0 45% 3.8 20.2% 0.62 7 Sl ova ki a 10.9 44% 0.8 24.4% 0.62 8 Euro a re a (17) 14.0 28% 2.2 20.3% 0.60 9 Bul ga ri a 3.5 46% -1.6 21.7% 0.60 10 Ma l ta 11.9 7% 1.2 15.2% 0.59 11 Es toni a 0.9 57% -2.3 21.2% 0.58 12 Spa i n 20.2 28% 1.0 24.2% 0.57 13 Aus tri a 9.1 82% 2.1 23.7% 0.54 14 Be l gi um 18.2 56% 2.0 24.3% 0.53 15 Cze ch Re p. 10.8 31% -2.7 20.2% 0.53 16 Ire l a nd 11.3 64% 3.4 19.0% 0.53 17 Hunga ry 14.2 68% 3.3 21.5% 0.52 18 La tvi a 2.8 74% -2.8 20.9% 0.49 19 Roma ni a 9.6 46% -4.0 20.7% 0.48 20 Uni te d Ki ngdom 12.8 32% -3.1 17.1% 0.45 21 Ita l y 20.0 35% 0.6 17.6% 0.45 22 Pol a nd 9.5 50% -2.7 17.6% 0.44 23 Li thua ni a 7.4 87% -1.3 17.7% 0.38 24 Fi nl a nd 7.5 90% -0.7 17.3% 0.38 25 Fra nce 15.6 63% -1.6 17.9% 0.37 26 Portuga l 16.4 61% -1.4 16.6% 0.35 27 U.S. 25.4 33% -3.0 17.8% 0.33 28 Cyprus 17.6 35% -1.7 9.1% 0.30 29 Gre e ce 16.4 66% -4.3 12.1% 0.21 - Fi n. Ne e ds : Gros s fi na nci ng ne e ds : ma turi ng de bt 2013, pl us budge t de fi ci t 2013, a s % of GDP 2013 - Exte rna l de bt: Exte rna l gove rnme nt de bt (de bt he l d a broa d) a s of Q3 2012 a s a % of tota l de bt - Curre nt a ccount ba l a nce , a s a % of GDP, e xp 2013 - Pri va te s a vi ngs : Gros s pri va te s e ctor s a vi ngs 2013, a s % of GDP

4. Solvability threats from financial sector shocks Shocks from the financial sector have been an important reason for public debt to rise quickly and solvability coming under stress. The example of Ireland was followed by that of Spain last year, as both countries had low public debts before 2008, which they saw rising to (unsustainable) high levels due to measures undertaken to support domestic financial institutions. A first indicator of increased financial vulnerability is private sector debt (non-consolidated, in % of GDP). 2 This measure consists of debt from non-financial corporations, households and non-profit organizations. The latest financial crisis pointed to the fact that excessively high private sector debt implies risks for growth and financial stability and increases the vulnerability to economic shocks. Countries with a more leveraged financial system and higher credit growth typically suffered more during the recent crisis. As a second variable, we use net investment position as a proxy for a countries vulnerability to financial markets shocks. Having a large negative position implies a large private debt abroad, which also poses threats as was illustrated in the euro crisis. As can be seen in graph 3, the net international investment positions of the GIPS countries remain strongly negative at around 100% of GDP. As a third variable we calculated the size of the domestic banking sector as a % of GDP. In case of a financial crisis, small countries with oversized banking sectors have much more chance of being dragged into a sovereign crisis. Many EU countries have a domestic banking sector (expressed in total consolidated assets) that is over 3 to 4 times the GDP of the country. The example of Ireland, Spain and, more recently, Cyprus, has shown the risk related to relatively large domestic banking sectors. A different measure that may be used is the size of all banks in a country. This variable may cover too broad a scope (e.g. subsidiaries of foreign banks in Luxemburg and Ireland).

Graph 3: Consolidated assets of banking sector (in % of GDP)

1000% 800% 600% 400% 200% 0%
Cyprus UK Netherlands Sweden Spain Denmark France Germany Austria Ireland Portugal Greece Italy Malta Belgium Luxembourg Slovenia Finland Latvia Hungary Poland Bulgaria Romania Slovakia Lithuania Estonia Czech rep
2

Luxembourg: 1848%

Domestic banks All banks

Alternatively, the variable consolidated private sector debt could be used, thus correcting for a.o. intra-company flows. This variable is however not available for all countries in the sample. For Belgium, the consolidated variable stands at 143.8% of GDP.

Related to the size of the domestic banking sector are the contingent liabilities from the banking sector. We used the contingent liability definition of Eurostat, which only includes effectively used guarantees, which is often substantially lower than the potential ceiling governments guarantees. New contingent liabilities related to the eurocrisis should also be reckoned with. 3
Table 4. Vulnerability for financial market shocks Size domestic Private sector debt banking sector Country Contingent liabilities

NIIP

Score

1 Li thua ni a 70.1 8% 0.0% -52.6% 0.81 2 Czech Rep. 78.1 5% 0.0% -49.3% 0.81 3 Roma ni a 71.8 11% 0.0% -64.9% 0.79 4 Pol a nd 79.5 29% 0.0% -63.5% 0.78 5 Sl ova ki a 76.3 9% 12.5% -64.4% 0.76 6 Fi nl a nd 178.8 74% 9.8% 13.1% 0.72 7 U.S. 164.8 82% 0.0% -17.0% 0.72 8 La tvi a 125.1 49% 0.6% -73.3% 0.71 9 Es toni a 132.9 7% 18.1% -57.8% 0.70 10 Bul ga ri a 146.0 24% 0.0% -85.6% 0.69 11 Ita l y 128.6 162% 17.0% -20.6% 0.67 12 Sl oveni a 128.3 106% 20.1% -41.2% 0.66 13 Germa ny 127.8 292% 15.7% 32.6% 0.66 14 Bel gi um 236.9 150% 24.5% 65.7% 0.65 15 Luxembourg 326.3 147% 10.6% 107.8% 0.65 16 Hunga ry 167.3 43% 0.0% -105.9% 0.64 17 Ma l ta 209.9 160% 16.1% 7.5% 0.62 18 Aus tri a 160.7 290% 17.3% -2.3% 0.59 19 Euro a rea (17) 162.8 272% 18.8% -14.0% 0.58 20 Fra nce 160.4 323% 16.6% -15.9% 0.56 21 Denma rk 237.6 335% 9.3% 27.8% 0.54 22 Greece 125.0 164% 41.5% -86.1% 0.53 23 Netherl a nds 224.6 418% 17.4% 35.5% 0.50 24 Sweden 230.9 416% 2.6% -6.9% 0.48 25 Uni ted Ki ngdom 206.4 440% 16.4% -17.2% 0.45 26 Portuga l 249.3 233% 19.2% -105.0% 0.41 27 Spa i n 218.1 339% 20.1% -91.8% 0.39 28 Cyprus 287.5 477% 29.1% -71.3% 0.25 29 Irel a nd 309.5 240% 96.1% -96.0% 0.15 - Pri va te s ector debt: non fi na nci a l corpora ti ons , hous ehol ds a nd non-profi t org. i n % of GDP 2012 - Si ze ba nki ng s ector: cons ol i da ted, domes ti c ba nks , i n % of GDP 2012 - Conti ngent l i a bi l i ti es on the ba nki ng s ector a nd Europea n funds (EFSF, ESM), i n % of GDP 2012 - NIIP: Net i nterna ti ona l i nves tment pos i ti on, a s a % of GDP, end 2011

Given their large, and mostly external, debt positions and relatively large seizes of domestic banking sectors, the GIPS-countries (Greece, Ireland, Portugal Spain) score very low in this sub-indicator. Central European countries on average score better, as their private sector debt levels are much lower, and their banking sector is mostly controlled by foreign parent banks. This partially explains why there sovereigns were less severely hit by the financial crisis of 2008 and the more recent euro crisis.

We define these as follows: firstly, the EFSF has an overguarantee structure of 165%, which means that in case of one or more countries not being able to meet their obligations, the others can be called upon. Secondly, only part of the ESM capital (EUR 32 bn) has been paid-in already, while 48 bn will be paid over 2013-14 according to the ESM contribution key. Thirdly, the total ESM callable capital amounts to EUR 700 bn, so that an amount of EUR 620 bn can also be defined as contingent liabilities.

Box 1. The Netherlands in the Sovereign Vulnerability Indicator

The relative position of the Netherlands has decreased over the several updates of our SVI ranking. From a solid th 7 position in our June 2011 update, when the Netherlands had a similar score as Germany, the country has th fallen in our latest update to only the 18 place, just above the Euro area average. Although the public finance outlook has worsened, the Dutch sovereign still has an easy access to financial markets. However, the country remains vulnerable for financial market shocks. Looking somewhat more into detail, we find that the Netherlands dropped the most places in the sub-indicators of the current and expected public finances. Gross government debt remains at relatively low level (70.8% of GDP in 2012), but despite continuous efforts of the Dutch government to curb public expenditure and raise new revenues, the expected 2013 deficit remains elevated (3.5% of GDP). The ongoing recession, with a strong rise in unemployment and a severe price correction on the housing market, partially explains the inability of the Dutch government to get the deficits below the targeted 3% excessive deficit limit. Unemployment continues to rise, and now stands at 6.2%, up from 4.1% mid-2011, and markedly above the 4.6% peak during the great recession of 2009. Employment will likely fall by a further 0.9% in the years ahead, as the government announced further labour shedding in the public and social sector, and the construction sector remains under severe pressure. Still, as the unemployment benefit schemes were drastically reformed, government expenditure will be less affected by these developments. The nationalization of the failed SNS Reaal-bank, which became a victim of the Dutch real estate crisis, will add another 0.6% of GDP to the Dutch debt. This effect will however be compensated by the sale of 4G mobile telephony licenses. Still, the nationalization of SNS Reaal showed the vulnerability of the Dutch financial sector, as SNS Reaal was the fourth Dutch lender that had to be rescued by the government (after Fortis-ABN Amro, ING, DSB), which has now about 6% of GDP in contingent liabilities to the banking sector. Private sector debt remains very high, at around 225% of GDP (well above the Euro area average of 163%), and the Dutch domestic banking sector is one of the largest of the EU, with assets of around 418% of GDP (compared to the 272% average of the EMU). This large financial sector can partially be explained by the large Dutch pension funds and the specific mortgage system, that allows the mortgage principle to be repaid only at the end of the term, in order to continue to profit from the generous fiscal regime. Recent reforms (e.g. lower tax deductibility) should put an end to this practice. Nevertheless, the Dutch situation is in no way comparable to that of the crisis countries. The Netherlands score very good in terms of ease of financial market access, as financial needs are low (11% of GDP only), private savings are the highest of our sample of countries (25.5% of GDP) and the country has a large current account surplus (8.6% of GDP) and a solid net international investment position (35.5% of GDP). Graph 4. Score and ranking of the Netherlands worsened
1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 11
0.56 0.62 0.55

Normalized score of the Netherlands (lhs) Position of Netherlands in the SVI (rhs)
0.58 0.61

0 2 4 6 8 10 12 14 16 18 18 20

0.55

9 14 13

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