Modelling the sovereign debt crisis in Europe

This note examines the impact of rising bond yields in certain Euro Area countries on debt sustainability. It concludes that without the financial assistance of the bailout packages, government debt in Greece would clearly have been unsustainable, while Ireland and Portugal would have been extremely vulnerable. We also examine the case of vulnerable countries which have not received bailouts – Italy, Spain and Belgium. We conclude that while they can absorb some temporary rise, as has been seen in recent weeks, a significant further sustained rise – more than 100–200 basis points – would call their solvency into question in the absence of financial assistance.

We also examine the macroeconomic impact of the Greek debt restructuring that will follow from the resulting reduction in private sector wealth and bank capital. While the impact on Greece itself is, not surprisingly, substantial and negative, impacts on other European countries are small to negligible. The largest impact is on Germany where the impact on GDP might be –0.1 to –0.2 per cent over the period 2012–14. Clearly debt restructurings in other, larger Euro Area countries, if they should materialise, would have a substantially greater negative impact.