The sovereign debt crisis: Structural reforms and country risk

Miguel Cardoso, Rafael Doménech 13 December 2010



Fiscal policies have been at the centre of the policy debate throughout the crisis – and with good reason. When activity in most advanced economies was falling sharply, experts and analysts, international institutions, and the public asked for active discretionary fiscal stimulus. At that, time reducing private-sector uncertainty was crucial to reducing tensions in financial markets. Later, once most economies had escaped from recession, the attention of financial markets focused on the sustainability of the newly burdened public finances. As a consequence of these subsequent financial tensions, Europe has faced two episodes of sovereign debt crises. In May it was Greece; in November it was Ireland. 

During this period of sovereign debt crises, financial markets have been putting more emphasis not only in government capacities for achieving fiscal consolidation, but also in the ability of their economies to sustain high GDP growth rates in the medium term without the support of fiscal and monetary policies. Thus, the different risk perceptions of advanced economies by financial markets reflect a combination of differences in terms of public budget deficit and debt levels (particularly held by foreigners) and expectations of future growth. But this combination of determinants of risk premia should not be surprising at all – the sustainability of the public debt to GDP ratio depends simultaneously on the ability to reduce public deficits and on the growth prospects of each country, which also depend on the structural capacity of their economies.

New evidence on structural capacity across countries

Differences across countries on their structural capacity are very relevant as Table 1 illustrates. The data in this table is based on the information provided by the IMF in its latest Regional Economic Outlook: Europe (2010). The information provided in this IMF publication is qualitative and refers to the need for structural reforms in nine areas (five of them are medium-term indicators and four refer to long-run determinants) in a sample of 16 developed countries. We have transformed this qualitative information into a quantitative indicator using the following procedure; we apply a score from 1 to 3 to each of the nine variables, where a higher score indicates a greater need for structural reforms. The advantage of this simple approach is that it allows us to obtain an average value for each country, labelled Structural Capacity Indicator, with information of the relative position of all of them with respect to the sample mean (1.7). Thus, the Netherlands, Denmark, and the UK are the countries that show the best scores (1.1), followed by Sweden, the US, and Japan. In the other extreme of the range, Greece (3.0) is the country where the number of structural reforms needed is larger. Germany (1.6) is slightly better than the simple average, whereas France is slightly worse (1.9), followed by Spain (2.2), Portugal (2.4) and Italy (2.6). According to Table 1, Ireland’s economy is not perceived to be that burdened with rigidities, regulations, or lack of infrastructure.

Table 1. The need for structural reforms

Source: IMF Regional Economic Outlook: Europe (2010) and own calculations.

As Figure 1 shows, relative income per head is closely correlated to the capacity indicator (the correlation is statistically significant and equal to -0.73)1. This result is not surprising at all. In fact, structural reforms in the nine areas covered by Table 1 are aimed at increasing labour productivity and/or the employment rate in the medium and long run (see, among others, Nicoletti and Scarpetta 2003, Blanchard and Giavazzi 2003, or Sapir et al. 2003).

Figure 1. Relative income per head and Structural Capacity Indicator

Figure 2. Relative income per head and human capital

As can be seen in Figure 1, the four countries where the need for structural reforms seems to be concentrated are also the countries with lower income per head in the sample. Among these four countries, only Spain gets a score of 1 in any of the categories (signalling no major need for improvement in those areas), while almost 60% of the scores are a 3. But most importantly, in the areas that determine long-term growth and in which transitions and reforms take a long time to develop, these four countries are lagging – especially with respect to the rest of their peers.

In this regard, the relative position of human capital is particularly worrying for these countries. Figure 2 shows that the correlation between the share of working-age population with at least secondary education (relative to the US) and relative income per head is very high (equal to 0.9)2. As shown in Figure 2, there is an obvious and significant gap between countries and, as was said before, one worrying aspect of this gap is that it will persist for a long time since working-age population changes slowly, so narrowing human capital differences will take several decades.

Risk premia and structural reforms

Since differences in the structural capacity of economies have implications for their productive capacity, financial markets are also concerned with the progress in structural reforms. As we said before, the stabilisation of the public debt-to-GDP ratio and eventually its fall depends on the success of fiscal consolidation and on potential growth, which at the same time depends on structural capabilities of the economies. Thus, it is not surprising at all that in the sample of the 16 advanced economies in Table 1 the correlation between the structural capacity indicator and the country risk premium, measured by the average 5-years credit default swaps in October 2010, is very high and positive (0.75).

In fact, according to our results, the structural capacity indicator comes out as the most robust and statistically significant variable in a regression analysis alongside more usual risk determinants such as public sector deficit, public debt, external debt or net international investment position3.

Figure 3. Risk premia (5y credit default swaps) and the structural capacity indicator

Figure 3 shows the close correlation (0.85) between the structural capacity indicator and the average country risk premia, once the impacts of public sector deficit and external debt/credit ratio are stripped out of both variables4. This positive relationship confirms that one of the concerns of international financial markets in the current sovereign debt crisis relates to economies’ medium-term growth potential. Many economies will have to absorb heavy quantities of debt in the future, which will always be easier if households, companies, and the government are able to deleverage in a context of strong economic growth.

These results support the attention that financial markets are paying to the implementation of structural reforms in those economies with larger spreads. The positive differentiation in sovereign debt markets that Spain went through after a particularly fast and significant period of economic reform between May and July 2010 was a good example of this attention. Within two months, the Spanish government made some progress reassuring markets regarding fiscal targets, imposing a new labour market reform and pushing for a restructuring of the financial system that had lagged for too long. After these developments, the Spanish sovereign risk premia fell significantly. More recently, after Ireland’s rescue, the acceleration and implementation of structural reforms in the Spanish economy have again received renewed interest in financial markets, explaining the reaction of the Spanish government to show its commitment to the reforms under way (collective bargaining reform and banking restructuring, among others) as well as with the public deficit reduction, both in the short and long run (the pension system reform).

To sum up, it is important to press boldly ahead with the reform process in countries where the sovereign debt problems are more intense, not only to generate higher employment and income per head over the medium and long term, but also to improve perceptions of financial markets in the short run regarding sovereign debt risk. Advances in this direction would go a long way in reassuring investors on the success of fiscal consolidations in those countries that improve their future growth potential through appropriate structural reforms.


Afonso, A and C Rault (2010), “Short and Long-run Behaviour of Long-term Sovereign Bond Yields”. CESifo Working Paper 3249.
Attinasi, MG, C Checherita, and Ch Nickel (2009), “What Explains The Surge In Euro Area Sovereign Spreads During The Financial Crisis Of 2007-09?”, Working Paper 1131, European Central Bank.
Blanchard, O and F Giavazzi (2003), “Macroeconomic Effects of Regulation and Deregulation”, Quarterly Journal of Economics, 118:879-907.
Manganelli, S and G Wolswijk (2009), "What Drives Spreads In The Euro Area Government Bond Market?", Economic Policy, 191-240.
Nicoletti, G and S Scarpetta (2003), “Regulation, productivity and growth: OECD evidence”, Economic Policy, 9-72.
Sapir, A, P Aghion, G Bertola, M Hellwig, J Pisani-Ferry, D Rosati, J Viñals and H Wallace (2003), An Agenda For A Growing Europe. Making the EU Economic System Deliver. European Commission.
Sgherri, S and E Zoli (2009), “Euro Area Sovereign Risk During the Crisis”, IMF Working Paper 09/222.

1 Income per head is measured as Gross National Income (GNI) over working-age population and expressed in relative terms to the Unites States (equal to 100). The use of Gross National Income instead Gross Domestic Product is particularly relevant in the case of Ireland. To avoid distorting the relationship between these two variables due to the varying impacts of the 2009 crisis, GNI over working-age population refers to 2008. The source of these data is the OECD’s Analytical Database.
2 The share of working-age population with at least secondary education comes from OECD’s Education at a Glance (2010).
3 Recent contributions include Attinasi et al. (2009), Sgherri and Zoli (2009), Manganelli and Wolswijk (2009), and Afonso and Rault (2010). Unlike our analysis, none of these papers include an indicator for the structural capacity or potential growth of the economy.
4 The slope of the regression curve shown in Figure 3 is equal to the regression coefficient of the SCI variable in an equation where the dependent variable is the CDS and which includes the public sector deficit and the external debt/credit ratio as additional regressors.



Topics:  Europe's nations and regions Macroeconomic policy

Tags:  Italy, Spain, Ireland, Greece, Eurozone crisis, Portugal, structural reform

Chief Economist for Spain, BBVA Research

Head of Economic Analysis of BBVA Research and Professor of Economics at the University of Valencia


CEPR Policy Research