Euro Area Sovereign Debt Crisis: Putting the House in Order

The recent IMF recommendation for a second aid package to Greece -- amounting to 28 billion euros over the next four years -- helped push through the biggest sovereign debt restructuring in history, after Greece got private investors to forgive more than 100 billion euros in debt. The IMF decision, announced by Christine Lagarde late last week, also marks yet another chapter in the ongoing saga of the European sovereign debt crisis. From the seats of distressed national governments in Athens, Dublin, and Lisbon, to the European Central Bank in Frankfurt and the European Financial Stability Facility in Luxembourg, European leaders continue to grapple with getting sovereign debt levels under control, restructuring balance sheets, and cutting spending.

The IMF's second aid package to Greece came three years into the euro area sovereign debt crisis, as investors continue to shun periphery government bonds, European Banks remain under severe funding pressures, and as the euro area faces an anemic growth outlook. According to the World Bank's Global Economic Prospects report released in January of this year, the Bank has lowered its growth forecast for 2012 to -0.3 percent for the euro area, down from its June estimate of 1.8 percent growth.

On the face of it, prospects look bleak. But according to the most recent Economic Premise, there may be hope for Greece and other countries riddled with high levels of sovereign debt. In "Looking beyond the Euro Area Sovereign Debt Crisis," Mansoor Dailami of the World Bank's Development Prospects Group argues while the current scenario portends gloom, "the future scenario looks more balanced, particularly following the conclusion of protracted negotiations on Greek bond exchanges under an EU-backed voluntary private sector involvement scheme." As leaders work to formulate significant structural reforms, Dailami highlights the importance of striking a balance between market discipline and centralized rule-making as the best way forward in light of the current crisis.

Indeed, a key element to moving the euro area beyond the sovereign debt crisis is to shore up the balance sheets of European banks that have large exposures to troubled sovereign debt. The second round of IMF support to Greece is a good step in this direction as it will dramatically reduce medium-term financing needs and contribute to debt sustainability. However, restoring competitiveness and a sustainable fiscal position in countries like Greece will require governments to undertake sustained and deep structural reforms for years to come.