March 28th, 2011 | By Nick SargenApril will mark the one year anniversary of the European sovereign debt crisis, which represents the first major test of the Euro-zone since its inception in 1999. While worries about European debt have faded and events in the Middle East/North Africa and Japan have moved to the forefront, investors should not become complacent about European sovereign debt. In fact, by some measures, problems may be brewing again.
One year ago, as the debt crisis spread from Greece to other countries in the periphery including Ireland, Portugal and Spain, European policymakers were unable to agree on how to deal with the situation. It is very complicated, because the underlying cause of the problems varies by country. Greece, for example, had an outsized budget deficit and was unable to compete at the existing exchange rate, while the problems in Ireland and Spain mainly emanated from the need to backstop their banks and savings institutions. Also, French and German banks held significant exposure to these countries and lacked adequate capital.
Accordingly, the European Union’s (EU) initial response was to negotiate with each country separately and hope that the markets would calm down. When that tactic failed and Greece reached a boiling point, European officials came up with a comprehensive plan that included the establishment of a European Financial Stability Facility (EFSF) to provide temporary financing for troubled sovereign borrowers. The objective was to provide sufficient financing so these countries would not have to tap the capital markets (and pay very high interest rates) for at least three years. Put simply, the goal was to buy time so that Europe’s economy and financial system would not be rocked by another crisis while it was still very fragile.
This bolder strategy appeared to work for a while: Europe’s economy proved to be resilient thanks to strong growth in Germany, and various measures of credit risk suggested that problems in the periphery were being alleviated. This year, however, headwinds to European growth have been intensifying: The euro has appreciated: fiscal austerity is being felt in the periphery; higher food and oil prices have boosted inflation; and the European Central Bank appears poised to tighten monetary policy.
Against this backdrop, European officials were hoping they could bolster investor confidence by taking more permanent action to lessen the risk of widespread sovereign defaults in the euro-zone. Towards this end, the heads of state of the EU met last week to set the stage for the post-2013 period by announcing plans for a permanent rescue fund (called the European Stability Mechanism) to be launched in mid-2013. The ESM will have lending capacity of E500 billion, backed by a E700 billion capital base. It essentially will serve as a European variant of the IMF, in which funding is granted to troubled countries at below-market rates in return for strict conditions on the management of their public finances.
If the intent was to reassure investors, however, European officials must be disappointed by the initial reaction to the announcement: Government bond yields for Greece, Ireland and Portugal surged and currently are at or near recent highs. One reason is that the terms established for the ESM confirm that if a country is deemed to be insolvent, private sector creditors will have to participate in any debt restructuring and they will be subordinate to the ESM in terms of repayment. Previously, when officials were trying to allay bond market concerns, they stipulated that a loan extended by the temporary (ESFS) facility would have the same standing as a private creditor. In this respect, the latest arrangement is less friendly to bond investors.
This begs an obvious question: How likely is the incidence of default?
Judged by prevailing rates on credit default swaps, investors are assigning high probabilities over the next five years for Greece (56%), Ireland (41%) and Portugal (37%). The prevailing view is that Greece simply has too much debt on its hands, and that a restructuring is likely at some point. The EU apparently acknowledges this possibility, as it recently lowered the interest rate it charges on Greece’s borrowing. The EU has made a similar offer to the Irish government, but the offer is contingent on Ireland raising its corporate tax rate – an action the newly-elected Irish Government believes would damage the economy. In the case of Portugal, the Government sought to take stronger action to curb its budget deficit rather than borrow from the EU. However, this proposal was defeated in parliament and has necessitated new elections.
While these developments are not encouraging, one bit of good news is that the markets have become more sanguine about the prospects for Spain and Italy: Their credit default spreads have narrowed recently, and their associated default probabilities are not excessively high. This is important from a global perspective, because Spain and Italy are considerably bigger than the three crisis countries, and their banks are also much more integrated into the world financial system.
My own assessment is that Spain is the pivotal country that could dictate whether the sovereign debt crisis is contained or morphs into a bigger issue. In this regard, the Spanish Government has taken action to bolster the country’s financial system by enacting legislation to increase the capital requirements for cajas (regional savings banks). The Bank of Spain, for example, recently raised capital requirements for 12 institutions by E15.5 billion. While this tally is short of the E50 billion figure cited by Moody’s and Fitch, it has calmed concerns for the time being, and Spanish banks have been able to reduce their borrowings from the ECB significantly in recent months. The Government has also announced fiscal measures that include salary cuts for public employees, and the ratio of government debt to GDP is very manageable at 63%.
Weighing these considerations, I believe the most likely outcome is that the EU and respective sovereign borrowers will be able to strike agreements that postpone the day of reckoning for Greece, Ireland and Portugal. While some concessions on outstanding debt may be required eventually, the authorities and bondholders likely will prefer to roll-over debt obligations in the meantime.
Whether this situation develops into a full-blown crisis at some point is hard to tell. However, I suspect any spill-over to the United States will be limited, because U.S. exposure to Greece, Ireland and Portugal is relatively small. As noted previously, Spain is important both to Europe and the global financial system. The good news here is that it has been successful thus far in differentiating itself from the problem countries.
Finally, whatever the ultimate outcome, it’s fair to say that one year after the crisis surfaced, the issue of European sovereign debt has not been resolved. In fact, there are some storm clouds on the horizon that could add to market volatility.