European debt woes in the so-called PIIGS countries (Portugal, Italy, Ireland, Greece and Spain) have captivated global attention and sparked a fresh wave of uncertainty recently.
The trouble began in late 2009 when Greece's new government announced the previous administration had understated deficits—subsequently tripling estimates from under 4% of GDP to over 12%. Similar announcements from Portugal and Spain spread fears of a "contagion" and global markets fell. The ensuing market decline through February was in all likelihood a fear-driven response to the murky European debt picture compounded by policy blunders. Specifically, EU officials took a hard-line stance, declaring Greece was on its own. Greece further exacerbated the situation by bungling a few debt auctions—underpricing its debt, stubbornly believing Greek bonds were attractive without any premium over prevailing market yields—only to be rebuffed by investors, upping anxiety and speculation.
Reversing course in late February, the eurozone backed Greece, offering a joint aid package with the IMF. Meanwhile, Portugal, Spain and Greece announced new fiscal austerity measures rife with spending cuts and lauded by markets. With tightened fiscal reins, implicit eurozone backing, and no appreciable fiscal deterioration since February, markets rebounded—until, that is, sentiment again soured in late April. Having only dipped their toes into markets with short-term debt at auction and facing fast-rising long-term yields, Greece officially shunned markets and requested eurozone/IMF aid. But again, politics were in play, roiling sentiment. It appeared Germany's (substantial) portion of the aid could be delayed. Upcoming local German elections and public disapproval had German politicians hemming, hawing, and bickering. Fear-based selling spiked, peaking on Thursday, May 6th, when a US stock exchange glitch sent markets awry and the ECB refused to buy government bonds to support European banks and maintain liquidity—a stand they reversed just three days later.
Investors feared a systemic freeze in interbank lending markets—a key component of the 2008 crisis. But importantly, the issues in 2008 are not comparable to recent events. Exhibit 1 shows the credit spread between LIBOR (the interbank lending interest rate) and the Fed funds target rate. A higher spread signifies increased credit risk, as shown after Lehman collapsed in late September 2008. It's key not to minimize the importance of interbank confidence—vital to overall financial market health. But notably, the most recent scare barely registers a blip in comparison to 2008.
Exhibit 1: Three-Month LIBOR–US Fed Funds Target Rate Spread
Source: Thomson Reuters; as of 5/18/10
After the volatile week ending May 7th, European leaders were convinced they needed to craft a massive preemptive response. (Whether they were right or merely swayed by market sentiment is, of course, now a moot point). Over the weekend, leaders announced a €750 billion bailout—more than enough to squelch current default concerns, if implemented properly. The package includes an immediately available €60 billion EU cash fund, €440 billion in eurozone government guaranteed loans, and €250 billion in IMF loans—covering Portugal, Ireland, Greece, and Spain's fiscal needs until the end of 2013 with €5 billion to spare (see Exhibit 2). (Note: It's appropriate to leave Italy out of this analysis because they're fiscally stronger than the other PIIGS nations. While debt levels are high, Italy has been staging fiscal improvements since the early 1990s, and their 2010 deficit is expected to reach just over 5% of GDP—equivalent to Germany's forecast deficit.)
Exhibit 2: Gross Government Financing Needs 2010-2013
Source: Barclays Capital Estimates, Bloomberg, Eurostat, National Sources; as of 5/12/2010.
But the above is a worst-case scenario, and it seems extremely unlikely a significant portion of the funds will be used—beyond Greece, the other PIIGS are still successfully auctioning debt. At the height of concern on May 5th and 6th, Spain and Portugal successfully raised capital. Italy followed suit on May 11th and Portugal again tested markets on May 12th and May 19th. All latter bond issuances garnered strong bids. Greece has chosen to avoid debt markets and had received its first aid payments of €20 billion to meet looming redemptions. But even Greek issues will eventually be publicly marketable. The European Commission recently said they expect Greece back at auction in 2011.
Besides these fiscal measures, the ECB reversed monetary course and has been purchasing PIIGS sovereign debt on secondary markets since May 10th. The emergency program has helped suppress yields, allowing governments to borrow more cheaply and relieving bank balance sheets (not unlike the Fed's purchase of mortgage-backed securities in 2008). Other ECB programs include resumption of unlimited longer-term liquidity operations and unlimited dollar availability from the Fed—helping banks stay liquid in the short term, should the worst-case event of an interbank lending market freeze occur.
While still early, improvements are visible. Exhibit 3 confirms yields contracted more than after previous promises of EU aid (late March and early May)—and have since stayed relatively low. Further illustrating the point, Portugal sold €1 billion worth of 10-year bonds on Wednesday May 12th at 4.5%, nearly two percentage points lower than where yields stood on Friday May 7th, when similar debt would have cost 6.3%.
Exhibit 3: Yield Spread Over 10-Yr German Bunds (since 10/1/2009)
Source: Thomson Reuters; as of 5/18/2010.
The bigger PIIGS debt picture appears manageable as well. An often overlooked statistic, net debt interest payments as a share of GDP, highlights a government's ongoing cost of debt. Current net debt interest payments (shown in Exhibit 4) look bearable both historically and in an absolute sense. Spain, Ireland, and Portugal will only allocate 1%–3% of GDP to debt interest in 2010. Italian recurring payments are larger, but their low current deficits mean debt financing needs are muted relative to much of the globe. Greece must deal with elevated ongoing payments and immediate financing needs, but the bailout provides more than enough coverage to fill any gaps.
Exhibit 4: Net Debt Interest Payments as % of GDP
Source: OECD. Germany represented by West Germany prior to reunification in 1991.
Make no mistake, an uncomfortable adjustment period lies ahead for all the PIIGS nations, with Italy perhaps the exception. Ireland, Portugal, and Greece are being forced to make deep wage cuts, reduce overall spending, and hike taxes. Such measures are inherently unpopular as shown by strikes and protests across the European periphery. Spain has already suffered weaker growth in the wake of a sunsetting construction boom, and further spending cuts may prolong the recession. But slightly better growth as things improve globally can drastically change a country's economic and fiscal picture, easing debt service.
Aggregate eurozone growth may suffer marginally from problems in the periphery, but Germany and France (half of the eurozone economy), are fundamentally strong. German unemployment has been falling for months and numerous manufacturing metrics, including industrial production and factory orders, are trouncing expectations. France was among the first nations in the world to emerge from recession and has been recovering for over a year. An accommodative ECB stance will also buoy growth and should not be discounted.
Immediate risks to the euro are contained, but questions surround the long-term future of the common currency. Combining divergent fiscal philosophies with monetary union is simply unsustainable. Appreciably, large spending cuts by heavily indebted nations are a start, and the EU is already proposing stricter fiscal surveillance rules (though this is not new, and previous rules have largely been ignored). National sovereignty must ultimately weaken to create a sustainable euro. But with the recent aid commitment, the process may proceed deliberately and in an organized fashion—as opposed to the forced, disorderly collapse investors fear. In the near term, more details about bailout measures will emerge, and volatility may continue as markets process the information. Ultimately it seems ever-strengthening global (and even European) fundamentals must be recognized and global markets will likely move higher.
Source: Fisher Investments, Thomson Reuters, Bloomberg, OECD, Barclays Capital, EuroStat, National Sources; as of 5/19/2010.