The widening European sovereign debt crisis

Euroland is coming apart at the seams. Belgian/Bund spreads are now also over 200bps along with Italy and Spain. Belgium has just entered the periphery and France is not far behind.

Right now there are four to five separate groups in Euroland’s sovereign debt crisis. First, there is Greece, assumed by everyone to be insolvent and the only country to default via its bailout package which reduces creditor repayments by 21%. Then there are Ireland and Portugal. These two countries have also received bailouts but have not defaulted. Next are Spain and Italy, what I have called “the new Ireland and Portugal”. These two countries are seeing their spread to German bunds widen considerably and yields explode above 6%. Fourth is a new and worrying development with Belgium and France becoming untethered from the core. Spreads are widening for these two countries in a way which is dangerous. Finally, there is the core of Germany, Finland, Austria, the Netherlands, Luxembourg, Malta, Slovakia and Slovenia. Estonia and Cyprus are special cases: one is new to the zone and the other has unique problems that I won’t discuss here. That’s 15 countries in six distinct categories (plus Estonia and Cyprus).

Greek, Irish and Portuguese yields have calmed due to the latest bailout. Spain and Italy are now on the hot seat. But my main concern is not Italy and Spain; it is Belgium and France.

This morning FT Alphaville quotes Divyang Shah of IFR Markets:

The 10-year spread on France/Germany has widened out beyond its July peak to its widest level since mid-1990. The 10-year spread on Belgium/Germany has broken through 200bps and currently at 203bps is close to breaking its record wide level just under 215bps from early 1999. Both are significant, but especially so the moves seen in France. It suggests that investors no longer regard it as part of the core and have been for the last few weeks trimming exposure.

Welcome to the periphery. And note that Belgium is now also over the 200bps spread to Bunds that I had said the ECB should target as a maximum for Italy.The problem here is that as more and more countries keep getting plucked off and put into the penalty box, there are fewer and fewer players left to skate. Once France has difficulties, the core only has one country i.e. Germany which is a truly large economy. In my view, that is the end of the line.

Was this inevitable? Well, here are a few thoughts about the euro crisis and the psychology of change from fourteen months ago saying it may have been:

When was the last time an unsustainable economic situation was solved without a crisis? Seriously, that’s a question. I can’t think of one. The way I see it, politicians are always focused on the short-term and that invariably means kicking the gas can down the road until it catches fire and you have to call in the fire department…

But now that it has gone pear-shaped, the EU has repeatedly tried to get through this crisis by making little fixes and tweaks without addressing the fundamental problems of excessive sovereign debt on the one hand and bank undercapitalisation on the other. They have their heads buried in the sand. Instead, politicians have argued that markets are acting like a speculating pack of wolves and creating crisis where none exists. Look at Jeffrey Sachs’ comments in the clip I showed you with Hugh Hendry and Gillian Tett. That’s the kind of rhetoric you see. Well, the wolfpack is at the door and they are going to rip the Euro house to shreds unless the bank capitalisation and national solvency issues are addressed without trying to socialize the losses across the entire euro zone.

This is pretty much the view that Pippa Malmgren took when talking to CNBC Europe last week about the European sovereign debt crisis…

Here’s what you should take away from her comments:

  1. On kicking the can: "If you’re going to make a bet on the European banking system which is purely based on the idea that policy makers will consistently bail them out, then you have to ask questions about the capacity of policy makers to deliver on that promise."
  2. On markets as a pack of wolves: "That is fine as long as the market doesn’t call their bluff… Do I think the markets are going to call their bluff? The answer is yeah, because that’s what markets do."
  3. On the psychology of change: "The thing is, in markets and politics, you have to have a crisis to get a solution. That’s the way it works. It always works this way."

I would suggest the capacity of policy makers to deliver on that promise is now exceedingly low. Either we get the ECB in here to provide liquidity while the Euro’s structural deficits are worked out or the game is over.

Note: This post has been changed to use Estonia in place of an earlier erroneous reference to Lithuania as part of the euro zone.

  1. Pedro Macedo says

    I believe you have mistaken Lithuania for Estonia since Lithuania is not even in the Eurozone and Estonia is the last country that joined the Euro.
    In what concerns to “…the markets acting like a speculating pack of wolves and creating crisis where none exists” I would say that more than the markes the rating agencies (particularly Moody’s) are the ones acting like a speculating pack of wolves, and are worsening a crisis that does exist and it’s serious.

    1. Edward Harrison says

      Sorry, yes, I did mean Estonia. Thanks. And I agree that the ratings agencies are making up for their errors during the housing bubble by perhaps being overly aggressive now. But we should look at them as indicative directionally rather than using them for credit analysis which is what everyone does now. The ratings agencies should have a diminished role.

  2. Namazu says

    Any thoughts on why EUR/USD is holding up reasonably well?

    1. Edward Harrison says

      Both economies are showing weakness and crisis so there hasn’t been a catalyst to break out of the trading range. You see both falling against the commodity currencies and the Swiss franc.

  3. David Lazarus says

    I am not so sure that France will be the last to fall. I still think that Germany is going to fall. It might be a huge diversified economy, but give it time I still think that Germany will become a target of speculators. As for Britain and Switzerland, I think both these countries could face problems. The UK because austerity will increase the debt burden, and I doubt that they have learnt the lessons of Ireland or Greece. The Swiss have a different problem, and that could be the toxic debts still on the banks balance sheets. Until they are clean expect problems at some point from Swiss banks.

  4. Henri Myllyniemi says

    I’ve got really hard time to keep tracking some of these European banking majors’ market values, their exposure on different “grade states” (according to EBA and its CT1 requirement) as you mentioned. When adding the CDS-spreads trying to figure out how much these “voluntary haircuts” are expected, all I got is a messy living room with dozens of papers.

    Mr. Berlusconi came out in public from his bunga-bunga parties and told there’s not enough faith in Italy. I think it’s Italian banks trying to make the ends meet? E.g. Intesa Sanpaolo’s books concerns lots of Italian debt and very little others, while its P/E hugs ground.

    I know these figures vary very rapidly depending on which eurodespots are on the tv-screen (and how often) but is there any good source of these exposures, I prefer graphics. Thank you.

    Or am I expected to turn more religious so that mr. Berlusconi can have more of his parties? It looks like more requiem for the people, though.

  5. Daniel Pennell says here we go.

    Question is; Who benefits from this mess? From my perspective it would look like nobody wins it is only a matter of degree of the loss.

    That said, I think the next test case for bank failures is going to be Bank of America. It is on a definate glide path to insolvency and I just do not see the Tea Party wing of the republican party standing by while it is bailed out again and I do not see the democrats or Obama wanting to be seen as allowing it either and getting hammered by the republicans for it.

    Guess we get to find out if the government of a major economy is ready, willing or able to jump in and bail out another systemicly important bank. My guess is no. They want to send a message.

    Hope FDIC has its wind down plans in place.

    1. David Lazarus says

      The hedge fund mangers are the only ones winning. The funds might do well but the managers will take their profits regardless.

      As for the FDIC I see it being kept busy for years. The numbers of at risk banks is still close to 1000 and that is after the hundreds of closures. The problem is that the banking system is sucking up trillions of dollars at everyone else’s expense and delivering nothing for it. I personally would like to see all the big 19 US banks fail and then smaller banks taking over. The investment banks should not be allowed access to Fed funds. The claims that big banks will give us new overseas markets ignores the fact that they are now just trying to exit the US because they see no future there. If US debts were written down to a level that would create surplus income and opportunities then the big banks would collapse. The economy would be good but the banks would be dead.

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