Rising fiscal deficits and pending bond maturities due in 2010 are paving the way for the next wave of the pan-European sovereign debt crisis. This next wave is supply, potentially in excess of demand, which portends higher yields and more onerous debt servicing at a time of record fiscal spending!
Please read the following in sequence if you have not already done so for the requisite background to this post:
- Can China Control the "Side-Effects" of its Stimulus-Led Growth? Let's Look at the Facts - Explains the potential fallout of the excessive fiscal stimulus in China
- The Coming Pan-European Sovereign Debt Crisis - introduces the crisis and identified it as a pan-European problem, not a localized one.
- What Country is Next in the Coming Pan-European Sovereign Debt Crisis? - illustrates the potential for the domino effect
- The Pan-European Sovereign Debt Crisis: If I Were to Short Any Country, What Country Would That Be.. - attempts to illustrate the highly interdependent weaknesses in Europe's sovereign nations can effect even the perceived "stronger" nations.
Expected higher fiscal deficit and bond maturities due in 2010 have increased the need for bond auction financing for all major European economies.
Amongst all major European economies, France and Italy have the highest roll over debt due for 2010 of €281,585 million and €243,586 million, respectively.
While Germany and France are expected to have the highest fiscal deficit of €125.1 billion and €96.0 billion, respectively in absolute amount for 2010 (this is without taking into consideration any possible bailout of Greece and/or the PIIGS, which will be a very difficult political feat given the current fiscal circumstances), Ireland and Spain are expected to have the highest fiscal deficit as percentage of GDP of 12% and 11%, respectively.
Overall, in terms of total financing needed for 2010 (which includes 2010 bond maturities, short-term roll over debt and fiscal deficit), France and Germany top the list with € 377.5 billion and €341.6 billion, respectively, while the total finance needed as percentage of GDP is expected to be highest for Belgium and Ireland at 26.3% and 22.4%, respectively.
However, the recent spate of bond auction failures across Europe is forcing governments to increase premiums on new bond auctions (higher yields), which in turn is resulting in a decline in existing bond prices.
As this phenomenon continues, the requirement to garner the required funds to finance scheduled debt repayments and ballooning fiscal deficit will force interest rate increases (due to market forces) by the central government agencies in these countries - a situation which will be unwelcomed in the current situation due to perceived multi-faced negative consequences.
This will, on the one hand, impact banks with exposure to government bonds, but will also have the impact of draining liquidity (excess funds) out of the economy - a factor which has been instrumental in driving the current rally in global securities markets since the March of last year - a rally that we feel has flown in the face of both the fundamentals and the global macroeconomic outlook. A rise in interest rates (other things remaining constant) is an unwelcome phenomenon for banks, as the interest rate spread (difference between interest rate earned and interest rate expended) narrows.
According to a recent Economist story:
The bigger concern, however, is not banks' direct exposure to government bonds, which average just 5% of euro-zone banks' assets, but the impact on their financing. The costs of funding for banks on Europe's periphery are rising in tandem with the allegedly "risk-free" benchmark rates on the bonds of troubled European governments. [The same risk is in store for US banks.] Steep downgrades of the sovereign-debt ratings of countries such as Portugal, Greece and Ireland would probably translate into immediate rating cuts for their banks, as well as higher capital charges on banks' debt holdings and bigger haircuts when using this debt as collateral. Regulators are busy designing rules forcing banks to hold more government bonds on the assumption that they are the most liquid assets in a crisis. That premise may not hold for every country's debt.
The current PIIGS scenario will put this theory to the test, most likely within one to two fiscal quarters.
The impact of even a small change in a bank's borrowing costs can be extreme. According to JPMorgan, an increase of just 0.2 percentage points in the borrowing costs of British banks such as Lloyds Banking Group and Royal Bank of Scotland (RBS) would trim their earnings by 8-11% next year, assuming they could not immediately pass these costs on to customers (an increasingly unlikely event).
Overall and contrary to many optimistic reports, the prospects of sovereign default across ALL major European countries are fearsome, and they are also quite real. This is particularly true in France, Greece and Italy, which have a significantly high share of debt and fiscal deficit as a percentage of GDP, and thus need to raise high levels of debt to meet their total finance need in an environment that will reflexively raise their borrowing costs whenever they attempt to hit the market. As it is, we have had several major European bond failures to date, and the heavy borrowing is just getting started.
PIIGS - A troublesome area:
Greek banks are the most exposed to the fallout as they hold about €39 billion of government debt, roughly equivalent to the amount of capital they have. Further, there are rumours that Greek banks have also been keen sellers of credit-default swaps on sovereign Greek debt, in effect doubling up on their exposure to a debt crisis.
This is telling, as one or the most important Greek banks is a publicly traded entity that sports almost 90x adjusted leverage. This leverage supports assets that total nearly 30% of Greece's GDP. This country's institutions appear to be literally resting on splintery stilts. (It is recommended that subscribers download the following for a list of Greek banks that we found to have material exposure: Greek Banking Fundamental Tear Shee 2010-02-17 02:57:39 420.93 Kb.)
Moreover, a fallout in Greece is expected to have an adverse impact across European banks as about 60% of the Greek government bonds issued over the past few years were sold to non-Greek European buyers (half of whom may have been banks) according to Commerzbank. The extent of this impact is not known (at least by me) at this time, and may be limited in absolute scope, but may spark a domino effect in relative terms.
Aside from Greece, fallout from other troubled sovereigns that make up the acronym PIIGS (Portugal, Ireland, Italy, Greece, Spain) is also a concern for the whole of European banking sector. According to the BIS, European banks have $253 billion at stake in Greece and $2.1 trillion with the other troubled sovereigns. Further, banks in Germany and France have a combined exposure of $119 billion to Greece and $909 billion to the other four members that make up PIIGS.
We should not forget the US banks, which have less exposure to the troubled eurozone countries in relative terms, but material exposure nonetheless. According to Barclays Capital, the ten biggest American banks have total exposure of $176 billion to Ireland, Portugal, Spain and Greece.
I believe that Greece's borrowing costs will spike significantly, whether they receive a bailout or not. Basically, their credibility has been shot. Reference the following news stories.
Jan. 6 (Bloomberg) -- Greece rejected speculation that it will need a bailout to tackle the European Union's biggest budget deficit as officials fly in fromBrussels to scrutinize tax and spending plans.
"We don't expect to be bailed out by anybody as, I think, is perfectly clear we're doing what needs to be done to bring the deficit down and control the public debt," Finance Minister George Papaconstantinou said in an interview with Bloomberg Television today.
Papaconstantinou Says Greece Wants to Repair Credibility: Video ... but then appears to be contradicted...
Greek PM says EU took too long to show support February 12, 2010 | Source: The Associated Press Greek Prime Minister George Papandreou on Friday criticized the European Union as "timid" and too slow to express unified support for his country during its financial crisis, a day after Greece won backing - but no detailed bailout plan - at an EU summit
EU summit to get to grips with Greece rescue plans February 11, 2010 | Source: Reuters
EU Discusses Aid for Greece But No Decision Imminent February 10, 2010 | Source: Reuters: Euro area finance officials said bilateral aid by individual EU members, chiefly Germany and France, or guarantees for Greek debt issues appeared the most likely solution but they cautioned that no decision was imminent
EU officials wrangle over possible Greece rescue February 10, 2010 | Source: The Associated Press European Union governments are wrestling over how to help Greece, whose debt crisis has shaken the EU and undermined the shared euro currency.
Jan. 28 (Bloomberg) -- Greece's first "deficit" is its credibility gap, Prime Minister George Papandreou said today at a panel event at the World Economic Forum in Davos, Switzerland.
Jan. 12 (Bloomberg) -- Greek stocks and bonds tumbled after the European Commission said "severe irregularities" in the nation's statistical data leave the accuracy of the European Union's largest budget deficit in doubt.
Feb. 17 (Bloomberg) -- Goldman Sachs Group Inc. managed $15 billion of bond sales for Greece after arranging a currency swap that allowed the government to hide the extent of its deficit.
No mention was made of the swap in sales documents for the securities in at least six of the 10 sales the bank arranged for Greece since the transaction, according to a review of the prospectuses by Bloomberg. The New York-based firm helped Greece raise $1 billion of off-balance-sheet funding in 2002 through the swap, which European Union regulators said they knew nothing about until recent days.
Failing to disclose the swap may have allowed Goldman, a co-lead manager on many of the sales, other underwriters and Greece to get a better price for the securities, said Bill Blain, co-head of fixed income at Matrix Corporate Capital LLP, a London-based broker and fund manager.
"The price of bonds should reflect the reality of Greece's finances," Blain said. "If a bank was selling them to investors on the basis of publicly available information, and they were aware that information was incorrect, then investors have been fooled."
... The yield on Greek 10-year government bonds jumped to as much as 7.2 percent on Jan. 28 amid the worst crisis in the euro's 11-year history. Thepremium, or spread, investors demand to hold Greek 10-year notes instead of German bunds, Europe's benchmark government securities, widened yesterday by 18 basis points to 323 basis points.
The spread reached 396 basis points last month, the most since the year before the euro's debut in 1999, compared with an average of 57 basis points in the past decade. A basis point is 0.01 percentage point.
"When people start to fear that the numbers aren't accurate, they fear the worst," said Simon Johnson, a former International Monetary Fund chief economist who is now a professor at the Massachusetts Institute of Technology's Sloan School of Management in Cambridge, Massachusetts.
... The swap enabled Greece to improve its budget and deficit and meet a target needed to remain within the region's single currency. Knowledge of their existence may have changed investors' perception of the risk associated with Greece, and the price they may have been willing to pay for the country's securities.
... European Union officials said this week they only recently became aware of the transaction with Goldman. The swaps don't necessarily break EU rules, European Commission spokesman Amadeu Altafaj told reporters in Brussels on Feb. 15.
The transaction with Goldman consisted of a cross-currency swap of about $10 billion of debt issued by Greece in dollars and yen, according to Christoforos Sardelis, head of Greece's Public Debt Management Agency at the time.
That was swapped into euros using a historical exchange rate, a mechanism that implied a reduction in debt and generated about $1 billion in an up-front payment from Goldman to Greece, Sardelis said. He declined to give specifics on how the swap affected the country's deficit or debt.
European politicians such as Luxembourg Treasury Minister Jean-Claude Juncker this week criticized Goldman Sachs for arranging the Greek swap and are pressing the firm and Greece for more disclosure. Chancellor Angela Merkel's Christian Democrats aim to push for new rules that will force euro-region nations and banks to disclose bond swaps that have an impact on public finances, financial affairs spokesman Michael Meister said.
"Investment banks are guilty of being part of a wider collusion that fudged the numbers to make the euro look like a working currency union," said Matrix's Blain. "The bottom line is foreign exchange and bond investors bought something sellers knew not to be the case."
Disclosure: Author holds a short position in certain banks and sovereign debt in/of eastern Europe and Spain