Seeking Alpha
Long/short equity, deep value, value, special situations
Profile| Send Message|
( followers)  

I am in the process of finishing up my Sovereign Debt Crisis series with a massive global model of the interconnected relationships between sovereign nations. In the building of this model, the team and I came to the conclusion that many pundits are truly underestimating the lose-lose situation that the eurozone, CEE and the UK are in. I went to lengths to demonstrate the interconnectedness of banks and the risk of global financial contagion that they pose. See this excerpt from "The Coming Pan-European Sovereign Debt Crisis":

Sovereign Risk Alpha: The Banks Are Bigger Than Many of the Sovereigns (Click charts to enlarge)

image015.png

This is just a sampling of individual banks whose assets dwarf the GDP of the nations in which they're domiciled. To make matters even worse, leverage is rampant in Europe, even after the debacle which we are trying to get through has shown the risks of such an approach. A sudden deleveraging can wreak havoc upon these economies. Keep in mind that, on an aggregate basis, these banks are even more of a force to be reckoned with. I have identified Greek banks with adjusted leverage of nearly 90x whose assets are nearly 30% of the Greek GDP, and that is without factoring the inevitable run on the bank that they are probably experiencing. Throw in the hidden NPAs that I cannot discern from my desk in NY, and you have a bank that has problems, levered into a country that has even more problems.

image009.png

Many countries in the eurozone will have to do some serious belt tightening, and I don't mean just the current whipping boys of the media and Red Bull-juiced CDS traders either. (From The Coming Pan-European Soverign Debt Crisis, Pt 4: The Spread to Western European Countries.)

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 rollover debt due for 2010 of €281,585 million and €243,586 million, respectively.

eurodebt1.pngWhile Germany and France are expected to have the highest fiscal deficit of €125.1 billion and €96.0 billion, respectively, in absolute amounts 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. eurodebt2.png

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.eurodebt3.png

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.

PIIGS - A troublesome area

eurodebt5.png

So, pray tell, what happens when austerity measures hit these countries that need to rein in their debt from the (I say current, others say past) financial crisis by raising taxes, cutting services, firing state workers either outright or through attrition and reducing wages? The quick answer: lower aggregate demand for goods and services. Raise the price (through taxation), lower the demand. Lower income and wealth (through taxation, layoffs and wage decreases) and you lower demand as well.

What does this portend for the four or five largest economies on Earth (US, China, Germany, Japan and the UK), all of which also happen to be the largest exporters? Well, they obviously will be exporting a lot less. This is even more notable when you take into consideration those economies that are very heavily dependent on exports - e.g. China and Germany, the countries that are considered the anchors of stability right now. Germany cannot be the export and economic powerhouse that it currently is if the PIIGS, US, UK and the eurozone tighten their belts. China cannot bring the world out of recession if the world won't buy lots of their stuff. This means that these two countries will have to make a significant (negative) adjustment to counter the drop in global exports.

I never believed the sell side mantra of China leading the way out of this to begin with. This article explains the potential fallout of the excessive fiscal stimulus in China. While not European, it is quite likely to kick off the daisy chain effect.

Now, even assuming the bigger countries can handle it (even though, at the very least it will dampen GDP), the smaller countries reliant on exports may get crushed, transforming the economic contagion back into financial contagion to be injected into the Eurozone.

Austria, Belgium and Sweden, while apparently healthy from a cursory perspective, have between one quarter to one half of their GDPs exposed to central and eastern European countries facing a full blown Depression!

Click to enlarge...

cee_risk_map.pngThese exposed countries are surrounded by much larger (GDP-wise and geo-politically) countries that have severe structural fiscal deficiencies and excessive debt as a proportion of their GDPs, not to mention being highly "OVERBANKED" (a term that I have coined).

Countries in this region are highly dependent on foreign trade, with exports accounting for more than 50% of GDP for many countries. Sharp declines in exports have triggered a series of internal predicaments including rampant and rising unemployment as well as declines in domestic demand that exacerbate trade account imbalances through declines in imports. However, the problems for these countries have been aggravated by huge foreign indebtedness and the resultant interest and income payments that put additional pressure on the balance of payments. While currency depreciation could have provided some much needed respite (although that can be seriously debated), for countries like Latvia, Estonia, Lithuania, Bulgaria and Ukraine which have a fixed currency peg to Euro, the option is not available. As a result, Latvia, Lithuania and Estonia have witnessed double digit negative real growth in GDP and are witnessing structural issues of deflationary pressures (owing to price and wage cuts) and very high unemployment levels. Click any graphic to enlarge...

image010.png

image030.png

Source: IMF, European Commission

image049.png

The banking crisis (born from reliance on boom/bust cycle economics) deposited a very large problem in the lap of the economy. Simply transferring half of the problem to sovereigns while changing accounting rules to hide the other half does absolutely nothing to solve or even ameliorate hide the problem. At the very best, sovereign nations my have succeeded in quelling the risk of financial contagion leading to part two of the crisis in exchange for exporting economic contagion that will (on the optimistic side) restrain growth for at least a couple of years and quite possibly send us back into a global recession (and increasing possibility).

The upcoming presentation of the Sovereign risk model will tie the Economic vs. Financial contagion thesis together in a very big way. We are also going through the proposed austerity measures and plans of all of the major contributors to this contagion to inform subscribers of the practical likelihood of success, and if unsuccessful, the timing of the potential fall.

Disclosure: Short positions in many of the banks mentioned above

Source: Sovereign Debt: Is the Market Underestimating the Effect of Economic Contagion?