The euro area debt crisis is almost two years old. What initially started as a crisis that could have been contained with the right government actions has become a full blown crisis beyond the point of control. Let’s take a quick look at the key developments in the last two years.
From late 2009, fears of a sovereign debt crisis developed among investors concerning some European states, intensifying in early 2010. This included eurozone members Greece, Ireland, Italy, Spain and Portugal.
On 9 May 2010, Europe's finance ministers approved a rescue package worth €750 billion. The package aimed at ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF).
In October 2011, eurozone leaders agreed on a new rescue package. This included a proposal to write off 50% of Greek debt owed to private creditors, leveraging the EFSF to about €1 trillion and requiring European banks to achieve 9% capitalization.
In November 2011, Italy 10-year government bonds yielded more than 7%, reaching the point were other euro members required a bail-out (graph 1). Active buying from the ECB has pushed down the yield slightly.
Graph 1: Italy 10 year yield (source: Bloomberg)
With the debt crisis spreading to Italy it has evolved from a crisis impacting 6% of the eurozone GDP to one that is now impacting the core eurozone countries. It is becoming more and more likely that France is next. On November 3 French bonds rose two basis points to 3.11%. This pushed the spread with German bonds to 133 basis points. Germany, France, Italy and Spain make up about 75% of the euro area GDP.
Graph 2 gives an overview of the debt as percentage of GDP for the four biggest members of the euro area. Spain’s debt is lowest, but the country is running a deficit close to 10% a year. Even German debt, perceived as one of the safest in Europe, is more than 80% of GDP, getting very close to the 90% level that is generally seen as the tipping point, where debt starts negatively impacting GDP.
Graph 2: Debt to GDP percentage Germany, France, Spain & Italy
Click to enlarge
Overall euro area government debt as percentage of GDP has increased from 66% in 2007 to more than 85% in 2011. The overall euro area deficit is around 6%. Graph 3 gives a good indication of how the situation in the euro area has developed in the last five years (source: eurostat). Government deficits are increasing debt and it doesn’t look like this trend will reverse soon. This has decreased the firepower available to deal with this crisis. With overall debt at 85% and core eurozone countries being impacted, it is hard to see where the €1 or €2 trillion will come from to stop this crisis. The contagion has gone too far to be stopped through conventional measures.
Graph 3: Euro Area Debt, GDP and Key Metrics
The eurozone is the second largest economy in the world. The euro is the second largest reserve currency as well as the second most traded currency in the world after the U.S. dollar. It is consequently used daily by 332 million Europeans. Looking at these numbers it is difficult to imagine how a further escalating crisis in Europe would not impact the overall world economy. It is just a question of time before unconventional measures will be called on to contain the crisis.
This will need to happen through a combination of the ECB turning on the euro press to monetize debt, potentially in collaboration with the IMF, and a haircut for bondholders on the debt of some of the most indebted countries. The political will is not there yet and the crisis hasn’t gone far enough to make this happen. Get ready for a few interesting weeks that will see further escalation and eventually the ECB stepping in. Position yourself well to take advantage of the market volatility that will come with it.