EU Debt Crisis, May / June Update: Imminent Default Threat Off, But Deterioration Continues

by: Cliff Wachtel

If you haven’t been keeping up with the European Debt Crisis, here’s your chance to get up to speed fast.

Imminent Default Threat Off, But European Deterioration Continues

Since the €750 bln EU/IMF (mostly US) rescue plan of early May, fears of imminent default have eased as most agree that there is enough cash in place to keep the most likely default candidates like Greece and Portugal out of default for the coming 3 years.

Otherwise, the crisis is in fact worsening as events feed an already self feeding crisis in confidence that sends borrowing rates higher and pushes nations into deeper economic trouble. Indicators of deteriorating confidence in the EU include the following:

  • Long Term Euro Downtrend

The EUR continues to plunge through long term support levels to 4 year lows, breaking through key support like the historical midpoint of its range at 1.2160 and then 1.2000.

  • Growing Default Contagion Fears

Contagion threat continues and grows: CDS spreads (the added cost to insure bonds over that of relatively risk free German bunds) continue to rise not just for the PHIIGS (PIIGS + Hungary) but also for more reputable (?) EU nations like, Germany, France and Sweden (Austria and Belgium are known to not be in great shape). Note the percentage changes as of June 4th. Note the table below as of June 4th ():

Table Courtesy of 17jun08

Ditto for other more trusted nations outside the EU, including the US, New Zealand, Australia and the Czech Republic ():

Table Courtesy of 18June08

Why? In sum, we're seeing a crisis in confidence fed by new events and the momentum it generates.

Recent Events

Recent events getting big play in the media feeding the ongoing fears about the EU include:

  1. Credit downgrades and bank failures in Spain
  2. Hungary’s announcement that the prior government has left the nation at risk of default
  3. Continued evidence that aid donors and recipients won’t be able to keep to the EU/IMF plan commitments
Can We Count On Germany?
  • Legal Challenges To German Bailout Payments: According to Der Spiegel, Germany’s high court may rule on the legality of German guarantees under the EU/ECB/IMF Stability Mechanism. It is not clear if the Constitutional Court would block German participation in the rescue plan, but the risk of this is now higher. Moreover, it further undermines already shaky confidence in the stability of the EMU. A piece in the UK Telegraph apparently says it could happen over the next five years, while the CEBR policy group says it could happen as within days.
  • PM Merkel has already lost control of the upper house of Parliament from a lost regional election widely seen as a protest against German spending to aid Greece and others.

Thus there is genuine doubt that Germany can be depended upon to underwrite other EZ members’ mismanagement before the PIIGS can recover.

The New Sovereign Default Risk Zone: Eastern Europe

Hungary’s default threat reminds markets of the Eastern European sovereign default threat.

The Hungary announcement serves as a reminder that there are other brewing sovereign debt crises beyond those of the PIIGS in Eastern Europe. Click here for a good summary from Key points include:

Ukraine, Latvia, and Romania are also considered to be among the most likely nations to default. The table below is as of June 8th ():

Contagion Risk Rising for Eastern Europe (NYSE:CEE), :
(via 21jun08

Eastern European countries have very large proportions of their debt denominated in foreign currency, limiting their ability to repay via money printing ():

(via 23jun08

High percentages of debt in foreign currency make repayment unlikely if the native currency is crashing. Since the beginning of 2010 and start of the EU debt crisis as a focus of global markets, the currencies of Hungary (Forint), Bulgaria (Lev), Poland (Zloty), Croatia (Kuna), Czech Republic (Karuna), Estonia (Kroon), Lithuania (Litas), Latvia (Lats) have all fallen 5%-15%. See here for chart illustrations.

Rising Borrowing Costs Now Endangering The Core EZ Members

As Edward Harrison points out here, contagion has been spreading from the weakest EZ members to the core itself, as France, Austria, and Belgium are all seeing their CDS prices (cost of insuring their bonds against default) rise. The same goes for the PIIGS nations.

That’s a huge potential threat, because EZ nations are so dependent on each other to repay their debts in order that all avoid default or a collapse and bailout of their banking systems. Just a few examples:

  1. Italy has about €25 bln in bonds to sell in June – watch for news on how well these go and at what rates compared to German bonds.
  2. Spain has about €25 bln in bonds to sell in July to refinance maturing debt – watch for news on how well these go and at what rates compared to German bonds.

Note that both of these nations have economies and debt loads 5 times larger than those of Greece or Portugal. Given the amounts of PIIGS bonds held in Europe, any default could quickly spread domino-style. Consider just some of the implications per the NY Times debt map here:

  1. About 22% of Portuguese bank assets are in Greek bonds, meaning that a Greek default is likely to suck down Portugal as well or at least destabilize its banking system. Markets are pricing in a roughly 75% chance of Greek (hence also Portugal?) default by 2015.
  2. About $86 bln, a third of Portugal’s debt, is held by Spain. This equals almost 8% of Spain’s total debts owed to others.
  3. Spain owes France $220 bln, about 8.6% of French GDP.
  4. Italy owes France $511 bln, roughly 20% of French GDP.
  5. About 22% of total French bank assets are in Southern European government bonds.

Uncertainty About Exposure Taints All: Most importantly, no one seems to know how much direct or indirect exposure specific financial institutions have to a given sovereign or major bank default. That means that if any of them appear close to defaulting, interbank and commercial lending is likely to become far more expensive or cease entirely, crashing Europe’s banking system and sparking yet another global panic.

The Only Realistic End Game: Restructure or Total Default, Probable EZ Breakup

As Ed Harrison points out here, with debt service costs around 5%, Greece and other weak economies receiving aid will need to grow their GDPs by at least that rate in order to ultimately pay off debt. Even without the new austerity plan spending cuts falling into place in the PIIGS block and elsewhere, such growth rates are extremely unlikely. With these cuts they are completely unrealistic.

One way or another, that means reducing their debt loads via restructure (partial default) or total default. Either case suggests an accompanying bailout for the main banks of each European nation caught taking a hit to their balance sheets as these bonds are written down or off altogether.

There seem to be 2 ways that will likely play out:
  1. The EZ stays together and accepts some major QE and/or additional stimulus that devalues the euro.
  2. More likely, we suspect at some point the more prosperous nations lose patience, leave, and accept the cost of bailing out their own banks, which at least will have a final price tag that doesn’t drag on indefinitely.

The sooner Europe reaches this conclusion and accepts it, the sooner the EU debt crisis will cease to weigh on global markets. Continued attempts at temporary solutions to buy time for a nonexistent chance of the PIIGS returning to health via more borrowing will just prolong the pain.

Investment Ramifications

Risk assets will remain in their long term downtrends that began in the summer of 2008. Safe haven assets like the JPY, USD, CHF, possibly the CAD, and AAA rated bonds denominated in these currencies will prosper. So will the usual array of instruments for shorting the markets. For the coming months these include:

  • Shorting risk currency pairs like the EUR/USD, EUR/JPY, EUR/CAD, EUR/CHF, NZD/USD, etc.
  • Shorting contracts for difference between global stock indices and commodities (not for gold, which is benefitting from the EUR’s troubles as an EUR hedge)
  • Shorting the related risk ETFs: UDN, FXE, BNZ, FXA, FXEN, DBV, CEW, ICI
  • Long the related safe-haven ETFs: GLD, UUP, FXY, FXF
Disclosure: No Positions