A new rift is emerging on the euro sovereign debt

Posted on 11. Oct, 2011 by Riskelia in Weekly Focus | Comments Off

The euro sovereign debts dynamic is one of the keys to the euro crisis. The recent improvement in Ireland and Spain radar’s trends requires specific attention but the Italian solvency issue is now at the epicenter of the debt crisis. This giant weakness will have to be solved to prevent this sword of Damocles from hitting the core of the euro zone.

Riskelia has documented the close connection between the sovereign and banking solvency issues since January 2010. The governments guarantee the banks (or the insurance companies) whereas the latter buy the debts issued by the former. The crisis transmission mechanism is twofold:

  1. When the solvency of Governments deteriorates, the banks’ assets depreciate, thus calling into question their ability to fund these poor quality assets in the wholesale funding market. Moreover, the austerity, required by the European Commission to reduce deficits, dampens growth and deflates the economy. These measures negatively impact business’ and households’ solvency, thus eventually deteriorate the heart of banks’ balance sheet: the commercial and consumer loans.
  2. When the banks are hurt, the Governments are forced to guarantee them (e.g. the case of Ireland with the bailout of AIB or the Belgium Government with the bailout of Dexia). As a result, the Government debt increases thus provoking a rating downgrade and a rise in yields. The doom loop is quick to bring down the country and prevents any debt issuance on financial markets.

The only way to overcome the second part of this doom process is to set up a credible guarantee of the banking system at the euro zone level: it would be wise to use the EFSF to directly buy stakes in European banks and recapitalize them. The first part of the doom loop is the key to the resolution of the financial crisis. It could be mitigated either by debt monetization (with the ECB buying the debt of insolvent countries on a massive scale) or by some fiscal transfers from solvent to insolvent countries within the euro zone.

As showed in figure 1, three groups of sovereign debts stand out in Europe:

  • The group of the safe havens represented by the UK and German debts. They are negatively connected to European Itraxx Investment Grade credit.
  • The risky sovereign debts or the so called “PIIGS” (Portugal, Italy, Ireland and Spain) negatively related to Credit and closely connected to each other. Meanwhile, we can observe that the recommendations on the Spanish and Irish debts have turned positive whereas the others are still in the midst of negative spirals. This improvement is mitigated by the close local connections between PIIGS’ sovereign debts. What would happen for Spain if Portugal were to default, above all if Spain solely bears the responsibility of rescuing its own banks?
  • An isolated France makes the connection between the havens and the risky debts.

The rerating of the Spanish and Irish debts is clearly apparent on figure 2, where we observe that the trends of these two debts have caught up with the French one. It is also clear that the Italian and the Portuguese debts are stuck in negative trends whereas the Greek one is killed anyway. Given the central role of Italian debt in the euro sovereign network, connecting France to the rest of PIIGS, and its weight in the balance sheets of all major euro zone financial institutions (30% of euro sovereign indices), curbing the Italian government yield is essential to alleviate the pressure on the European financial system.

A decrease in the funding cost is the only way for Italy to escape from a certain restructuration as the debt nearly reaches 120% of GDP. Should Italy retrieve a decent political leadership, it would be natural for the euro zone to decrease its funding yields as the primary budget (before interest payment) is balanced. Such a move would be highly legitimate for a country which used to accept the price of a deeply overvalued currency in exchange for low interest rates but which presently cumulates two drawbacks from its euro zone membership: high interest rates and an overvalued currency.

Figure 1: the euro sovereign debts network

Positive (resp. negative) radar’s recommendations are represented in green (resp. red).

Positive (resp. negative) correlations are represented in blue (resp. orange) while the edge thickness depends on the strength of the causal relationships.

Figure 2: the euro sovereign debts trends dynamics

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