Greece has been in debt-default for 50% of the last 179 years. Although its debt and low productivity grab headlines, its GDP of $305 billion is a small part of the European Union (EU) countries using the Euro. Greece is headed for bankruptcy on its $500 billion in debt despite bailouts from the EU and austere budget plans adopted by the Greek parliament. Those loans are needed to redeem Greece’s matured bonds and pay coupons due.
Most of the Euros going to Greece are from Germany and France, as were earlier loans that attempted to stabilize Ireland and Portugal (each owes $210 billion in public debt). Ireland was fine until it decided to backstop, then to nationalize its major banks troubled by underperforming mortgages. Portugal just suffers from chronically low productivity and growth. The Spanish and Italian economies are large and suffer from big budget deficits and high interest rates on their sovereign debt (e.g. 10-year bonds from Greece, Ireland, Spain and Italy have yields of 17%, 6.2%, 6.2%, and 6%, respectively). S&P rates the debt of Portugal and Greece as “junk.“ Moodys rates Ireland’s as “Junk.”
If Euro zone members could print currency to devalue their existing bonds, the sting of debt would be softened. But, that would be possible only if they exited from the EU – something abhorrent to Germany and France, yet deemed likely by savvy traders such as Dennis Garman, George Soros and others.
Spain and Italy present daunting potential problems for the EU. Spanish public debt stands at $850 billion and Italian at $1.7 trillion. The EU would find it difficult to bailout even the portion of their debt that is refinanced each year. That’s partly due to the scale, and partly to the perception by German and French citizens that they are sacrificing unfairly to prop-up unaffordable government programs and profligate lifestyles elsewhere. Portugal, Italy, Ireland, Greece and Spain are collectively known (with all due disrespect) as “PIIGS”.
Banks in the Euro zone hold about 50% of their respective country’s sovereign debt. They also hold PIIGS bonds with the juiciest yields. When an issuer defaults on a bond, the holder faces incomplete and/or delayed payments. If the total of those defaults exceeds the bank’s capital reserves, the bank may become illiquid or worse, insolvent, presenting its country with the decision to bailout the bank or face higher interest rates and slower economic growth going forward. US investors have little direct exposure to risky EU bonds, but some US banks have loaned their money market deposits to large EU banks.
Irish and Spanish banks’ weakness stems largely from underperforming mortgages, but for the rest of the EU, any bank’s weakness typically stems from holding sovereign debt with a poor credit rating. The EU organized a “stress test” for the top 91 banks to reveal problems of holding PIIGS debt and other economic stresses. The test is more vigorous than the one from a year ago. The results were; one bank backed out, some boosted capital reserves during the testing period, 8 failed, 16 passed narrowly, and the rest passed. The EU wants the failures and wobblers to increase reserves to a level that prevents failure under the stresses, or to merge with a stronger bank. The stress test did not push down sovereign bond yields in the market, as the EU hoped it would.
In the next decade, the EU needs a period of sustained higher economic growth (currently 1.1%) to help right-size its debt. Its own aging population is not conducive to vigorous growth and EU’s best bet is exports, largely to China and the US. Unfortunately, astute observers say the US and the global economy are in a “persisting malaise,” i.e. slow growth that will last for years, dampening receptivity to EU’s exports. Likewise China is trying to transition from producing goods made possible by cheap labor to goods made possible through technical prowess and that compete directly with those from Japan, Korea, Taiwan, US and EU, further eroding EU’s prospects for growth.
In the shorter term, major future events could produce ripples from the EU that we feel:
- Greece will probably default on some or all of its debt, and it may secede from the EU to give it monetary flexibility. Ireland and Portugal will likely seek additional bailout loans from the EU (their public debt will vault over 100% of GDP this year). These events are likely to devalue the Euro, improving its exports but making new debt issues a little harder to place.
- Spain itself may require an EU bailout. Spain is too big to bail so it may eventually follow Greece – out. That would further fracture ties among EU members, possibly calling for a radical rethinking of the mutual financial obligations of EU members. This is likely to further devalue the Euro.
Quick recovery from debt problems by the EU members is unlikely and none of the EU’s problems seems like a significant opportunity for the US. As the denouement unfolds, the US dollar’s position as reserve currency of choice will strengthen.
Alan Daley is a retired businessman living in Florida. He follows public policy issues from the consumer’s perspective.