europe sovereign debt crisis in...
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INVESTMENT BULLETIN FEBRUARY 2012
Europe Sovereign Debt Crisis in Brief
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Origins
The European sovereign debt crisis can trace its roots back to weak fiscal unity and lax discipline. The creation of the euro gave all eurozone countries access to cheap public and private debt as the primary benefit of a common currency. Despite this accomplishment, the EU failed to create a central institution to coordinate and enforce the necessary and prudent economic policies within each member state. All countries in one way or another failed to adhere to a 3% budget deficit and maximum debt-to-GDP ratios of 60% outlined under the Maastricht Treaty (see selected countries and eurozone figures below). Localized economic imbalances and differing competitiveness across the continent led to some countries becoming much weaker fiscally than others, particularly across Southern Europe. Not recognizing this, debt markets demanded a very low yield premium for funding these weaker eurozone countries, prior to the awakening brought about by the Greek crisis.
2010 € mln Germany France Italy Spain Greece Euro 17
Revenues 1,079,750 957,590 712,075 381,427 89,750 4,093,742
Expenditure 1,185,750 1,094,489 782,301 479,645 114,213 4,665,855
(Deficit)/Surplus (106,000) (136,899) (70,226) (98,218) (24,463) (572,113)
Budget Deficit % GDP 4.3% 7.1% 4.5% 9.3% 10.8% 6.2%
Government debt 2,061,795 1,591,169 1,842,826 641,802 329,351 7,818,724
GDP 2,476,800 1,932,802 1,556,029 1,051,342 227,318 9,161,459
Debt/GDP 83.2% 82.3% 118.4% 61.0% 144.9% 85.3%
Source: EUROSTAT
The unexpectedly large Greek deficit revealed in 2010 shocked world financial markets and gave rise to contemplation of a sovereign debt default in Europe and possible collapse of the euro. This also came at a time when fiscal deficits had risen following the 2008-09 global economic slump. The fear of contagion moved beyond Greece to other periphery European countries. This created a self-reinforcing effect as rising yields led to heightened uncertainty about eurozone fiscal fitness, pushing yields to even higher levels. The European sovereign crisis was born and the otherwise peripheral countries of Portugal, Ireland, Italy, Greece and Spain found themselves at the epicenter of the upheaval. The negative impact on sovereign bond prices also led to strains in the European banking sector. Many eurozone commercial banks were accustomed to owning large amounts of government securities and were drawn into the crisis in that way. The timing was very unfortunate as these banks were only just starting to recover from the 2008 financial crisis.
European officials failed to pursue debt restructuring and austerity reforms aggressively. As a result, the European debt crisis and the Greek debt problem remained unresolved. Finally, financial markets started losing patience, pushing Italian and Spanish 10-year yields to potentially unsustainable levels
Simon ChesterVice PresidentPortfolio ManagerGlobal Fixed Income
of 6% in July 2011. The graph below demonstrates how the divergence between German and French debt yields and Italian and Spanish yields became too large to ignore.
European 10-Year Yields
Source: Barclays Capital
The Response
Sovereigns
There is nothing that roils financial markets more than uncertainty and indecision. The political system in Europe is hampered by enshrined national identity and sovereignty of member states and a bureaucratic process. This meant the EU crisis committees have heretofore produced a great deal of uncertainty and indecision. For Greece, a €110 billion bailout was proposed in relative short order (April 2010) followed by a €750 billion support package, the European Stability Mechanism (“ESM”). The ESM is intended to promote financial stability in Europe and is underwritten with economically-proportional guarantees from eurozone member states.
The Greek bailout, however, failed to address how private investors would be treated and was fraught with execution risks. This was especially true because Greece initially failed to deliver needed economic reforms. The unfolding crisis would lead to bailouts for Ireland and Portugal, fueling additional concerns about other periphery countries. In particular, eyes turned to Italy and Spain, whose sovereign yields were attracting attention (see graph above).
A series of European summits to resolve the crisis continued (and generally disappointed), culminating in a December 2011 summit agreement for a new “fiscal compact” in Europe, setting out a path for greater fiscal unity and discipline in Europe, and a mechanism to police the rules on
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10-Year Germany
10-Year France
10-Year Italy
10-Year Spain
European 10-year yields
Source: Barclays Capital
10-Year Germany
10-Year France
10-Year Italy
10-Year Spain
a centralized basis. The launch of the ESM program was brought forward by a year to July 2012 and the funding capacity was expanded through the potential use of a partial risk protection structure and/or a co-investment fund.
Banks
In conjunction with the above measures addressing the sovereign situation, the European banking sector also needed to be fortified against significant cross-border exposures to government debt. The European Banking Authority (“EBA”) undertook a stress test of European banks in 2010 in an effort to demonstrate the resilience of the system. The exercise, however, lacked credibility and was undermined when Irish banks that had passed the test had to restructure shortly thereafter. In 2011, the EBA conducted a far more robust stress test specific to sovereign debt exposures. For the new stress test, the EBA announced a requirement of a 9% Core Tier One capital ratio by mid-2012, well above the 7.5% ratio initially envisaged under global bank regulation reforms. The stress test results implied banks would need €114 billion in additional capital. In addition to this measure shoring up bank capital bases, the European Central Bank has actively provided liquidity support to banks. This effort was significantly enhanced by the Long Term Refinancing Operation (“LTRO”) which launched in December 2011. The LTRO provided €489 billion in three year funding to banks. The facility came with wide-ranging collateral eligibility with another tranche becoming available on February 29, 2012.
Our View
Our central view is the eurozone will emerge from the crisis intact. A break-up of the currency would be debilitating for all concerned. In our opinion, the fiscal compact represents the right solution to addressing flaws in the eurozone structure. The European banking system is on track to achieve robust capital ratios and has substantial backstop liquidity from the ECB. The ESM and LTRO facilities act as a safety net to buy the time the eurozone needs to implement reforms. The economic outlook is clouded by unknown consequences of unprecedented government austerity measures. Additionally, the bank deleveraging process continues to constrain credit provision. On the positive side, labor and economic reforms could provide the basis for an economic resurgence across Southern Europe.
Despite the recent progress achieved, investors need to stay up-to-date with developments in Europe. Without a single eurozone bond financial instrument that carries joint and several liability from all eurozone nations (not proportional guarantees per the current ESM structure), investors still run the risk that individual nations may need to restructure some of their debt. Executing the fiscal compact also has an unpredictable political element given that the austerity measures and economic reforms have proved to be unpopular. The threat of Greece leaving the euro remains a destabilizing risk for the region. Improved firewalls, with the potential to redistribute Greek bailout funds to other countries, makes Greek default and exit from the euro a potentially positive development for European stability. This, however, is a highly speculative scenario.
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April 2010€110 bln
Greek bailout
May 2010 €750 bln euro
stability package announced
May 2011 €78 bln
Portugal bailout
Dec 2011 Europe plans new unifying
"fiscal compact"
July 2012 ESM €700 bln
bailout facility comes into force
Nov 2010 €85 bln
Ireland bailout
July 2011 2nd Greek
bailout
March 2012 €14.5 bln
Greek bond maturity
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These factors have seen market volatility escalate to levels that significantly reduce active risk tolerances within a fixed income portfolio. For example, in 2011 German government bonds rose 9.7% while Italian government bonds fell 5.7% even after posting a 5.3% positive return in December alone.
The successful implementation of the fiscal compact should lead to some convergence of yields across eurozone countries. Focusing on the main markets, this would see rising yields in Germany and France and lower yields for Italy and Spain. These market moves are unlikely to occur in a linear fashion and will be volatile, but we are positioning ourselves to benefit from this trend over time. The most recent development in the crisis, the second Greek bailout, should not be viewed as a game changer for the European sovereign debt crisis and is instead, another round of “kicking the can down the road.” Be that as it may, it does avoid, for now, the uncertainties of an uncontrolled Greek default and exit of the euro. This is a positive development of sorts but is fraught with execution risks. We can therefore expect more European debt headlines in the coming months.
Glossary
Gross Domestic Product (GDP) Gross domestic product (or GDP) is a measure of the total economic output in goods and services for an economy.
International investing involves special risks, such as political instability and currency fluctuations.
This information is not intended to serve as investment advice. Investments are subject to market risk.
The opinions expressed are those of Simon Chester and are no guarantee of the future performance of any American Century portfolio. Nothing in this document should be construed as offering investment advice. Please note that this is for informational purposes only and does not take into account whether an investment is suitable or appropriate for a specific investor.