In our Autumn Newsletter¹ titled “The Sovereign Debt Debacle – Phase 2 of the GFC?” we detailed the extent of the sovereign debt problems and the potential ramifications for investment markets. In this update we take a more detailed look at the Eurozone’s problems and discuss the implications for sharemarkets.

Eurozone Sovereign Debt – How bad is it ?

Recent statistics compiled as at the end of 2009 show that Eurozone government debt totals 78.7% of GDP. Country specific details are shown in the table below.


Importantly this data does not include the full impact of the elevated level of government spending in the Eurozone (EZ) that arose from the global financial crisis. Debt levels in most countries are projected to increase further in the next few years.

When does the debt burden become too great ?

The debt burden becomes too great when a country can no longer service the interest burden. Defaulting on an interest payment provides prima facie evidence that the country can no longer meet its debts as and when they fall due. Historical precedents² would suggest that a tipping point is, on average, reached when debt to GDP roughly reaches 70%.

If we revisit the table on the previous page, then it becomes clear that a moderate number of EZ countries are already above the 70% realm as follows:


Interestingly, this table does not include noted PIIGS, Ireland and Spain, nor another important highly indebted country, the UK. This is because the table only takes into account government debt rather than public debt, which, in the case of the PIIGS not listed, is much higher (and definitions differ between each country as to what constitutes government and public debt).

It would be remiss of us to suggest that 70% was a definitive figure. The ability to meet repayments clearly depends on a number of factors including available liquidity, the average interest rate on the debt (the lower the interest rate the higher the debt that may be accommodated), the ability to generate budget surpluses, and refinancing options available.

It is likely that many countries with debt levels in excess of 70% may not yet be troubled by the interest burden due to the low relative interest rates on offer in the EZ. This could easily change if interest rates rise significantly from current levels.

What are the consequences of a default?

There is no real commonality in dealing with defaults that have eventuated over the last 100 hundred years. The causes and actions taken varied. A study performed by Moodys indicates that the average historical sovereign debt recovery rate for an investor was about 50% over the period 1983-2009, but ranges varied significantly. When Russia defaulted investors recovered only 20%. By way of example, a hypothetical default may play out as follows:

• A government defaults on interest repayments (usually on government bonds that have been issued).
• Debt is restructured in some form or another, often the maturity dates are lengthened to give the government more time to consolidate finances. Often the amount that has to be repaid is also reduced (by, on average 50%), resulting in losses to the investor. In addition, the government is also often given financial assistance by the IMF.
• Prospective investors lose faith in the defaulting government, until it can re-establish financial credibility, and invest elsewhere.
• To restore financial credibility and attract new investment the government typically embarks on fiscal consolidation measures (cuts in spending, higher taxes, asset sales etc) that may take many years.

Greece – a solution found but are the problems resolved?

When the full extent of Greece’s debt problems became clear late last year, a bailout by Eurozone members had seemed evitable. For various reasons, support for such action began to waver in April – governments didn’t want to be seen using their own taxpayer funds to assist a country that had been living beyond their means for far too long. With a deadline looming for bond repayments, investors began to worry that a default may in fact occur. Earlier this month French and German banks with large exposures to Greece suddenly began to struggle to access interbank funding upon higher counterparty risk perceptions. With credit spreads rising, global sharemarkets also began to fall as it became obvious that the collateral damage to any Greek bailout would be more significant than first thought. At a special Eurozone summit meeting on May 8 and 9, leaders reached agreement on a 750 billion Euro Stabilisation Plan, two thirds of which will be provided by EZ members and one third by the IMF. The details may be somewhat complex but essentially are tantamount to a bailout via new loan facilities, term extensions on existing facilities and the ability for the European Central Bank to
buy unloved government bonds on the secondary market (removal of toxic debt).

The scale of the package took markets by surprise as it was the first real step in recognising that the EZ sovereign debt issues needed to be addressed on a wider scale than Greece alone. The package took provision of the total financing needs of Portugal, Ireland, Spain and Greece until 2012 (which have been estimated at 600 billion Euros). Since that announcement investment markets have begun to stabilise somewhat.

Despite this announcement, the fact remains that the underlying problems that have caused these sovereign debt problems have not yet been resolved. It is true that the Greek government has begun the fiscal consolidation process by slashing spending and increasing taxes. It is now up to those other highly indebted EZ countries to follow suit and implement genuine structural reforms that will provide a more sustainable platform for future growth.

The bailout program has merely bought the PIIGS more time to restore their balance sheets. Nothing comes without a cost. Funds are not given unconditionally. Greece and other countries that may call upon funding will need to sustain austerity measures. Such measures inevitably lead, in the short term, to sharp reductions in growth, increased unemployment and social unrest. Ironically, EZ members that have assisted in the bailout will only increase their own sovereign debt, which, in some circumstances is already verging on entering the danger zone (Debt to GDP above 70%).

So, if we can now assume that the balance sheet repair process by over indebted European governments has begun, the question then arises as to what impact this reduction in aggregate demand will have on global investment markets.

                                                                                         
^{1 dated 2 March 2010
2 based on a study conducted by Reinhardt and Rogoff.}

What does this mean for investment markets?

This is a difficult question to answer definitively but we can perhaps make some assumptions based on the EU's largest economy, and the third largest in the world, Germany.

When we look at Germany’s major trading partners below, we start to again an understanding of the potential impacts that may arise.


We make the following brief comments:

• According to Eurostat, Germany is the second largest exporter in the World (behind China). From the charts above, it is highly dependent on EZ trade with most of its exports going to France, UK, Netherlands and Italy. Interestingly, China is not in the top 10, although the United States is second behind France.
• Germany is also a large global importer, with most goods and services imported from Netherlands (1st), France (2nd), China (3rd) and the United States.

There seems little doubt that intra EZ trade will be impacted by the slowdown in demand that will emanate from those highly indebted EZ countries. This does not augur well fro Germany and, by extension, the EZ given that 3 of Germany’s 4 biggest customers are other EZ nations. We can therefore only conclude that the medium term prospects for growth in the EZ are likely to be subdued at best.

In regard to the rest of the world it should be noted that the world’s largest economies the United States and China also rely heavily on the EZ for buying its products. The EU continues to rely on the United States for most of its export growth and visa versa. The EU imports more goods from China than any other country (the United States is 2nd) but is not a large exporter to China (relatively speaking). It follows that EU growth prospects are somewhat tied to the fortunes of the US economy more so than the fortunes of China’s economy. In contrast, China exports more goods to the EU than any other area.


So, in conclusion, subdued growth rates expected out of the EZ are likely to have some impact on the United States and China as both countries have a moderate reliance on the EZ to purchase its exports. Domestic demand though remains a key driver of GDP in both China and the United States so, on balance, we do not expect any slowdown in the EZ to necessarily materially impact global growth. Furthermore, given Australia’s relatively nominal trade relations with the EZ, we do not envisage any major impact on our own economy. Australia’s prospects remain tied to continued growth in the Asian region, in particular China.

Nevertheless, it is conceivable that a deterioration in the sovereign debt situation in Europe could lead to further impairments in the global banking sector which could increase funding costs generally. Such an impact, would of course be detrimental to global growth (and sharemarket returns), including Australia, generally. It should not be forgotten that the United States Government itself remains heavily indebted and faces its own challenges in coming years. For these reasons, caution remains warranted.

For more information please do not hesitate to contact one of the following members of our Wealth Management team:

Charlie Viola
Director
+61 2 8236 7798

Martin Fowler
Director
+61 2 8236 7776

Haris Argeetes
Manager
+61 2 8236 7851


Disclaimer
The information provided is not personal advice. It does not take into account the investment objectives, financial situations or needs of any particular investor and should not be relied upon as advice. While the information is provided in good faith and believed to be accurate and reliable at the date of preparation, we will not be held liable for any losses arising from reliance thereon. We recommend investors consult their personal financial adviser to discuss suitability and application to their individual circumstances. The article represents the views of the author, Martin Fowler, which are not necessarily representative of Moore Stephens Sydney generally.