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.}