Posted by: Josh Lehner | November 10, 2011

European Debt Woes

The major economic concern for near term growth is obviously the continually evolving situation in Europe.  The will they or won’t they game of possible bailouts or blowups changes daily and the potential downside risks are huge. In our office, we’ve been thinking about how to distinguish where on the spectrum of pessimism economists and other prognosticators are. One good way to do so is look at their views on Europe. Those who are especially downtrodden about future growth prospects typically see the European situation in a terrible light with the potential for another Lehman-type moment. The economists who are merely pessimistic see Europe as a large speed bump en route to a slow growth outlook. On Wednesday it was interesting to note on the Economist’s View that two posts at, essentially either end of this spectrum, were juxtaposed within hours of each other. First, Tim Duy discussing the abyss Europeans are falling into and second, Antonio Fatas discussing how the ECB has the power to stop the decent into the abyss. I don’t want to speak on behalf of either of these two, however they are both right: the current trajectory in Europe is not good from both an economic growth and policy response perspective and there are in fact tools available to stop the EMU from falling into the abyss, e.g. the ECB needs to act as the lender of last resort.

When it comes to the economic outlook, the overall view is greatly influenced by one’s perspective on the European end game. The fact that a recession looks highly likely in Europe today doesn’t mean our revenue and economic outlook necessarily needs to be revised down as such scenario is already built into our office’s forecast. We use a major forecasting vendor and their baseline U.S. forecast assumes a mild Eurozone recession (~1% GDP decline) with its effects being felt in the U.S. via direct channels such as consumer demand and exports. The real issues moving forward in terms of our revenue and economic forecast are the severity of the recession and any contagion effects. A blowup of the Euro is not built into the forecast and neither is a credit freeze (both to customers and interbank lending), a la post-Lehman. Such an event would send the U.S. (and Oregon) back into recession and revenues would be substantially below our baseline outlook.

Given all of this, here are a couple of interesting graphs and a table regarding the debt situation in Europe. This first graph, a repeat from last week, compares interest rates on different 10 year bonds. The baseline is 10 Year U.S. Treasuries and the ratio value is relative to this U.S. rate. E.g. U.S. High Yield Corporate bonds are nearly 4 times the U.S. treasury rate (7.8% vs 2.0%). While rates have adjusted somewhat in the past 8 days, the picture remains qualitatively and nearly quantitatively the same.

One of the items of note is the interest rates on big, developed economies such as France, Spain and Italy. All these yields have risen in recent weeks and months, distancing themselves from the safe-haven rates seen by the U.S., Japan and Germany, for example. One reason for this is not only the economic, fiscal and political prospects for these countries, but also their respective banking sector’s vulnerability or perceived vulnerability. This second graph uses data from the Bank for International Settlements (BIS) consolidated banking statistics. Peripheral Europe is defined here as Greece, Ireland, Italy, Portugal and Spain. The blue bars on the left axis are the dollar values of exposure by each country to Peripheral Europe. Included in these figures are not only government debt but also loans to foreign companies/entities. E.g. the U.S. figure would include a loan from a U.S. bank to an Italian corporation. The red bars on the right axis represent these exposures as a percent of total bank asset. While U.S. banks are exposed by nearly $190 billion, this represents only 5.4% of bank assets. Clearly France stands out on the graph and this is likely one of the reasons yields on French bonds have not fallen as they have in the U.S. and Germany. French banks, out of the BIS data, have the largest total dollar value of exposure and at the same time this represents 24.9% of total French bank assets. Those are certainly substantial figures.

Finally, following in the footsteps of the Wells Fargo’s economic team and The Economist (which has a great interactive tool for this), the table below highlights the nominal GDP growth rates needed to stabilize the debt to GDP ratios for each of the listed countries. The interest rate on each of these countries’ bonds for today is listed in the second column and these rates are used as the market rate for each of the three scenarios. The first scenario uses current market interest rates and assumes a budget surplus of 3%. The second scenario assumes a 5% budget surplus and the third scenario assumes a balanced budget (0% surplus). What is interesting to note is the differences across countries and what is essentially the distinction between liquidity and solvency issues.

Greece needs to grow its economy 18% per year even with a 3% budget surplus to stabilize its debt to GDP ratio. Given that U.S. NGDP typically grows around 5%, such rates are difficult to achieve unless there is substantial inflation involved, thus in the current environment Greece is not experiencing a liquidity issue but a solvency one (hence why their debt is currently 13x U.S. debt, see the first graph). Portugal is most likely insolvent as well. The issues facing Ireland, Italy and Spain may generally be viewed as most likely liquidity issues and not fundamental solvency. If these three countries could borrow at even twice the rate of the U.S. or Germany and manage a balanced budget, the required growth rates to stabilize debt to GDP would decline substantially. If these countries could find a way to get to a budget surplus, even a small one, economic growth would only need to crawl along slowly to manage the debt. Unfortunately, without a backstop or lender of last resort today, these countries continue to face steep market prices and have the nasty potential to turn into a self fulfilling prophecy/financial crisis.

Note 1: General rule of thumb: the nominal economic growth a country needs to stabilize its debt, if in fiscal balance, is equal to the interest rate paid on the debt

Note 2: These estimates are approximate growth rates and are based on static estimates. Obviously there are dynamic effects at play, especially regarding automatic stabilizer spending on the cost side of the ledger should a country’s GDP contract.


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