Tuesday, February 19, 2013

European Debt Conditions Continue to Worsen

While the actions of the European Central Bank have eased the most immediate concerns about Europe’s debt crisis, the crisis is in a state of hibernation rather than dead and buried. The European Central Bank provided massive liquidity to the banking system, offering unlimited loans to banks at its policy rate of 1% for up to three years. It has also offered to buy unlimited amounts of sovereign debt from nations that apply for aid from Europe’s bailout fund, the European Stability Mechanism, or ESM. These actions essentially underwrote the rally in European equities and sovereign debt over the last 15 months. But, we remind investors that the central bank has not fixed the continent’s debt problems. Rather, it has simply bought time for fiscal authorities to create the banking and fiscal union necessary to truly address the debt crisis. While modest progress toward a banking union has been made, little if any progress has been made toward a true fiscal union.

Whilst some, European Central Bank President Mario Draghi among them, might suggest that the worst of the debt crisis is past, the fact remains that debt-to-GDP ratios continue to rise in Europe’s most indebted nations, and indeed in the Eurozone as a whole. The debt-to-GDP ratio of the 17-member currency block rose from 87.3% at the end of 2011 to 90% over the first nine months of 2012, increasing similarly for the entire European Union, which includes non-common currency members, rising from 82.5% to 85.1%. While data for the 4th quarter of 2012 has yet to be released, given the contraction in the Eurozone economy during the quarter, it’s a safe bet that debt ratios rose further still during the final quarter of the year. Importantly, debt ratios rose dramatically among the most troubled nations in Europe, the so-called PIIGS – Portugal, Ireland, Italy Greece, and Spain. Debt-to-GDP levels climbed substantially in all of the PIIGS during the first nine months of 2012 with the exception of Greece. However, the ratio only declined in Greece after it defaulted in the 1st quarter of 2012. After the default, its debt-to-GDP ratio continued to rise rapidly, climbing from 135.5% in March to 152.6% at the end of September. 

Much of the Eurozone was in recession throughout 2012 and we expect many of the most troubled nations to remain in recession throughout most, if not all, of 2013. This poses an enormous challenge for reducing debt-to-GDP ratios since GDP itself is contracting. It is very hard to reduce government debt when tax revenue is low and social safety outlays high due to high unemployment rates. In November, Eurozone unemployment reached a new all-time high of 11.8%. With the exception of Italy, with a rate of 11.1%, unemployment in each of the PIIGS was at least 14.6%. That of Greece and Spain was north of 26%.


It’s certainly possible that the Eurozone economy will improve a bit this year, but weak economies coupled with continuing budget deficits make it highly probable that debt ratios in the currency zone, as a whole and specifically in it most troubled nations, will continue to rise in 2013. Even once the Eurozone returns to growth, the massive debt levels in Europe will be a significant drag on growth for the foreseeable future. Similar to companies which very rarely, if ever, cut themselves to prosperity, the Eurozone will need growth along with austerity if it is to escape its debt crisis. Yet the accumulation of debt, coupled with poor demographics, will make growth extremely hard to come by. That is Europe’s conundrum.