Monday, December 12, 2011

Will S&P downgrade Europe?

Last week, Standard and Poor's warned the 15 EMU sovereigns that they may be downgraded. They expected "review of eurozone sovereign ratings as soon as possible following the EU summit scheduled for Dec. 8 and 9, 2011". They went on to state:
Depending on the score changes, if any, that our rating committees agree are appropriate for each sovereign, we believe that ratings could be lowered by up to one notch for Austria, Belgium, Finland, Germany, Netherlands, and Luxembourg, and by up to two notches for the other governments.
Now that the EU Summit has come and gone, what now?

The effects of the "fiscal compact"
I did some projections and assumed a number of problems of the latest "fiscal compact" away, such as the difficulties of treaty ratification, specification of enforcement mechanisms, etc. Using this handy tool from the Economist, I projected a probable path for selected eurozone countries. The blue line represents the base case estimates from the IMF and the red line are my revised assumptions. Since the latest "fiscal compact" amounts to nothing less than an austerity club, I made the following rather conservative changes to IMF assumptions to account for the more immediate fiscal tightening effects of austerity programs:
  • Growth slows by 0.5%
  • Inflation slows by 0.5%
  • Primary budget balance is reduced by 0.2%, which is also a side effect of austerity measures
  • Interest rate is the average of the current 5 and 10 year bond yield for that country
The results aren't pretty. Consider Spain, a Club Med country. Debt to GDP is project to spiral upwards, worse than the base case estimate from the IMF (blue=oringal IMF assumptions, red="fiscal compact"):

What about Portugal? The only silver lining is that things don't deteriorate as badly as Spain under these assumptions.

Italy, the biggest Club Med country of all, doesn't fare all that well either as its debt to GDP gets out of control rather quickly. The problem of Italy lays the groundwork for another eurozone crisis in the near future.

What about France? Oh, dear! It looks like Sarkozy is likely to lose his precious AAA credit rating.

The only question at this point is whether it will be one or two notches. This chart below compares the France under my new projections with the United States under IMF's base case projections. At least the French are outperforming the Americans...

The only country that fares reasonably well under these revised assumptions is Germany, whose debt to GDP ratio continues to contract. Even then, its deficit to GDP measure won't be below the magic 60% target, which would suggest further fiscal tightening under the terms of the "fiscal compact".

This analysis indicates that the fiscal balance of major eurozone countries will deteriorate under the terms of the new "fiscal compact", which leads to the conclusion that a wholesale downgrade of many eurozone sovereigns is very likely.

Setting the stage for another debt crisis
The next question for me was, "How much more risk would a credit downgrade introduce to the eurozone?"

Using this data from Jason Voss of the CFA Institute, I constructed a spreadsheet for the likely rollover of debt in 2012 of selected eurozone countries as a measure of the degree of funding stress they may have to undergo. (All amounts are in billions of euros.)

In his article, Voss showed the likely rollover of debt as a percentage of GDP for all eurozone countries. I then went to the IMF website and looked up the projected 2012 GDP by country to calculate the projected rollover figure for 2012. Italy is one of the more problematical as it is scheduled to rollover over €300 billion in 2012 (even this estimate may be low as others have cited a figure of €440 billion). Surprisingly, France will need to come to market with nearly €400 billion and the German rollover comes close to €600 billion.

If you include all the major eurozone countries together, they need to roll over €1.8 trillion in 2012, or 19% of estimated GDP. Supposing that we assume that Germany will have no trouble rolling its debt and excluded her from 2012 financing needs, then the eurozone debt market will see roughly €1.2 trillion in sovereign debt issues - an astoundingly large number. The PIIGS alone will need to finance about €700 billion next year.

These are very large numbers. Given that European banks are in the process of shrinking their balance sheets, which will reduce their appetite for sovereign paper, where will the money come from? The combination of EFSF and ESM? But the funding for the EFSF and ESM come from the eurozone sovereigns. Can they loan money to themselves?

What about the IMF? There was some discussion that some sovereigns, e.g. Germany, could lend to the IMF, which when then lend it back to troubled European country, e.g. Italy. However, the total amount of that facility amounted to €200 billion.

The size of the ESM, EFSF and new IMF facility is simply not enough. It's like sending out a riot squad of 10 police officers with helmets and batons to face an angry mob of a thousand people. If the mob stampedes, the results won't be pretty.

What about the ECB? Mario Draghi made it clear that the ECB would cap bond purchases to €2 billion a week (when actual recent purchases have amounted to roughly €1 billion a week). The total cap adds to about €1 trillion a year, which could be a big bazooka if it was un-sterilized. However, such intervention would be sterilized, which begs the question of where the money to buy the ECB's sterilized paper would come from.

This analysis tells me to be prepared for more volatility and crisis summits in 2012, if not before.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

1 comment:

Tiho said...

Just short Treasuries! That is the right thing to do for the next couple of months...