European crises – Who’s next?

GIIPS stands for Greece, Italy, Ireland, Portugal and Spain, also commonly known as PIIGS, which is preferred by the German press as Germans become more wary of rescuing other sovereign members within the eurozone. In the past few months, two of Europe’s states were given financial help, first Greece in May and then Ireland last week, obtaining a combined €200 billion in aid to avoid default. But to properly assess the depth of the crises we should review GDP figures published by the ECB (as a percentage of EU 16 for September 2010).

Greece and Ireland combined approximately total four per cent of Europe’s GDP. The crisis of both countries together seems manageable indeed. But Spain and Italy are by far larger, and combined are larger than Germany. Managing such a crisis would require more than aid to convince the global investing community that the eurozone can continue to exist.

The problem started with the sub-prime housing crises two years ago. European banks were happy to invest in (and sell) products whose risks were barely understood. Since then governments responded by increasing state aid in various forms to restart a failing economy. The consequences are clear today, deficits and debts ballooned to a level that is making sovereign debt investors nervous. The increase in total debt ranges from 30 per cent to 400 per cent, either due to structural deficits, or in supporting the banking sector.

These levels of total debt in the economy were last seen after the Great Depression or after World War II. The problem that lies ahead is simply that no super growth period is forecasted for any economy in Europe. Germany might grow at an average rate that compares with pre-crises levels, around 2.5 per cent, but Spain is forecast to grow by an anaemic 0.9 per cent, and this may not be achieved.

The tables show both the central government debt to GDP and the total economy debt to GDP. The latter is more important as it seems more likely that governments will assume the total national debt as they guaranteed debt issued by financial institutions, only to diminish the contagion effect. This has not served Ireland well in the past, as the Irish were the first to officially guarantee all the debt issued by its banks. Spain is following this path as Cajas (non-profit institutions that make roughly half of all loans in the country) are absorbed and assisted by the country’s Fund for Orderly Bank Restructuring (FROB) so far at a cost of €15 billion.

Spain is the more worrisome of Europe’s ailing economies. Spain’s central government debt stands at only 53 per cent of GDP, hardly troubling. But this has nearly doubled in the past three years when deficits ran above 10 per cent per annum. Worse, next year’s deficit is estimated at nearly seven per cent and Spain will be required to fund its maturing debt and deficit which reaches nearly €200 billion, the combined aid received by Greece and Ireland.

The Spanish banking system is assumed to be strong but profitability is shrinking fast, as banks are exposed to €325 billion of the ailing property developers, while unemployment is at 20 per cent. Although banks reduced their dependency on ECB funding, borrowing came at a higher cost and was often available only when provided by state guarantees. The Cajas might require further funding and another round of consolidation to avoid a collapse. Hopefully the FROB’s capacity of €99 billion would suffice.

Spanish Prime Minister José Luis Zappatero has to convince the markets that Spain has the political will and resolve to weather the crisis without resorting to aid. If not, investors will require more compensation to assume risk on Spanish bonds. This will push borrowing costs higher for all entities in Spain, only making the problem much worse. Italy and Belgium both seem to suffer from the same ailment. Although growth is projected to be higher than Spain’s and deficits lower, they both suffer the lack of political strength to carry forward required reform packages. Belgium’s very shaky coalition has brought its intractable regional divisions to the fore. And Mr Berlusconi is on equally shaky ground. So who’s next to rock the boat? The markets will target the one that looks weaker.

% GDP of EU 16
Germany - 26.56%
Italy - 17.03%
Spain - 11.49%
Belgium - 3.81%
Greece - 2.54%
Portugal - 1.86%
Ireland - 1.70%
Malta - 0.06%

Debt As % of GDP - Sep 2010

This article has been prepared by Sandro Baluci, an Investment Executive at Curmi and Partners Ltd, and is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.

www.curmiandpartners.com

Mr Baluci is portfolio manager with Curmi & Partners.