Back With a Vengeance: The EU Debt Crisis

By Arnold Ahlert (Archive) · Tuesday, January 17, 2012

On Friday the 13th, ratings agency Standard & Poor's (S&P) downgraded the credit status of nine European nations. The ratings of Cyprus, Italy, Portugal and Spain were lowered by two notches while Austria, France, Malta, Slovakia and Slovenia were lowered by one. Italy's rate cut from A to BBB+ reflects the second S&P downgrade since September 19th, and Portugal's debt has now reached "junk" status. "Today's rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policy makers in recent weeks may be insufficient to fully address ongoing systemic stresses in the euro zone," said S&P in a written statement.

The downgrade was hardly a surprise. On December 5th, S&P put 15 European nations on review, warning them that the decisions made during the European Union (EU) summit ending on December 9th would be the primary basis for determining those nations' credit ratings going forward. The result of that meeting, the EU's fifth attempt to stem its credit crisis, produced a "deal" best described as an agreement to come to an agreement. The only real highlight of the summit was English Prime Minister David Cameron's rejection of the treaty in favor of a concept increasingly out of favor among other EU leaders: national sovereignty.

Despite the warning by S&P, the downgrade is being characterized as a "rebuke" of the EU's prime movers, French president Nicolas Sarkozy, and German Chancellor Angela Merkel. Both are on politically shaky ground. Sarkozy is running for re-election in the spring and the downgrade of France to AA+ for the first time since 1975 does not bode well for a man who had often cited his country's AAA rating as a "badge of honor." In Germany, one of Merkel's partners in her governing center-right coalition, the Free Democrats Party (FDP), is sliding deeper into crisis, threatening her grip on power as well.

Germany was the only EU nation to emerge from this latest downgrade completely unscathed. It retained both its AAA rating and a stable outlook going forward. 14 other EU countries -- Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain -- were put on a "negative" outlook. This means the S&P believes that there is a better than one-in-three chance a country's rating will be lowered in 2012 or 2013. "It will make it harder to erect firewalls around struggling euro zone economies and convince investors that things are more sustainable," said Simon Tilford, chief economist for the Center for European Reform in London.

Two countries to watch in that regard are Italy and Spain. Both began the year with fairly successful debt sales, but after Friday's downgrade both countries saw their bond yields rise, along with those of France and Belgium, while safe-haven German Bund futures hit a new high of 140.22, up over a full point for the day. Another possible complication arising from the downgrade is the likelihood that the European Financial Stability Fund (EFSF) will also lose its AAA rating as well, because its guarantor nations have had their ratings cut. An EFSF downgrade could be avoided if the four remaining AAA nations -- Germany, the Netherlands, Finland, and Luxembourg -- would increase the size of their guarantees, but such a move is not considered likely.

Ominously, all of the above is the "good" news. On Friday as well, talks between private creditors and the Greek government on the re-structuring of that nation's debt have, for all intents and purposes, broken down. "There is extreme tension," claimed a source close to the negotiation. "All parties involved in this crucial negotiation ought to be aware of this very grave condition and assume their responsibilities to avoid the worst. No one should be under any illusion that this would be the worst possible outcome for everyone involved. The results would be catastrophic and not only for Greece or Europe."

Greece is facing a must-make payment of $17.9 billion on its debt load on March 20th. In October, European leaders had agreed to a second bailout package for the beleaguered nation that required private bondholders to bear part of the burden. A 50 percent "haircut" on the value of those bonds is necessary in order to reduce Greece's overall debt load by $127 billion. German Chancellor Angela Merkel and French President Nicolas Sarkozy made clear earlier last week that Greece won't get its next tranche of rescue funding without a deal.

The critical word here is "voluntary." The lack of an agreement has stoked fears that the Greek government could move to make the debt restructuring compulsory. This would create an official "credit event" (read: "bankruptcy") requiring banks and other financial institutions to make payments on credit default swaps, and other derivatives used to insure against debt nonpayment. Such an abrupt and disorderly demise of Greek finances would undoubtedly lead to "contagion" throughout the European Union. "It is essential in order to finalize the voluntary PSI [private-sector involvement] agreement that support be given by all official parties in the days ahead," said Charles Dallara and Jean Lemierre, co-chairs of the Steering Committee of the Private Creditor-Investor Committee for Greece, in a statement on Thursday. Both men met last Thursday and Friday with Greek Prime Minister Lucas Papademos and Finance Minister Evangelos Venizelos. News reports say talks will resume this Wednesday, but neither Dallara and Lemierre offered any indication one way or the other.

Further delays may complicate the issue even more. A schedule had been set up in which Greece's lenders -- the EU, the International Monetary Fund (IMF) and the European Central Bank (ECB) -- were to provide the country with two separate tranches of financing totaling $19.16 billion, most of which would have been used to meet their March debt payment of $17.9 billion. "The delay would mean this would no longer be feasible, meaning agreements on the PSI and the second bailout are required to avoid a default on the repayment," said Gustavo Bagattini, European economist at RBC Capital Markets.

As of this writing those private bondholders have "paused for reflection."  The key issue appears to be the rate of interest for the new bonds. Some countries are demanding a level as low as 3 percent. That's a rather paltry return on an investment paid off in a 20-30 year time frame, according to those critical of that demand.

Thus, the story that "went away" over the Christmas holidays is back with a vengeance. Greece remains in mortal peril, along with the bureaucratic pipe dream known as the European Union. EU-philes will keep kicking the debt can down a road whose last mile is coming closer and closer into view, while the people of individual nations continue to grapple with the implications of seemingly endless austerity, stubborn recession, and a loss of national sovereignty. In other words, meet the new year, same as the old year -- if all goes well. If it doesn't?

It may be 2008 -- or worse -- all over again.

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