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According to WSJ, less than two weeks after European leaders unveiled an agreement that was designed to bolster confidence in the region, the yield on Italy’s 10-year debt drew close to the 7% mark, a line in the sand of both practical and psychological importance to the market.
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Psychologically, 7% has become a beacon due to the fact that Greece, Portugal and Ireland each sought bailouts soon after their debt reached these levels. While analysts said it is too simplistic to say that Italy will be forced to ask for support if its 10-year debt yields 7%, they said the recent selloff is taking the country to the tipping point.
A sharp slide in bond prices pushed yields to their highest levels since the inception of the euro. The two-year yield rose a staggering 0.60 percentage points to 6.04% while the five-year yield climbed 0.37 percentage points to 6.56%.The 10-year yield was up 0.27 percentage points to 6.60%, having hit a new high of 6.62% earlier Monday.
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Update 1 (on Nov. 10, 2011)
Italian gov. bond yields continues to soar, now above 7% threshold. See the chart from WSJ below:
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It seemed that Europe is gradually approaching its own Lehman moment. What’s different, compared to previously trouble of other smaller PIIGS, is that the latest escalation fed fears that the euro-zone debt crisis is starting down its most perilous path: going from a storm raging among small countries at Europe’s fringe to one that strikes a major economic power.
Also, Italy’s debt load of €1.9 trillion ($2.6 trillion) is the second largest in Europe, behind Germany’s, and the fourth largest in the world. Next year, more than €300 billion of debt comes due, and Italy must continually tap markets to refinance it.
Country, unlike firms, can never go bankrupt. Lehman became “too big to save” for Washington, but will Spain become “too big to fail” for Europe?
An European sovereign debt crisis could at least affect the US economy in the following two respects.
First, the devaluation of the Euro triggered by the debt crisis will make American exports more expensive. So far this year, Euro has depreciated against US dollar by nearly 15% (from 1.44 to 1.23). This will hurt the US’ exports. During the last couple of years, government spending and exports have been the only two growth engines of the American economy. With tepid consumer demand and very weak labor market, consume- spending recovery is less likely to be quick and robust. The recovery now requires a very strong corporate spending to fill the holes left by the American consumers. One way to spur corporate spending is to sell overseas. Since Europe is the largest export market for the US, a sharp rising dollar is going to kill one of the two recovery engines of the US economy.
But the bigger worry remains in the banking sector. The financial markets across the Atlantic are highly integrated with each other. If the Greek debt crisis spills over into other bigger economies such as Spain and Italy, it will shake the European core: Germany and France, to which the US banking sector has very exposure. The following article from WSJ offers an in-depth analysis of what a potential debt contagion in Europe could impact on the US big banks.
Federal Reserve officials took pains this past week to dispel any notion that their support of Europe’s $1 trillion bailout meant U.S. taxpayer funds would be used to prop up the profligate Greeks. But in explaining the need for it to help ease financial strain, the Fed underscored that big U.S. banks remain vulnerable to Europe’s financial contagion.
During a closed-door meeting on Capitol Hill, Fed Chairman Ben Bernanke told lawmakers a European crisis would threaten U.S. banks, Sen. Richard Shelby said after the meeting. In a speech Thursday, Fed Vice Chairman Donald Kohn noted that lending systems “remain somewhat vulnerable.”
Yet big U.S. banks reported minimal exposures to Greece or Portugal, the most at-risk countries. So where does the danger lie?
The biggest threat is that the European rescue operation proves insufficient and problems spread from smaller euro-zone countries to bigger economies like France or Germany. That may threaten the viability of the euro, potentially paralyzing credit markets globally, just as happened following the collapse of Lehman Brothers.
If so, this could spell big trouble for five of the biggest U.S. banks—J.P. Morgan Chase, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley. Exposures to France and Germany, along with second-tier euro countries, is equal to about 81% of the banks’ combined Tier 1 common capital, a buffer to absorb losses, according to first-quarter and year-end securities filings.
While the risk of widespread contagion is still a worst-case scenario, fears that Europe’s debt crisis is far from over and that austerity measures may slow economic growth roiled stock markets on Friday and pushed the euro to 19-month lows.
Which countries should investors in U.S. banks worry about? Take Ireland, Spain and Italy. Exposures of the big-five to these three are equal to about 25% of the banks’ combined Tier 1 common capital. In particular, U.S. banks have to worry about banks in these countries being hit. Exposure to banks in Spain and Ireland, for example, exceeds risks to government or private entities.
An even bigger risk is if any European crisis blows back on the bulwarks of the euro: France and Germany. It isn’t impossible for that to happen. French and German banks have Greek exposure of more than €110 billion ($138 billion). Analysts have predicted that any restructuring of Greek debt could force France and Germany to recapitalize some of their own banks.
The big U.S. banks had exposures to the debt of governments, banks and other entities within those two countries equal to about 61% of their combined Tier 1 common capital. Exposure of the big-five banks to French and German counterparts totals about $100 billion. And while German government bonds likely would be a haven, the U.S. banks’ exposure to German banks is greater than their government exposure.
Clearly, holdings of European bank and government debt wouldn’t be worthless, but the financial crisis showed how quickly bank fears can feed on themselves. And the need for the Fed to help backstop Europe raises the question of whether, nearly two years after the crisis, U.S. banks really have enough capital, and liquidity, to weather big global shocks.
Investors in U.S. banks should be on alert: what happens in Europe may not stay there.
Update 1 (Nov. 7, 2011)
WSJ had an article with a nice graph depicting the ties between Europe and the US:
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Daniel Gros at WSJ asks the interesting question:
The real question is: Would a messy (and massive) default under which the country refuses to repay in full signify the end of the euro?
Yes and no.
A messy default would certainly end the ideal of the euro area as a club whose members are all equal and work toward a common goal, namely the stability of the common currency. Membership in such a club protects against financial problems, because members are supposed to behave well and help each other in case of unjustified speculative attacks. Although the EU Treaty says that members are not liable for each other’s public debt, there is an implicit political commitment, as we see right now, to provide emergency help.
The quid pro quo for this solidarity is of course the expectation that all members abide by certain standards, for example those embodied in the Stability and Growth Pact, that aim to limit budget deficits and debts. The continuing misreporting of fiscal data by Greece has already severely damaged this ideal. But the “club” could still be saved if Greece undertook a determined national effort to service its debt and avoid a messy default.
However, even a messy default by Greece alone would not necessarily mean the end of the euro area. The day after a formal default, Greek banks would no longer have access to the regular monetary policy operations of the European Central Bank. The ECB could no longer accept their collateral, Greek debt, which would immediately have less than junk status. The country would thus effectively cease to be part of the euro area. Its status would resemble that of Montenegro, which adopted the euro as legal tender without officially being a member of the single currency zone.
In Greece, following a messy default, euro notes and coins would still circulate in the economy, but one euro on a Greek bank account would no longer be automatically equivalent to one euro on a bank account elsewhere in the euro area, as Greek banks might immediately become insolvent and thus be shut out of the payment systems. Until Greek solvency has been re-established, the euro zone would thus de facto have lost one of its members—although the Greek Central Bank head would still sit on the Governing Council of the ECB, and the Greek finance minister would still be a member of the Euro Group, with his country’s normal voting powers intact.
The Greek economy would collapse, but the impact on the rest of the single currency zone should be minor, given that the country represents only about 2% of the euro area’s GDP and is not home to any systemically relevant financial institution.
In many ways, a Greek default would leave the euro zone in better shape. Its institutions would probably be strengthened, because it would have become clear that the framework is strong enough to withstand the failure of one of its members. Tolerance toward deficit violations and inaccurate reporting would be much reduced. The club would have been transformed into a federation whose peripheral components can be told to “get lost,” so to speak. As a result, majority voting would tend to replace consensus as the normal way of decision-making.
The potential monkey wrench is contagion. The main reason Germany is now agreeing to accelerate the Greek bailout package is that tension on Spanish financial markets has arisen over the past several days. In contrast to Greece and Portugal, Spain (and even more so Italy) are indeed “too big to fail.”
Will contagion prove fatal? The fundamentals of Spain and Italy, especially their self-financing capacities, are much stronger than in Greece and Portugal. Moreover, neither Spain nor Italy would gain much from a default, since most of their public debt is held by their own citizens. A default would thus not lower the foreign debt of the country. For Greece, by contrast, 90% of all public debt is held by foreigners, who could be expropriated by a default.
However, markets can at times be irrational. The real test of the euro area is thus not Greece, but whether it can protect members that do not have an insolvency problem from speculative attacks.
The signals are so far mixed. After an initial bout of generalized nervousness in February, when it first became clear that the second leg of the financial crisis could imply sovereign default, financial markets have increasingly differentiated among the weaker members of the euro area. Risk premia have tended to move together in the same direction, but with completely different orders of magnitude. The spreads on Spanish bonds have increased, but they remain less than one third of those of Greece, with Italy even lower.
The fate of euro is not being decided in Athens, but in Madrid and Rome.
WSJ analyzes why investors are still betting down Euro and Greece:
This is not the beginning of the end, not even the end of the beginning. The International Monetary Fund and euro zone’s €110 billion ($145.37 billion) three-year Greek debt support package still needs to be given final approval by 15 euro-zone leaders. They in turn must satisfy themselves—and their national governments and voters—that there’s a reasonable chance their loans can be refinanced, rather than turning into a straight fiscal transfer. That’s far from certain.
First, the plan does not buy Greece quite as much time as it appears. Of the €110 billion headline figure, €10 billion is going to a Financial Stability Fund to support Greece’s banks. Greece needs around €30 billion for 2010; for 2011-2012 debt and interest payments alone total €93 billion, according to Barclays Capital. So even with the program, Greece is likely to need to return to the markets in late 2011 or 2012. Ideally it would return as soon as possible, if the plan works.
Second, debt will still be rising in 2011 and 2012, topping out only in 2013 at an eye-watering 149% of GDP. In 2012, the budget deficit is still forecast to be 6.5% of GDP. Greece’s credit ratings may then be even lower than they are today; this may further complicate market access. Bond investors will have to be convinced already in 2011 that the debt trajectory and economy will turn around decisively, in order to engender private interest in Greek debt.
True, the new plan is at least realistic, recognizing the damage the economy will suffer: Greek GDP is assumed to shrink 4% in 2010 and 2.6% in 2011, before growing just 1.1% in 2012. The total fiscal adjustment of 11% of GDP is now in line with economists’ assumptions of the scale of effort necessary. And there will be quarterly monitoring of progress; International Monetary Fund involvement should boost credibility.
But the deal faces substantial execution risks: The Greek government is facing growing domestic opposition to its new austerity program announced last weekend, which includes further public-sector pay cuts and a VAT increase. Success also depends on global growth remaining robust as Greece is ill-equipped to deal with any fresh external shocks.
Euro-zone leaders may persuade themselves they have to endorse the package since any alternative, such as a restructuring, would be so traumatic. But they need to be clear about the risks: Even if the Greek economy performs in line with the IMF’s projections, they may yet need to provide further support packages as private lending starts to re-engage. The euro-zone’s engagement with Greece is likely to be a lengthy one.
Euro reached its lowest level against US dollar since April 2009, now trading below 1.30 $/euro. Looks like the market is not happy about the huge costly Greece rescue plan put out by Germany-led EU and IMF.
We are also seeing signs of contagion, to Portugal and Spain…now let’s see if the Euro can hold at 1.25 level. If not, Euro will have a real problem.
Marty Feldstein thinks Greek default is inevitable. I think default is one possible outcome, and the alternative is for Greece to ask EU to be “kicked out” of European Union, so it can depeg itself from Euro zone and use monetary policy to stimulate its own economy.