About six weeks ago, there was some seriously gleeful backslapping going on in Europe. A perception took hold that Europe’s leaders, employing promises of bail-outs, budget austerity programs and Eurozone reform, had managed to stem the debt crisis that ravaged through the continent in the first half of 2010. Bond markets stabilized and the euro strengthened against the dollar. Fears of impending insolvency abated.
Looks like the celebration came too soon. The respite in Europe’s debt crisis appears to have been only temporary. Once again investors have come to realize that the real, underlying problems of Europe’s weaker economies remain generally unresolved, while the European Unions still has no clear agenda for resolving them.
The renewed jitters have showed up in sovereign bonds yields. The spread in yields between benchmark German bonds and those of Europe’s weaker economies –especially Greece, Ireland, Portugal and Spain – have been rising again in recent weeks, back towards levels last seen during the depth of the crisis in May, an indication that investors consider their bonds riskier to hold. In fact, the spread on Ireland’s bonds hit a record level after Standard & Poor’s downgraded its sovereign rating in late August.
What makes these jittery bonds markets even more disconcerting is that spreads are rising even though overall the Eurozone is performing better than expected. The Eurozone’s weaker members are generally holding true to promises they made to investors to reform. Spain, for example, has implemented not just accelerated budget cuts but also a reform of its labor market. Greece has stuck to its painful fiscal restructuring program much better than many had anticipated. And supporting such efforts, Europe’s economic recovery has also been stronger than expected, especially in light of the financial market turmoil the region has suffered through most of the year.
But none of that is easing the concerns investors have about the future solvency of Europe’s weakest economies. Investors are focusing once again on the fact that the core problems of the Eurozone are very much the same as they were back in May. The recovery in the zone is extremely disparate, with Germany racing along while others, including Spain, labor with high unemployment and meager medium-term growth prospects. Nor have the fundamental weaknesses of the Eurozone been alleviated. S&P downgraded Ireland because of concerns over its ailing banking system, which has been crushed by property-market losses, and the extra burden shoring it up could place on the state’s already questionable financial health. The rating agency upped its estimate for the government’s total cost of bailing out the sector to the equivalent of 58% of GDP and now expects its government debt-to-GDP ratio, the primary measure of a country’s sovereign debt burden, to reach 113% by 2012, well above the level of most European countries. A further downgrade, the agency warned, could be coming. Here’s what S&P had to say in a statement:
After a decade of rapid credit growth, which in our view greatly increased the risk profile of Irish banks, the Irish government has adopted what we view as a proactive and transparent approach to dealing with the financial sector’s difficulties…Nonetheless, we believe that the government’s support of the banking sector represents a substantial and increasing fiscal burden, which in our view will be slow to unwind.
In fact, all of the problems facing the Eurozone – from housing-bubble fallout to fiscal deficits to current account imbalances – will prove slow to unwind, keeping the financial pressure on Europe’s governments. The always-cheerful Wolfgang Münchau wrote in The Financial Times that he believes the bond markets know what they’re talking about:
To guarantee the solvency of the eurozone’s periphery would require not a few quarters of solid growth, but an entire decade. I am at a loss to understand how countries still recovering from an enormous asset implosion can generate so much growth. We can either dig our head in the sand or prepare for the inevitable – that one day a eurozone state will either default, or, more likely, be forced to restructure its debt. It is important not merely to accept the principle, but also to make the institutional preparations for an orderly default of a eurozone member. It is going to happen.
Another test of investor sentiment towards Eurozone sovereigns is around the corner. Governments in the zone intend on raising more than $100 billion in bond auctions in September – roughly twice the amount sought in August. Hopefully everyone in Europe enjoyed the celebration while it lasted.