How bad off are the PIIGS?

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The crisis in Europe was sparked by the widespread belief among investors that Greece’s financial woes were just the tip of a much bigger debt iceberg in the Eurozone. The fear has been that other member nations – Portugal, Ireland, Italy and Spain, which, along with Greece, are called the PIIGS – were also buried in debt and could tip over into crisis just as Greece has done.

But is that really the case? Are all the PIIGS in the same hot water as Greece? Barclays Capital economists ran some figures in a recent report analyzing the chances that the various PIIGS would fall into Greek-like debt meltdowns. What did the findings show?

Though the other PIIGS are better off than desperate Greece, most of them unfortunately are very, very vulnerable.

Barclays looked not just at the solvency position of the PIIGS’ governments, but also the severity of the fiscal adjustment necessary, the total financing needs of the state, the strength of the banking sector, and the level of dependence on foreign sources of financing. Then the bank awarded each PIIG a “score” measuring its vulnerability to insolvency. Needless to say, Greece’s score was the worst, but surprisingly, most of the rest of the PIIGS posted scores remarkably similar. Portugal came in an uncomfortably close second with a score of 4.3 versus Greece’s 4.5. In third place was Ireland, at 4.1. Spain followed at 3.4. I was struck by Ireland’s ranking here, since the financial markets seem to indicate greater confidence in Ireland than the other PIIGS. Ireland’s score got hit because Barclays figures it has the most troubled financial sector.

The only country that Barclays questioned should be a PIIG is Italy, with a much lower score of 2.1. Here’s why:

Italy does not really belong to the group. It has been included based on its high initial debt-to-GDP ratio. However, when accounting for the fiscal dynamics (ie, the very low primary deficit), the potential financing needs (ie, the larger domestic creditor base) and the comparatively modest risk in the banking sector (in particular, the low real estate related risks), it becomes clear that Italy is not in the same risk category.

How did Europe’s giant 750 billion euro ($950 billion) rescue fund announced this week change the picture? Quite a bit, Barclays says. The folks at the EU obviously did a good job on the math:

The EUR750bn more or less matches the combined gross financing needs of Greece, Portugal, Ireland and Spain for three full years. Therefore, it would allow for the replication of Greek-like packages, allowing these countries, in principle, to remain out of the market for two to three years. This would seem to substantially reduce the immediate threat of financing crises.

Barclays says that, with the crisis package in place, now investors will be closely watching the incredibly drastic fiscal adjustments the PIIGS need to make:

Going forward this is likely to shift the market’s attention to the actual implementation of announced fiscal measures and also to growth performance as these measures are being implemented. The risk is that if these developments surprise on the downside, markets’ enthusiasm for the EU’s mega package may not last.

My guess is that investor sentiment will almost definitely turn on this fiscal reform issue, despite the big bailout fund. I don’t see that it’s possible for all of the PIIGS to undertake the fiscal measures necessary. Especially Greece. Barclays figures that Greece must completely reverse its fiscal position, from a primary deficit of 8.5% of GDP in 2009 to a surplus of at least 5% by 2014 in order to ensure solvency. Such a turnaround just seems ridiculous. That’s why widespread fears remain that Greece will eventually need its debt restructured to lessen the burden on its feeble finances, no matter what bailout packages might be put in place by the EU. If that happens, creditors will take a hit, and we could end up rebooting the debt crisis.

So Barclays sums up on a sour note. Aside from Italy, the other PIIGS are in a bad enough financial position to keep investors nervous, and thus crises likely.

Most of the other countries studied, however, would seem sufficiently fragile for a potential solvency crisis to become self-fulfilling, in our view, especially if investors price in higher default probabilities, raising the countries’ financing costs.

In other words, Europe’s debt crisis, which now seems to have abated, could roar back again at any moment. Yikes.