The travails of the euro zone are intensifying with ratings agencies like Moody’s warning of the prospect of multiple defaults by member countries. As if all of this weren’t bad enough, speculation is rife of countries like Greece exiting the euro zone even as financial panic threatens to engulf stronger ones like Italy, France and Germany.
The warnings of ratings agencies need not be taken too seriously since their credibility is low. After all, these are the same agencies that considered Greece’s debt to be investment grade for most of the last decade, even when this country admitted to cooking its budget deficit numbers to join the euro zone in 2001! Nevertheless, this debt-ridden economy is truly in a bad shape — reflected in the massive 2,816 basis point spread on its 10-year bonds vis-a-vis the risk-free German Bunds.
The sovereign spreads in the euro zone as a whole point in the same direction. Portuguese 10-year bonds with yields of 13.74 per cent entail a 1, 157 basis point spread against Bunds. Even the 10-year bonds of stronger members like Italy have a 468-basis point spread. Hundred basis points is one percentage point. The spread of French bonds has only recently managed to fall below the 100 basis point level. A rule of thumb is that sovereign bond yields or borrowing costs of seven per cent is a level that can push their respective governments to seek a bailout. Italian bonds hit this level not so long ago.
An interesting analysis of the rise and dispersion of sovereign spreads in 10 euro zone countries to tell a story of escalating financial tensions has been done by Ashoka Mody and Damiano Sandri in a recent International Monetary Fund (IMF) working paper “Euro zone Crisis: How Banks and Sovereigns Came to be Joined at the Hip”. Prima facie, such data indicates that 10-year government bond yields for many of these countries were fairly stable and indistinguishable from one another during the past decade before they sky-rocketed from 2009 onwards with the yields of Greek bonds touching 30 per cent!
However, these economists take a closer look at sovereign spreads of 10 euro countries from June 2006 to May 2011 and argue there are three phases through which the ongoing financial tensions have unfolded. The first phase follows the sub-prime lending crisis of July 2007, the epicentre of which was the US. As financial stress was communicated to Europe, sovereigns paid a premium for global financial risk. Spreads rose modestly. The differentiation in spreads across the euro 10, however, remained low.
The turning point was the rescue of Bear Stearns in March 2008 when a distinctly European dimension to the financial crisis decisively emerged. During this second phase, a sovereign spread responded increasingly to the weakness of its own financial sector. In early 2007, the spread on a 10-year Irish bond was still negative. Even in 2008, the Irish spread was only 30 basis points vis-a-vis the German Bunds. Thereafter, such spreads rose rapidly to 300 basis points. When these economists were writing their paper in mid-September 2011, Irish spreads were 650 basis points.
This second phase lasted till January 2009 when a relatively small bank, Anglo Irish, was nationalised. To be sure, global factors like the Lehman Brothers’ bankruptcy raised risk premia everywhere. But in this second phase the rapid rise in spreads was accompanied by a significant differentiation across countries. The big change after Bear Stearns was the markets’ assessment of the financial sector prospects in the euro zone. Following an observed weakness in financial sector prospects, sovereign spreads inversely rose in the euro 10 rapidly with a delay of only a few weeks.
The post-Anglo Irish third phase indeed is the one in which crisis became full-blown. Not only did growing financial stress raise sovereign spreads, but sovereign weakness was also transmitted to the financial sector. Financial stress and the rise in sovereign spreads moved contemporaneously. With the spreads, health of the financial sector and declining growth prospects reinforcing one another, the financial sector ceased to be the driving force of the euro crisis as it became joined at the hip with the fate of the sovereigns!
What is to be done? While the move by leading central banks to provide liquidity for troubled euro banks is a step in the right direction, it is not sufficient to address the sovereign debt crisis and lessen the prospects of a global recession. Mody and Damiano recommend that additional fiscal costs are necessary for strengthening banks. This can pay off through higher growth in the euro zone and reduce the chances of multiple defaults. Additional support for banks, thus, must be an overriding policy priority and must be extended without delay as the zone hovers on the brink.
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