Debt default virus has no respect. Not even for triple-A ratings

Two years ago, “bankruptcy” and “debt default” were expressions locked with seven keys in the ark of history. When Carmen Reinhart and Kenneth Rogoff in early 2009 revisited eight centuries of “financial folly”, “sovereign debt crises” had died to developed countries, particularly Europe, 70 years ago. “This Time is Different”, the title of the book, was an irony. It meant precisely the opposite. The work was received by economists and politicians in rich countries with jeers and laughter.

In their prototype of the sequencing of major financial crisis, they warned that, at a given point, bankruptcies, due to internal or external debt, would come out from behind the curtains of the great recession.

The argument of the critics and skeptics of that historical research was that bankruptcies were then things of the Third World. Soon after the book release, one of the richest countries per capita, Iceland went bust. In November 2009, the debt crisis broke out in Dubai, another paradise. And shortly after the Anglo Irish Bank case broke out, within the Euro area. In January 2010, Moody’s announced the “slow death” of Greece and Portugal. The rest is history.

Who is next?

Since 2010, three Eurozone countries in a pre-bankruptcy situation had to be rescued. Already convinced that the sovereign debt crisis virus can even penetrate the armored dome of a single monetary zone – the fortress of the euro – readers start to wonder, who’s next.

Bets of speculators focused on two large economies that were part of the playful acronym PIIGS. From the little ones we went to the too big ones, that weren’t supposed to fail (TBTF). The credit deterioration of Italy and Spain accelerated. Since the last quarter of 2010, the cost of credit default swaps soared 311% for Italy and 138% for Spain. This acceleration would eventually bring down the two governments, in Rome by presidential initiative and pressure from Brussels, and in Madrid, a week ago, through elections.

November showed, quite clearly, a new pattern of the epidemic. The virus crossed the border of the “peripheral” – those undisciplined spenders and financial ‘bubbles’ lovers, that rabble from the ‘South’ and the Irish island – to the core of the Eurozone. And worse, it reached two economies that still with triple A ratings – France, the second pillar of the euro area and Austria, a “bridge” country for the entire Eastern Europe in the European Union (EU). In between, supreme irony, it took also Belgium, the country hosting the EU’s center of power, that fails to form a government since the elections in the summer of 2010 or even adopting a budget commitment for 2012. Belgium CDS cost has risen 131%, France 129% and Austria 125%.

To get an objective view of the situation in the euro area – and its 17 members – the Portuguese weekly Expresso set up a dashboard, assessing the countries that have not been rescued based on five criteria: yields on sovereign bonds in the secondary market, deficit and public debt to GDP, cost of CDS and growth forecast through 2016.

The score aligns the remaining 14 members of the euro in risky areas, red and yellow, or risk-free, green. Italy (in the worst situation), Spain, France and Cyprus (due to the umbilical connection to Greece, an economy in imminent default), are already in the red. Belgium, Slovenia and Austria are in the yellow zone. The rest are still in the green zone, with Finland, Estonia and Luxembourg in more comfortable positions.

Even changes of government, as occurred in Italy with the appointment of the executive by presidential initiative, led by the independent Mario Monti, or the large majority of the Popular Party in Spain’s elections, did not alter the basic data of the epidemic, despite the dismay of the supporters.

Paradoxically, despite Spanish voters having thrown out the PSOE, the debt markets signs were clear. The auction of very short-term debt, early this week, went seriously wrong with the Spanish Treasury having to pay yields above 5%, even higher than those paid by IGCP in the most recent Portuguese debt auction for the same time periods – 3 and 6 months. Spanish bond yields for medium and long term debt remain above 6%, despite ECB’s intervention in the secondary market.

The two Italian Super Marios – Mario Monti, the new head of government in Rome, and Mario Draghi, the new president of the ECB in Frankfurt – have failed to hold the yield rising on Italian debt, which remains on the 7% level, both in the short, and in the medium and long-terms.

Probably thinking of Italy and Spain, and in the European inefficiency (of Brussels and the ECB) that is in plain sight, the IMF decided to launch the Precautionary and Liquidity Line (PLL) a “more flexible” special line of liquidity for the crisis bystanders (one more linguistic innovation). A curious expression to define the profile of the economies that have healthy key indicators but suffer from the contagion of the debt crisis. Investors wonder who will be the first knocking on Washington’s IMF door.

The attack on the triple-A

France and Austria’s Triple-A ratings remain under stress. But the none of the three major rating agencies have yet made the critical step, as Standard & Poor’s did in August with the United States. If these countries lose the highest rating, the European Financial Stability Fund becomes junk. Therefore, or the the IMF wins the hegemony on the management of the European debt crisis, which would be a political defeat for the euro area, or Europeans will have to create a financial instrument that convinces. Hence all the debate on changing the mission of the ECB and the possible creation of Eurobonds.

But the icing on the cake came in the middle of the week. An auction of German debt become a fiasco, and the Bundesbank, the central bank, had to retain nearly 40% of the issuance. That was a clear sign that investors are turning up their noses even to Bunds, the safer sovereign debt that served as reference, until then. On Friday, the cost of credit default swaps on the German debt rose to more than 120 basis points and the cumulative probability of default crossed the 10% barrier, according to the CMA DataVision.

On Wednesday, the day of that German debt auction, the cost of credit default swaps rose significantly from 101 to 107 basis points and the cumulative probability of default rose to over 9%, which contrasts with 8.2% for the UK and 4.8% for the United States. Equity markets around the world added losses of € 800 billion. If we add the impact of the failure of the super committee of U.S. Congress responsible for the planning of cutting debt and deficit, in three days, equity markets added € 1.75 trillion in losses.

On Thursday Chancellor Merkel and President Sarkozy joined the new Italian Prime Minister Mario Monti in a mini summit in Strasbourg. It is not known yet whether this G3 is here to stay. The French newspaper Le Figaro saw in the action the intention of bringing Italy back on the table as a power player.

However, the mini summit was another fiasco. The compromises were postponed until the eve of EU summit on December 9. International investors interpreted the picture of the three as another drag of a situation that is deteriorating day by day. Markit went even further, considering the performance of Chancellor Merkel as a “Pyrrhic victory”. “But there is no doubt that the uncertainty permeating the market is causing participants to take off risk, and it is more than likely that Germany’s actions – or lack of them – are contributing to the volatility. Ruling out a change of mandate to allow the ECB to act as a lender of last resort negates the most plausible short-term solution to the debt crisis. Fiscal integration through a treaty change may be desirable but it won’t happen overnight and will do little to quell the unrest sweeping through the markets”, wrote the agency on Friday afternoon.

In these nearly two weeks before next summit much water can run under the bridges. Next week is full of debt auctions in the euro area – Belgium on Monday, Italy on Tuesday and Spain and France on Thursday – and meetings – the United States – Europe summit on Monday and the Eurogroup meeting on Tuesday.

Although the evolution pattern of such crises is typified, at least since the crises of the waves of financialization and nineteenth century bankruptcies, the current context is different from the long period of the first phase of globalization since 1450 and the first bankruptcies of 1500. The context of financial capitalism and globalization has changed radically since 1971. But that’s another story. The current crisis can be different this time – and we could be navigating in uncharted waters.

Source: An article by João Silvestre and Jorge Nascimento Rodrigues on the November 26 printed edition of Expresso Economia. Dashboard concept by Joao Silvestre. English Edition by: JPO | LISwires (c) 2011, JNR/JPO;

One Response to “Debt default virus has no respect. Not even for triple-A ratings”

  1. Don’t worry!!! one of these days we’ll all be surrounded by slant-eyed people, they’ll buy all the debts and they’ll take over Europe, bite by smal bite!!! I wont be here to see. But I’ll enjoy their food for the time being.

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