According to Eurostat, second-quarter GDP in the Euro-zone registered a growth of merely 0.2%, the slowest pace since the regional economy escaped the last recession in late 2009. The quarter over quarter growth of Germany, France, Italy, Spain, and Portugal came in 0.1%, 0.0%, 0.3%, 0.2%, and 0.0%, respectively. Meanwhile, Greece's second-quarter GDP, unadjusted for seasonal changes, contracted 6.9% compared with the same period last year. The slowing growth of the Euro-zone economy fully reflects the continual spread of the sovereign debt crisis. As such, the future developments of the Euro-zone have become a focus of market participants.
The expanding crisis
The European debt crisis first broke out in Greece in December 2009 and spread rapidly to Ireland, Portugal, Italy, and Spain. As Europe and the IMF put together a rescue mechanism, Greece, Ireland, and Portugal, three worst-hit countries, received 110 billion euros, 85 billion euros, and 78 billion euros in bailout funds, respectively. In May, markets panicked after the EU, IMF, and ECB postponed sending Greece its fifth bailout funds. On July 21, the Euro-zone agreed on a second rescue package for Greece that provided 109 billion euros in funds as well as relief measures such as debt repayment postponements and the lowering of borrowing costs. Soon afterward, investors shifted their attention to other debt-ridden countries such as Spain and Italy. Standard & Poor's downgrade of the U.S. credit rating on August 6 shook the markets, and the fiscal conditions of France and the possibility of its top rating being downgraded became the latest focus of the European debt crisis. Clearly, the European debt crisis is engulfing increasingly more countries and has become an important factor in financial markets. The current European debt crisis has the following features.
Debt crisis transformed from a liquidity crisis to a solvency crisis.
Debt crisis spreading from peripheral to core countries
As the third and fourth largest economies of the Euro-zone, Italy and Spain's debt problems are garnering increasingly greater attention. As Moody's added Italy to its negative watch list of sovereign ratings, the market began to consider Spain as the "risk threshold" of the European debt crisis. The 10-year yields of both countries once rose to an historic high of over 6%. Meanwhile, the public debt and deficit levels of German and France are also worrying. The public debt to GDP ratios of Germany and France are 83% and 82%, respectively, whereas the deficit to GDP ratios of the two countries are 3.3% and 7.1%, respectively. In June, Standard and Poor's cautioned that France might lose its triple A rating if it failed to solve its overspending problem. In addition, Moody's placed France's three biggest banks on its negative watch list. For a long while, yields on 10-year government debts of France and Germany are considered the benchmark for the borrowing costs of European governments. However, due to French banks' considerable exposure of about 300 billion euros to the debt-ridden European countries, the 10-year yields on French government bonds have recently begun to jump and reached the largest spread over comparable German bonds since 1995. Furthermore, a stagnating French economy, the possibility of a higher-than-expected debt to GDP ratio of about 85.4%, and plunging support for the Sarkozy administration with an approval rating of 33% all combined to heighten the risks of insufficient debt reduction and credit downgrade. In the meantime, the chances of the debt crisis spreading further are increasing as Germany, the economic engine of the Euro-zone and the largest benefactor of the bailouts, is facing sagging economic growth and rising domestic opposition. The IMF warned in its global economic outlook report that the debt crisis could spread to the core countries of the Euro-zone as well as some Eastern European countries. As it stands now, such risks are rising with each passing day.
Crisis-induced risks in banking sector emerging
According to the results published by EBA in July, 8 out of 90 European banks failed in the second round of stress test. Overly optimistic assumptions were applied, and the test did not consider the possibility of sovereign defaults. Regardless, the test revealed significant exposure of the European banks to sovereign and personal loans in the debt-ridden countries. By December of last year, four French banks, BNP Paribas, Credit Agricole SA, Societe Generale SA, and BPCE Group, had lent 300 billion euros to the five PIIGS countries. Meanwhile, ten German banks including Deutsche Bank AG and Commerzbank AG had lent 174 billion euros to such countries. Most of the loans were residential mortgages, small business loans, corporate bonds, and commercial property loans. Should the debt crisis worsen, default risks would definitely rise. The second rescue package for Greece included such features as extended maturities and voluntary exchange and buyback of bonds that would have a negative impact on the balance sheets of banks holding Greek debts. According to the Institute of International Finance, BNP Paribas may incur a loss of 1 billion euros, and Societe Generale and Deutsche Bank may lose 500 million and 317 million euros, respectively. In addition to impairment loss, the sovereign debt crisis also reduced the value of collaterals that banks pledged for debt financing and central bank loans. Moreover, governments became less able to provide help for their beleaguered banking sectors, which further increased borrowing costs. In Greece and Ireland, deposit outflows and credit tightening are taking place. The recent downward pressure on European banking shares also reflects investor worries on the prospect of potentially massive losses in the sector.
Originally published in The Stitch Times, October 2011
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