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