European Debt: That sinking feelingagain?

December 01, 2014

Europe periphery debt: Plus a change, plus c'est la mme chose?

This French quote meaning the more things change, the more they remain the same summarizes the debt scenario in Europes
periphery nations. Not too long ago, in 2012, European bond markets were spooked by prospects of Greece default and large
intercountry exposures between European nations. Since then, austerity measures have been adopted by these nations in return for
bailouts. The European Central bank (ECB) too joined the action by lowering interest rates to near zero levels. In July 2012, the ECB
governor Mario Draghi promised to do whatever it takes to defend the Euro, presumably to buy time for European nations to manage
the fiscal situation. In spite of no commendable improvement, European bonds have rallied since then, with 30287 bp compression
in yields last year. However, instead of declining, debt has increased either absolutely or as a percentage of GDP. A closer look at
the reasons for the same reveals that austerity has had the opposite effect of the one intended, and has given rise to the specter of
deflation. While the ECB has recognized the urgency of action and announced a broad-based asset purchase program,
disagreement among major European nations over structural reforms may bring back Europes weak macroeconomics in focus. The
movement in Greek bond yields over the last three months (Sep Nov) gives a glimpse of what may be in store for other sovereign
yields in 2015.

.2012: The darkest hour for Europe?

Nearly two years ago, toward the mid of 2012, Europes debt concerns were at the peak among the international investment
community. After the onset of the subprime crisis of 2008 in the US, Europe too was impacted. Europes debt-to-GDP ratio soared from
67% in 2008 to more than 90% by 2012, as debt increased and GDP declined. Not surprisingly, the bond market panicked and
sovereign yields for several European countries soared to staggering levels. Countries such as Portugal, Italy, Ireland, Greece and
Spain came to be identified as the periphery nations due to their deteriorating socioeconomic conditions and were clubbed together by
the unflattering acronym PIIGS.

European Debt to GDP (%)

Sovereign bond yields (%)

39.9

7.5

2012Q3

2011Q2

2010Q1

2008Q4

2007Q3

2006Q2

2005Q1

2003Q4

2002Q3

2001Q2

2000Q1

65

Spain (LHS)
Greece (RHS)

45

Oct 22, 2012

70

Jul 30, 2012

0
May 07, 2012

75

Feb 08, 2012

Nov 15, 2011

Aug 23, 2011

18

May 31, 2011

5
80

Mar 04, 2011

27

Dec 08, 2010

85

Sep 15, 2010

36

Jun 23, 2010

Mar 29, 2010

90

Jan 04, 2010

Oct 06, 2009

95

Italy (LHS)
Portugal (RHS)

Source: Eurostat

On top of concerns over absolute debt of each European nation and its ability to service the debt, a new concern soon emerged:
intercountry exposure and interlinkages. The foreign debt obligations of each country were sliced and diced to reveal which European
country owes how much to which European country, and what a default by a periphery nation (such as Greece) would mean in terms of
bond losses to other nations. Furthermore, speculation over a chain reaction of defaults was rife. This speculation took on a new form
of which country will exit the Eurozone first to devalue its currency and repair its economic woes. It required a strong reprimand from

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European Debt: That sinking feelingagain?

December 01, 2014

Mario Draghi (Dont bet against the euro) and a promise (The ECB will do whatever necessary to preserve the euro) to stop the
depreciation of the euro against the US dollar and bring into fruition the Draghi Put. The promised weapons of Eurozone rescue
included monetary policies (hold interest rates close to zero as long as required) and asset purchases by ECB (if required).

European Debt: Intercountry exposure (2012)

EUR vs. USD: The Draghi Put

1.6

The
Draghi
Put

1.5
1.4
1.3
1.2

Jan-14

Jul-13

Jan-13

Jul-12

Jan-12

Jul-11

Jan-11

Jul-10

Jan-10

Jul-09

Jan-09

Jul-08

Jan-08

1.1

Source: Eurostat, NY Times, Reuters Eikon

Three nations required to be bailed out by the ECB: Greece (EUR 130bn), Ireland (EUR 85bn), and Portugal (EUR 78bn). These
bailouts, although necessary, were opposed by stronger economies (such as Germany), which demanded stringent austerity measures
to be imposed on the bailed-out nations. The entire Eurozone, including Germany, went through a wave of austerity measures in terms
of government expenditure cuts and varying degrees of reforms in terms of tax raise and structural reforms. The expectation was that
soaring government debt would be reined it, giving the respective nations the required respite from credit agencies. This was expected
to improve debt repayment capabilities, which would bring down sovereign debt yields. This was also anticipated to aid the private
sector to invest in productive capacities by borrowing debt at lower cost.

Austerity measures taken up by Eurozone nations

Greece

Massive bailout (EUR 130bn) in return for spending cuts equaling 1.5% of the countrys total output; new property tax;
suspension of 30,000 civil servants on partial pay

Italy

Public sector pay cuts and freezing of new recruitments created savings of EUR 70bn

Ireland

EUR 85bn bailout in return for government spending cut by EUR 4bn, with all public servants' pay cut by at least 5%;
lower expenditure on social welfare; VAT rose to 23%

Spain

EUR 27bn cut from the state budget; public sector workers' salaries frozen and departmental budgets cut by up to 17%

Portugal

EUR 78bn bailout in return for 5% pay cut for top earners in the public sector; 1% increase in VAT; income tax hikes for
high earners

Source: Aranca Research

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European Debt: That sinking feelingagain?

December 01, 2014

20102014: Not much of a difference in Europes macroeconomics

Although in theory the measures taken were appropriate, the expected results have not come through. The overall debt to GDP ratios
remain high; in fact, they are higher than the 2012 levels. The absolute debt levels too have crept up instead of decreasing. The
expected private sector momentum has not picked up in spite of record low interest rates. Unemployment remains stubbornly high, to
the extent of 25% in Greece and 15% in Spain. On top the specific problems faced by these countries, the entire Eurozone appears to
be on the brink of deflation, with inflation levels at 0.5%, far away from ECB target of 2%. It is doubtful if economic recovery would pick
up as there has been no real strong growth.

European Debt to GDP updated till Q12014 (%)

2009Oct
2011Q2

2013Dec

2007Sep
2010Q1

2011Nov

2005Aug
2008Q4

2003Jul

2001Jun

1999May

2013Q3

1997Apr

-1

Eurozone inflation is far below

ECB target of 2%

1991Jan

65

2012Q4

2012Q1

70

2011Q2

2010Q3

75

2009Q4

2009Q1

80

2008Q2

2007Q3

85

2006Q4

2006Q1

90

1995Mar

Overall Debt to GDP has kept on rising

1993Feb

95

Eurozone inflation (% yoy)

Source: Eurostat

Eurozone Unemployment rate (%)

Eurozone GDP growth (% yoy)

13

4
Eurozone unemployment appears to
have lowered mainly because of
Germany; rest European nations
continue to suffer high unemployment

12
11

3
2
1
0

10

-1

-2

-3
-4

-5
2013Q4

2012Q3

2007Q3

2006Q2

2005Q1

2003Q4

2002Q3

2001Q2

-6
2000Q1

2013Apr

2010Oct

2008Apr

2005Oct

2003Apr

2000Oct

1998Apr

Source: Eurostat

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European Debt: That sinking feelingagain?

December 01, 2014

Austerity not the silver bullet it was meant to be.

The current situation warrants an explanation in terms of what the austerity measures managed to achieve. The expenditure cuts and
postponement of non-essential expenditure were undertaken by several European governments with the hope that fiscal deficits would
be controlled. Along with increase in taxes, curtailment of concessions and exemptions to several industries and target groups were
expected to beef up the fiscal positions. However, the austerity measures appear to have impacted the overall demand environment
more severely than was anticipated. In addition to poor consumer demand, which was expected in view of salary freezes and a halt in
incremental recruitment in government jobs, corporate investments too slowed down. Consequently, corporate profit growth slowed,
thereby impacting government revenues from tax rate increases. Therefore, gains from expenditure cuts appear to have been
neutralized to a large extent from lower revenues due to the overall economic slowdown. Consequently, incremental government
borrowing has continued to fill the fiscal gap.

Individual countrys net debt (EUR Billion)

2,000

800
700

1,600

600
500

1,200

400
800

300
200

400

100

0
2005

2006

France (LHS)

2007
Italy (LHS)

2008

2009

Greece (RHS)

2010

2011

Ireland (RHS)

2012

2013

Portugal (RHS)

2014
Spain (RHS)

Source: IMF

ECB The new knight in shining armor.

Currently, all eyes are on the ECB to rescue the Eurozone from a looming financial crisis. Although admitting that monetary policy cant
do everything and that it can do more if structural reforms are implemented, the ECB Governor Mario Draghi is cognizant of the lack of
structural reforms in several countries, including his home country Italy. Therefore, he has undertaken unconventional monetary policy
measures. Having already surprised everyone by taking the interest rates on bank deposits to unprecedented negative levels (-0.2% in
two steps) in October 2014, Mario Draghi announced purchases of asset-backed securities of various types. Currently, the ECB is
buying covered bonds (bonds worth c.EUR10.5bn bought so far) and may start buying asset-backed securities. The unconventional
monetary policy measures, according to the ECB Executive Board member Yves Mersch, may also theoretically include sovereign
debt, gold, exchange-traded funds, and real estate. The ECB appears increasingly desperate to ward off the threat of deflation.

.fighting the ogre of deflation?

With inflation in the Eurozone declining since 2012 and at 0.5% in October 2014, far away from ECBs target of 2%, the threat of
deflation is real and immediate. Famously described by the International Monetary Fund (IMF) Managing Director Christine Lagarde as
the ogre that must be fought decisively, deflation is now rising up the priority list of concerns for ECB. Due to the widespread
unemployment in several European countries and austerity measures undertaken, purchasing power has been impacted and consumer
demand is weak. Corporate demand too has been affected, which may lead to conditions for a prolonged, broad decline in prices,
similar to that in Japan. That is exactly the situation the ECB intends to avoid. But its means are restricted, and it needs support in

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European Debt: That sinking feelingagain?

December 01, 2014

terms of spending from nations such as Germany and the Netherlands, which are far better fiscally and can afford to spend productively
on infrastructure development, thereby starting a virtual cycle of consumption and investment in the Eurozone.

Germany: A new cause of concern for Eurozone?

Germany, the largest Eurozone nation, is adamant on pursuing its path of fiscal prudence. The stentorian fiscal discipline and pledge by
German Chancellor Angela Merkel to balance Germanys budget is backed by Bundesbank, its central bank. Germanys opposition to
the ECBs asset purchase program and its wish to finance investment in infrastructure without adding new debt is delaying the much
needed action on the ground. This is despite criticism of its fiscal tightness, persuasions from the US Treasury Secretary John Lew and
ECB Chief Economist Peter Praet encouraging Germany to spend more to spur the Euro area economy. Furthermore, the sentiment
within Germany itself is dampening, as indicated by monthly surveys such as the ZEW indicator and IFO survey. Whether the
improvement in most recent survey data sustains, remains to be seen. Especially, since the impact on Germanys exports to Russia,
after the sanctions imposed by the EU due to the Ukraine conflict has added to the possibility of the countrys growth slowing down
more than anticipated.

Germany IFO Business Climate Index

Germany ZEW survey of economic sentiment

116
65
114
55

112

Oct-14

Jul-14

Apr-14

Jan-14

Oct-13

Jul-13

Apr-13

Nov-14

Jun-14

-5

Jan-14

100
Aug-13

5
Mar-13

102
Oct-12

15

May-12

104

Dec-11

25

Jul-11

106

Feb-11

35

Sep-10

108

Jan-13

45

110

Source: Reuters Eikon, Centre for European Economic Research

Greek bond yield movement in 2014 The trailer for 2015?

Greeces benchmark government bond yields have gyrated wildly in 2014, from 5.6% to 8.9%. During January to September, the bond
yields kept declining, as the overall economic environment in Greece kept improving marginally, although most macroeconomic
indicators for Europe kept on either deteriorating or stagnating. Even with the Ukraine crisis at its peak in July 2014, the bond yields
held their ground on presumption that the conflict may be contained or resolved sooner than later. However, during the September
October period, as the view on stretched valuations of the US and Europes equity indices, low volatility, and investor complacency
started gaining ground, the imminent sell-off triggered a sharp fluctuation in bond yields, which lost the gains of the entire year to settle
at the old lows. Although the reasons were global, Greek bonds appeared to have been singled out among European sovereigns as
private sector debt has emerged as a new cause of concern. There are several reasons indicating heightened risks facing sovereign
yields of other European nations and 2015 may be the year in which the macroeconomic concerns once again evoke fear among
European investors, especially in the bond market.

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European Debt: That sinking feelingagain?

December 01, 2014

Greek benchmark bond yields (%)

8.9

9
8.5
Sharp rise in bond yields
indicate sudden
escalation of concerns
on Greece

8
7.5
7
6.5
6
5.5
Jan-14

5.6
Feb-14

Mar-14

Apr-14

May-14

Jun-14

Jul-14

Aug-14

Sep-14

Oct-14

Nov-14

Source: Reuters Eikon

Research Note by: Nikhil Salvi with contribution from Rishabh Rathod and Akash Agrawal

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European Debt: That sinking feelingagain?

December 01, 2014

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