Executive Summary In the second of two special reports on the European
sovereign debt crisis, we look at which countries have exposure to
government bonds in the European periphery. Although we are not
arguing that restructuring of government debt in Greece, Ireland,
Portugal, Spain and Italy, hereafter referred to as the European
periphery, is necessarily inevitable, we try to analyze who would bear
the losses if any restructuring were to occur.
The outstanding government debt of the European periphery totals
roughly €3 trillion, about onehalf of which is held by foreign
investors. Americans own a miniscule amount of these government bonds,
so it appears that the United States has very little direct exposure
to European government debt that potentially could be restructured.
Although a complete country-by-country breakdown of these holdings is
not readily available, it is reasonable to expect that the countries
with the biggest holdings of peripheral European government debt are
other European countries. Indeed, data on overall bank assets suggest
that European countries have significant exposure to the European
periphery.
However, the point about overall bank asset is instructive. There is a
complex web of financial interactions among European banking systems,
whereby government debt restructuring in the periphery could lead to
losses for institutions in other European countries. Consequently,
banks in countries that have very little direct exposure to peripheral
European government debt could suffer "collateral damage" if debt
restructurings lead to ratings downgrades or even bankruptcies among
private-sector institutions to which the banks are creditors.
Moreover, strains in bank funding markets could cause LIBOR to spike,
which would push up borrowing costs for many non-financial businesses.
The bottom line is that restructuring of government debt in peripheral
European countries, should it occur, could be a major financial event
even for countries that appear to have little direct exposure to that
debt.
*European Debt Crisis Continues to Fester*
The European sovereign debt crisis burst on to the scene last year
when investor reluctance to continue buying Greek government debt
forced the European Union (EU) to provide a financial rescue package
to the Hellenic Republic in May 2010. Ireland was the next country to
fall when it went hat in hand in November for financial support. Other
European governments with questionable financial profiles, namely,
those in Portugal, Spain and Italy, have to date been able to avoid
the ignominy of their own bailouts. However, yields on government that
remain elevated are a sign of investor unease concerning the financial
outlooks for those governments. In a recent report, we analyzed the
debt sustainability issues that Portugal, Spain and Italy currently
face and concluded that investors likely will remain nervous and
yields elevated for the foreseeable future.
As we noted in that report "officials from Eurozone countries have
stated that private-sector involvement in any restructurings will not
occur before 2013, if at all, but investors appear concerned that
haircuts could indeed be forced on them in a worst-case scenario."
Although we do not necessarily believe the worst-case scenario of
widespread debt restructuring is inevitable, we proceed in this report
under the assumption that the governments of peripheral European
countries will eventually need to restructure their debt. Under such a
scenario, owners of peripheral government debt would accrue losses due
to lower coupon payments, haircuts on principal and/or stretched-out
repayment schedules. Who would get hurt if the unthinkable happens and
governments in peripheral Europe are forced to restructure their debt?
Would the pain be borne primarily by domestic investors, or would the
capital losses accrue mainly to foreign owners of the debt? Would
restructuring be a relatively painless procedure, or would it turn
into a messy affair? We try to provide some answers to these questions
in this report.
*Holdings of Government Debt Alone Understate American Exposure*
At the end of 2009, the outstanding government debt of the European
periphery totaled nearly €2.9 trillion (Figure 1).2 Italy, which has
the largest economy among the five peripheral countries as well as one
of the highest government debt-to-GDP ratios in the Eurozone, accounts
for €1.7 trillion, almost 60 percent, of the total debt outstanding.
Together, the other four governments have €1.2 trillion worth of
outstanding debt with Spain accounting for nearly onehalf of that
amount. Not only would domestic investors be hurt by debt
restructuring in the European periphery, but foreigners would bear
significant losses as well because roughly 50 percent of the
outstanding debt is held by foreign investors.
Unfortunately, a complete country-by-country breakdown of foreign
ownership of peripheral government debt is not readily available.
However, data that are available on U.S. holdings of peripheral
European government debt provide some perspective. The good news for
the United States is that American investors have very little exposure
to the government debt of the European periphery, at least not
directly (Figure 2). At the end of 2009, American ownership of these
government bonds totaled only $18 billion. There would be very little
direct effect on the U.S. financial system even under the truly
worst-case scenario of outright default with no principal recovery.
However, overall American exposure to the European periphery is deeper
than the miniscule holdings of government bonds would indicate.
Although Americans own only $2 billion worth of Spanish government
bonds, their holdings of private-sector Spanish bonds total $24
billion. Spanish investors, who own about €330 billion ($430
billion) worth of Spanish government bonds, could realize significant
losses in the event of a restructuring of Spanish government debt.
Ratings downgrades or even insolvencies at some Spanish private-sector
institutions could follow, which would lead to financial losses for
any American investor who owned the financial instruments of the
affected institutions. Not only do Americans own private-sector
securities in Spain, but they are also creditors to the private sector
in the other peripheral countries. In total, Americans own $70 billion
worth of private-sector securities from peripheral European countries,
an amount that is four times greater than their holdings of government
bonds from those five nations. Although the United States may have
little direct exposure to the debt of peripheral European governments,
its indirect exposure is significantly larger.
*Significant Foreign Ownership of Peripheral Debt*
Figure 1 showed that foreign-ownership of peripheral European
government debt totals €1.3 trillion. If Americans own only €14
billion ($18 billion) of that amount, then who holds all the rest? Due
to geographic and cultural proximity, it is reasonable to expect
European investors to have significant exposure to government debt in
the European periphery. As noted above, however, a country-by-country
breakdown of government debt ownership is not readily available. That
said, data on overall bank assets, which we discuss in more detail
below, support the hypothesis that European investors have significant
exposure to the European periphery. Moreover, analyzing overall bank
assets, which include government debt as well as private-sector
credit, captures the indirect as well as the direct exposure that a
country has to government bonds from peripheral European countries.
When total bank exposure to the European periphery is measured as a
percent of GDP, Ireland leads the pack at nearly 40 percent (Figure
3). Irish banks, which have been crushed already by the nation's burst
housing bubble, could suffer further losses if governments in Spain
and Italy were forced to restructure debt. In terms of absolute size,
however, French banks have the most total exposure to the European
periphery at roughly €550 billion, which is equivalent to nearly 30
percent of French GDP. French banks could be significantly affected if
part of their €325 billion and €125 billion exposure to Italy and
Spain, respectively, were to sour due to restructuring of Italian and
Spanish government debt. Germany is next on the list with €420
billion of bank exposure to the European periphery followed by the
United Kingdom at €260 billion. The U.S. banking system has €120
billion ($155 billion) worth of exposure to the European periphery,
which is equivalent to just a mere 1 percent of U.S. GDP. Japanese
banks also have relatively limited exposure to the European periphery.
But if debt restructuring among peripheral European governments leads
to the insolvency of, say, a French bank, could that not eventually
lead to losses for institutions in other countries, say in Germany,
that own the debt obligations of that French bank? Given the
intertwined nature of the European financial system, it is not
unreasonable to expect that losses suffered by one European bank could
have a knock-on effect on another European bank located in a different
country. Not only do German banks have indirect exposure to the
Italian government through Italian institutions that own Italian
government bonds, but they also have indirect exposure to the Italian
government via French institutions that also own Italian government
bonds. Indeed, the subprime mortgage crisis in the United States was a
painful reminder that financial problems in one country can quickly
spread to other countries.
Figure 4 shows a country-by-country breakdown of total bank exposure
to European countries, not only exposure to peripheral European
economies but to other European nations as well. Measured as a percent
of GDP, Ireland again leads the pack with a figure that exceeds 180
percent. Not only do Irish banks have a fair amount of exposure to
peripheral European countries (about €60 billion) but they also have
significant asset holdings in other European nations as well (roughly
€225 billion) that give the Emerald Isle indirect exposure to other
peripheral European countries.
Not surprisingly, other countries in the Eurozone place high on the
list with bank exposure-to- GDP ratios in excess of 50 percent in many
economies. Therefore, the banking systems of most countries in the
euro area could be buffeted by debt restructurings in the European
periphery even if their direct exposures to those government bonds are
relatively limited. Sweden and Switzerland, two countries that are not
members of the Eurozone, would not be immune either. Although Swedish
and Swiss banks have limited ownership of peripheral European assets,
they large indirect exposure via their holdings of other European
assets. In both cases, indirect exposure exceeds 100 percent of
respective GDP.
The small size of the Irish economy helps to inflate its
exposure-to-GDP ratio.4 In terms of absolute exposure, however, the
French banking system, with credit outstanding to other European
countries totaling €1.5 trillion, has the most to potentially lose.
Close on the heels of France are Germany (€1.4 trillion) and the
United States (€1.3 trillion). Measured as a percent of GDP,
however, American bank exposure to European countries is rather small,
as is the overall exposure of Japan and Canada.
Nonetheless, the U.S. banking system could feel the strain of a debt
restructuring-inspired crisis in Europe. When the sovereign debt
crisis first entered an acute phase in early 2010, the scramble for
dollar liquidity, both among American and European banks led to a
backup in U.S. dollar LIBOR (Figure 5). The 25-bp rise in LIBOR last
spring pales in comparison to the 200-bp blowout that occurred in the
immediate aftermath of Lehman Brothers failure in September 2008. That
said, the episode last spring was not as dramatic as any financial
crisis caused by a restructuring of debt in peripheral Europe likely
would be. Because many short-term lending rates are tied to LIBOR, a
financial crisis in Europe could quickly be transmitted to the real
sector of other major economies, including the United States.
*Conclusions*
The European sovereign debt crisis, which has been ongoing for nearly
a year, continues to fester. Although the €440 billion financing
facility that the European Union established last year easily has
enough funds to rescue Portugal, a bailout package for Spain, should
one prove necessary, could exhaust the facility. Unless EU leaders
significantly increase the size of the fund, Italy, which has €600
billion worth of government bonds maturing by the end of 2012, could
be forced to restructure its debt profile if investors balk when it
comes time to roll Italian government debt. Given extensive
interconnections among financial institutions in the world's advanced
economies, investors would be wise to consider which countries have
financial exposure to peripheral European countries.
Not surprisingly, European banks have the most exposure to peripheral
European countries, with France and Germany at the top of the list.
However, there is a complex web of financial interactions among
European banking systems, whereby government debt restructuring in the
periphery could lead to losses for institutions in other European
countries. Therefore, banks in countries like Sweden, Switzerland and
even the United States, which have very little direct exposure to
peripheral European countries, could suffer "collateral damage" if
government debt restructuring leads to ratings downgrades or even
bankruptcies among private-sector institutions to which the banks are
creditors. Moreover, strains in bank funding markets could cause LIBOR
to spike, which would push up borrowing costs for many non-financial
businesses. As the collapse of Lehman Brothers in September 2008
painfully demonstrated, financial problems in one country can be
transmitted quickly to the real sectors of other economies. The bottom
line is that restructuring of government debt in peripheral European
countries, should it occur, could be a major financial event even for
countries that appear to have little direct exposure to that debt.
Source: ActionForex.Com
No comments:
Post a Comment