Here We Go Again, Underpricing Europe Debt Risk
Over the past six months, market sentiment toward the euro area has swung spectacularly from panic to growing confidence.
Greece is the most conspicuous example, as fears about its possible exit from the single-currency area faded. But Spain and Italy, the twin bellwethers of sentiment on Europe, show how markets are underpricing sovereign risk -- again.
If the euro-area crisis taught us anything, surely it is the importance of distinguishing between the creditworthiness of different economies. Lest we forget, it was the decade-long “convergence play” that laid the foundations for Europe’s debt crisis. Yield-hungry investors bet that Europe’s monetary union would result in the borrowing costs of member countries converging to that of the strongest, Germany. I fear that history may now be repeating itself.
The very idea now seems absurd. Investors have just witnessed decades of European financial integration unravel before their eyes, so surely they wouldn’t make the same mistake again? Yet markets have short memories, particularly when exceptionally low interest rates make the lure of higher- yielding investments irresistible.
This week, Italy sold 8.5 billion euros ($11.5 billion) of six-month treasury bills at 0.731 percent, the cheapest yields in three years. Demand for a new Spanish 10-year syndicated bond offering on Jan. 22 reached a staggering 23 billion euros, far exceeding the 7 billion euros-worth of bonds on offer.
Even a cursory glance at the economic fundamentals of Spain and Italy suggests that the rally in their sovereign-bond markets is way overdone. Since European Central Bank President Mario Draghi pledged in July to do “whatever it takes” to shore up the euro area, the yield on Spanish two-year bonds has tumbled more than four percentage points. Even the yield on Spain’s benchmark 10-year debt, which the ECB has excluded from its (as-yet-unused) program to purchase government bonds, has fallen 2 1/2 percentage points. The yield on Italy’s 10-year benchmark has dropped by almost the same amount.
These drastic reductions in yields are partly justified, stemming from the near-elimination of the so-called breakup premium that many euro-area governments were paying to borrow money in the sovereign-bond markets. The premium referred to that part of the spreads between German and other euro-area sovereign-bond yields that was solely attributable to fears about the currency zone falling apart. Borrowing costs for countries such as Spain and Italy were bound to fall sharply once fears of a breakup disappeared.
Yet relief that the euro area isn’t about to implode doesn’t explain the confidence in its third- and fourth-largest economies that current bond yields imply.
In their haste to reprice Italian and Spanish debt, investors have taken their eyes off the sovereign component in sovereign risk -- just as they did before the crisis struck and, for that matter, before the start of the euro, when divergences between southern and northern Europe’s economies were already apparent.
The two countries are in a far worse state economically and politically than they were in December 2010, yet their 10-year bond yields are narrower now than they were then. The difference can’t be explained by the removal of the euro area’s breakup premium, because in 2010 that particular panic hadn’t yet set in. This smacks of mispriced sovereign risk.
Let’s look at these two economies that investors are betting on so confidently. In Italy, the central bank just cut its growth forecast for this year: Instead of contracting by 0.2 percent of gross domestic product, the economy would do so by 1 percent of GDP. This follows a contraction estimated to be more than 2 percent last year -- one of the steepest declines in output in the European Union. Domestic demand in Italy has fallen by an average of 1.8 percent annually since 2008, having grown by a meager 1.3 percent from 2003 to 2007, the second- lowest rate in the euro area, according to the European Commission. Export growth is insufficient to pick up the slack.
Adding to this gloomy picture, Italian politics are becoming messier. Next month’s parliamentary election is likely to result in a fragmented legislature and a leftist coalition government with limited appetite for the kinds of structural changes to the economy that Italy needs if it is to create meaningful growth.
Are these risks being adequately priced in? Hardly. Investors still expect Mario Monti, Italy’s technocrat premier- turned-politician, to be part of the next government and that this will ensure policy continuity. Yet Monti is not a miracle worker, and Italy’s problems are deep-rooted.
Still, at least Italy is in better shape than Spain. The economy remains trapped in a vicious circle, despite improvement in its current-account balance as collapsing domestic demand has reduced imports. Problems in enforcing fiscal discipline in Spain’s regions, shockingly high unemployment, a credit crunch and a persistent lack of growth will make it extremely difficult for Spain to get back on its feet.
Spain’s budget deficit is expected to have reached about 8 percent of GDP in 2012, despite the government’s austerity policies, driven up by the cost of shoring up the country’s still-vulnerable banking sector. So Spain’s debt burden continues to grow. The nation entered the crisis in 2008 with an admirably low public-debt level of 40 percent of GDP, but this has risen to almost 90 percent of GDP today, according to figures from the International Monetary Fund.
Again, are investors taking these risks into account? If they are, they have parked such concerns at the backs of their minds. The rally in Spanish and Italian debt is fueled by liquidity and shows no signs of ebbing. Market prices, particularly in the case of Spain, are increasingly detached from fundamentals -- just as they were when investors fretted about the euro area breaking up.
Now that the self-fulfilling panic of a euro-area collapse has disappeared, investors should pay far more attention to country-specific risk. Failure to do so is a big part of what got us into this mess in the first place.
(Nicholas Spiro is the managing director of London-based Spiro Sovereign Strategy, a consultancy specializing in sovereign credit risk. The opinions expressed are his own.)
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