Euro periphery: Lehman-type shock still on cards

February 13, 2012

The passing of Greek austerity measures is fuelling a rally in peripheral debt today with Italian, Spanish and Portuguese yields falling across the curve.

However, one should not forget that peripheral economies are still under considerable risk of becoming the next Greece — rising debt and weak economic growth pushing the country to seek a bailout — as a result of tighter financial conditions.

Take this warning from JP Morgan:

Financial conditions have deteriorated far more in peripheral Europe than in the core. The drag from this on peripheral GDP is akin to that seen following the Lehman crisis.

JP Morgan uses analysis based on quantifying the impact of financial market developments and monetary policy actions on economic activity. The main variables the analysis uses is: the three-month LIBOR rate, the yield on investment grade corporate bonds, the spread of high yield corporates over that of high grade, real equity returns, the change in the real exchange rate and bank lending standards for businesses as reported in loan officer surveys.

According to JP Morgan’s calculations, the 838 basis-point rise in the peripheral HY spreads implies a drag of -2.2 percent of GDP relative to what it would otherwise have been, had the HY spread unchanged.

Overall, the GDP impact from tighter financial conditions is -5.9 percent in the peripheral economies, compared with -1.7 percent in the core countries.

The deterioration in bank lending standards have also weighed considerably more on growth in the periphery than in the core. Overall, the impact on growth in the periphery is comparable to that seen in the aftermath of the Lehman crisis, while conditions in the core are much less severe.

This large divergence raises questions about debt sustainability in the euro area’s periphery as positive growth is essential for peripheral countries to avoid Greece’s spiral of rising debt and never-ending economic contraction.

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