Will Europe’s peripheral debt crisis go global?

November 29, 2010

The second bailout of a Euro zone nation in less than a year has spooked the markets and looks set to be the dominant theme as we move into year end. Ireland’s financial crisis, culminating in the state’s application for EU/IMF funding on November 21, has shattered market confidence and caused some sizable moves in the forex markets. Since the start of November the euro has fallen nearly 6 percent against the dollar, and the dollar index – which measures the dollar versus its largest trading partners – has risen by 5.5 percent over the same period as the greenback attracts safe haven investor flows.

Europe’s periphery has witnessed their bond yields rise to extreme levels, Irish 10-yr yields are currently above 9 percent. The markets remain unwilling to hold Irish debt because the outlook for growth remains uncertain, which continues to worry investors that Ireland may not be able to finance its beleaguered banking sector – the nexus of the emerald isle’s fiscal woes. Right now peripheral Europe, including Greece, Ireland, Portugal and Spain, are in a negative debt spiral. Investors sell their bonds because they believe their budget deficits are unsustainable, and then they sell them some more when austerity measures designed to reign in these deficits look like they will stunt economic growth. This is a dangerous position to be in, and right now there is no easy solution to the problems of the periphery. While the market remains willing to punish excessive budget deficits, investors need to ask who could be targeted next, and could this sovereign debt crisis go global?

The most likely targets are the UK, the US and Japan. All of these nations have either high budget deficits (the UK’s deficit is expected to be 12 percent of GDP this year) or high levels of public debt (Japan’s public debt is above 220 percent of GDP), which make them ripe targets for the bond vigilantes. In the US several states are suffering from deep fiscal crisis, including California, and some are near to bankruptcy.

So will the market’s focus pan back to the debt problems in the major western economies? The markets can certainly force governments  of all sizes to reign in their public finances. The UK’s Conservative-led coalition government has embarked on one of the first and most harsh austerity programmes in the western world, which includes £80 billion of public spending cuts and £40 billion of tax increases to be implemented over the next four years. The scale of austerity measures were considered necessary to ensure the UK kept its top AAA credit rating. Indeed, after the government presented its budget in June, the top credit rating agencies reaffirmed that the UK’s sovereign rating was safe.  So, post the budget, UK bonds seem safe for now.

So far, the markets seem happy to leave Japan alone. This is probably because most of Japan’s huge public sector debt is held by domestic investors, giving the markets little incentive to target Japanese government bonds. This leaves the US. Although the yields on US Treasuries have been rising recently, they still remain at low levels. The 10-yr Treasury yield is below 3 percent suggesting that investors are still willing to fund the US government.

So does the US deficit matter? It all depends on the future outlook. The Congressional Budget Office in Washington estimates the US budget deficit to reach 9.1 percent of GDP this year, falling to 7 percent in 2011, 4.2 percent in 2012 before reaching a low of 2.6 percent in 2018. This looks like a sizable adjustment and should keep the markets happy. However, the canary in the coal mine for the US could be the finances of some individual states. State tax receipts have fallen sharply since the recession, falling 8.4 percent in 2009 relative to taxes collected in 2008 and are expected to be an additional 3.1 percent lower in 2010. As a result most states (46) struggled to balance their budgets for the fiscal year 2011. This means that states have had to embark on harsh austerity measures to try and get their finances back in shape.

But balancing the books hasn’t all been plain sailing. California, the biggest issuer of municipal debt in the US, which also has a budget deficit of $25 billion over the next 18 months, struggled to auction $14.5 billion in short-term notes and longer-term maturities to finance public sector works. It had to stagger the auction after the yields investors demanded to hold Californian debt surged to 12-month highs of 5.51 percent for long-term debt.

There were several reasons for this including dampened investor appetite due to sovereign debt fears in Europe and large amounts of debt issuance flooding the market and depressing demand. This isn’t exactly a crisis territory; however, if the states cannot bridge their deficits then the federal government may have to step in. The municipal bond market is $2 trillion dollars. If a state like California was to get frozen out of the bond markets then the US government might be saddled with a gargantuan bail out, dwarfing the problems facing the Eurozone.

The US authorities will hope that the markets will continue to have faith in the US economic outlook and continue to buy its bonds.

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