Aranca views: Europe Debt - That Sinking Feeling Again

European Debt: That sinking feeling…again?
December 01, 2014
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Europe periphery debt: Plus ça change, plus c'est la même chose?
This French quote meaning ‘the more things change, the more they remain the same’ summarizes the debt scenario in Europe’s
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 30–287 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 Europe’s 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, Europe’s 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. Europe’s 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 (%)
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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2002Q3
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2005Q1
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2012Q3
7.539.9
0
9
18
27
36
45
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8
Oct06,2009
Jan04,2010
Mar29,2010
Jun23,2010
Sep15,2010
Dec08,2010
Mar04,2011
May31,2011
Aug23,2011
Nov15,2011
Feb08,2012
May07,2012
Jul30,2012
Oct22,2012
Spain (LHS) Italy (LHS)
Greece (RHS) Portugal (RHS)

December 01, 2014
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Mario Draghi (‘Don’t 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
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 country’s 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
1.1
1.2
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1.6
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
Jan-13
Jul-13
Jan-14
The
Draghi
Put

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2010…2014: Not much of a difference in Europe’s 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 (%) Eurozone inflation (% yoy)
Source: Eurostat
Eurozone Unemployment rate (%) Eurozone GDP growth (% yoy)
Source: Eurostat
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95
2006Q1
2006Q4
2007Q3
2008Q2
2009Q1
2009Q4
2010Q3
2011Q2
2012Q1
2012Q4
2013Q3
-1
0
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1991Jan
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1999May
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2005Aug
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2009Oct
2011Nov
2013Dec
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1998Apr
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2013Apr
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2000Q1
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2005Q1
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2011Q2
2012Q3
2013Q4
Overall Debt to GDP has kept on rising
Eurozone inflation is far below
ECB target of 2%
Eurozone unemployment appears to
have lowered mainly because of
Germany; rest European nations
continue to suffer high unemployment

December 01, 2014
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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 country’s net debt (EUR Billion)
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 can’t
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 ECB’s 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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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
France (LHS) Italy (LHS) Greece (RHS) Ireland (RHS) Portugal (RHS) Spain (RHS)

December 01, 2014
P a g e | 5
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 Germany’s budget is backed by Bundesbank, its central bank. Germany’s opposition to
the ECB’s 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 Germany’s exports to Russia,
after the sanctions imposed by the EU due to the Ukraine conflict has added to the possibility of the country’s growth slowing down
more than anticipated.
Germany – IFO Business Climate Index Germany – ZEW survey of economic sentiment
Source: Reuters Eikon, Centre for European Economic Research
Greek bond yield movement in 2014 – The trailer for 2015?
Greece’s 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 Europe’s 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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December 01, 2014
P a g e | 6
Greek benchmark bond yields (%)
Source: Reuters Eikon
Research Note by: Nikhil Salvi with contribution from Rishabh Rathod and Akash Agrawal
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8.9
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Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14
Sharp rise in bond yields
indicate sudden
escalation of concerns
on Greece

December 01, 2014
P a g e | 7
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