Europe, courting trouble
MARKETS were jolted this morning as rumours spread that Greece had gone to the International Monetary Fund and the European Union to request a debt restructuring. The Greek government has denied that this is so, but restructuring increasingly seems to be a matter of when, not if. Yields on 2-year Greek debt are up 7% and 10-year yields are up over 5%. Both are at crisis highs. There is no question of the Greek government's ability to borrow in private markets any time soon.This hardly comes as a surprise; The Economist has been calling for restructuring for some time now. What's somewhat surprising and very troubling is the erosion of the firewall that the euro zone had managed to erect around Greece, Ireland, and Portugal. Ireland and Portugal are in similar straits and will almost certainly need to restructure their debts as well. And indeed, their bond yields are up this morning. For a while, however, it seemed that Spain had detached itself from this bunch, and that no longer appears to be the case. Yields on 2-year Spanish debt are also up 7% today, and yields on 10-year debt have risen nearly 3% to a new crisis high. Why does Spain matter so much?Calculations by the Bank of England on losses that would arise from haircuts to Greek, Irish, Portuguese and Spanish debt suggests that a 50% haircut would wipe out 70% of the equity in Greek banks, almost half of it in Portuguese and Spanish banks and about 10% of the equity in German and French banks.That spells trouble of a different kind. Sovereign defaults would entail much more than just a haircut on German banks’ government-bond exposures. It could easily lead to a slew of bank defaults—and corporate ones, too. German banks are owed twice as much by banks in the three bailed-out countries as they are by governments. Once corporate loans and other exposures are included, Germany’s vulnerability is clear: its banks are owed some €230 billion. These numbers would ratchet up further were Spain to default. German banks have an exposure to Spain that is about three-quarters as great as it is to Portugal, Greece and Ireland combined.Spanish trouble could potentially fuel contagion, as well. Italy might find itself in the mix, for example. Europe's top priority needs to be to find a sustainable solution for Greece, Ireland and Portugal—and this almost certainly involves restructuring—that will effectively move Spain out of the danger area. Spain does not face insolvency question to the extent the others do and should be able to manage its debts provided that it keeps market confidence.Of course, the European Central Bank continues to complicate the situation. ECB officials are strongly signalling that further rate rises will be forthcoming this year, and at least a 50 basis-point total increase seems likely. That's very unfortunate given that the IMF projects a 3% contraction in the Greek economy in 2011 and a 1.5% contraction in Portugal. Irish and Spanish growth are projected to be an anemic 0.5% and 0.8%, respectively. Unemployment in Greece and Portugal is forecast to increase this year and next year. That's going to make austerity difficult to maintain in countries that have almost no economic room to manoeuvre.Europe has been behind the curve for a year now, so it's not that surprising that a bolder solution has yet to appear. The big risk now is that Europe will finally recognise the need for restructuring in Greece, but will again pursue half-measures that fail, once more, to get ahead of markets.