Why Italy and Spain can’t be knocked out of the Eurozone

For all its faults, the Eurozone as a whole is growing as fast as the UK, saving more, and running a lower fiscal deficit. If it’s being written off as a viable entity, we should all be very afraid, says Alan Shipman. 

But none of the 17 members (except Germany) has an incentive to drop out – since even if they get half their euro-denominated debt written off (as did Greece), the inevitable devaluation of their new national currency would multiply the cost of the remaining euro debt. They’ll find borrowing in euro increasingly expensive, but borrowing after leaving the euro would be even more so. 

However, the Eurozone is a different kind of single currency area now that only a minority of its members have a top (AAA) credit rating. There are three rating agencies, but they tend to reach similar verdicts, and those of one (Standard & Poor’s) at the start of November can be seen below: 

Eurozone credit rating by country (outlook November 2011)

 Outlook:  = Stable + Positive - Negative 

These ratings suggest that only one member (Greece) is expected to default on its debts – indeed, it has already done so in all but name, the name being avoided so as not to trigger credit default swaps on the sovereign debt, which would spark a flurry of protests and legal actions from the US where many of these default-insurance contracts were written. Portugal is strongly expected to default, but may still be small enough to get a Greek-style bailout that prevents this.  

A helping hand for Europe’s banks…
All the other members below AAA are still expected to honour their debts. But by being less than top-rate, they must pay a significantly higher interest rate than Germany and the other AAA countries. Although not intentional, this may provide a rescue mechanism for Eurozone banks, still struggling to regain profitability and balance sheet strength after the asset-price falls of 2007-9. By holding the debt of zone members rated BBB+  to AA+, they can get an extra return (compared to German debt) without incurring significantly more risk. These high-yielding bonds are still investment-grade, and still given the lowest risk weighting when international regulators set banks’ minimum capital requirements. 

However, most of these countries are too small to issue significant amounts of sovereign debt. (Estonia’s government hasn’t been a net borrower at all until this year, its debt problem being in the private sector). Italy and Spain are the two big sources of ‘high-yield’ Eurozone government debt. That’s why any debt repayment problems on their part would be a disaster for the whole European banking system, not just the governments and citizens of those two countries.  

… that may be halted by the dangers of high interest … 
The Eurozone could tackle the danger of Italian or Spanish default by forcing the European Central Bank (ECB) to buy their debt, becoming their lender-of-last-resort. It doesn’t want to do so, because this would put the ECB’s own AAA credit rating a risk. Eurozone credit ratings might then sink to their current average, rather than be pulled back up to the top. 

Its alternative plan is to let the European Financial Stability Facility (EFSF) lend to Italy and Spain when the private markets refuse to do so (at affordable cost) – and then invite governments and other investors outside the Eurozone to lend to the EFSF. That might be a way to get China, Japan, the oil-rich Middle East and other high-saving nations with capital surpluses to finance marginal Eurozone members’ heavy borrowing requirements.  

But it’s not certain: these creditor nations may prefer to go on lending to the US, which has the advantage of printing the world’s reserve currency. The US has been able to continue borrowing at near-zero interest rates, even though S&P bizarrely reduced its sovereign rating to AA+ in August. 

… and by disinterested outsiders
Eurozone plans are also frustrated by the decision of three AAA-rated EU countries – the UK, Sweden and Denmark – to stay outside the euro area. Of these, only the UK issues significant amounts of debt. But for Eurozone investors, it’s another opportunity to get higher returns without higher risk, if they believe that the UK pound sterling is going to appreciate against the euro. That can be a self-fulfilling expectation, if enough investors sell euro to buy sterling debt. The capital inflow from the Eurozone has helped the UK reduce its sovereign borrowing costs to record low levels in 2011. 

The Eurozone’s problems began because it admitted members who couldn’t match German standards of monetary and fiscal discipline, and who lost the incentive to do so once they adopted the single currency; and because it lacks the mechanisms to re-allocate funding from members with surpluses to those with deficits, via either its budgets or its central bank.

But these problems have now become intertwined with those of the European banking system, still recovering from the shocks of 2008. If Italy or Spain lurch further towards default, and don’t get ECB or ESFS support to stop their borrowing costs rising, then the banks’ gamble on buying their debt will backfire. The capital they are required to hold against that debt will rise, forcing them into another self-destructive scramble to raise new capital (pushing up its costs) and sell assets (pushing down their value).  

But the UK can’t afford to watch complacently from the sidelines. Its own banks’ holdings of Eurozone sovereign debt will run them into similar trouble if the borrowers need a bailout or if sterling appreciates. And its stalling growth rate, which would be exacerbated if stronger sterling restrained its exports, means its own AAA rating is not indefinitely secure. 

Sovereign ratings can stay at AAA if the government can keep raising enough tax revenue to service its debt, without undermining the national-income growth from which the debt will eventually be repaid. For all its faults, the Eurozone as a whole is growing as fast as the UK, saving more, and running a lower fiscal deficit. If it’s being written off as a viable entity, we should all be very afraid. 

Alan Shipman 22 November 2012 

Alan Shipman is a lecturer in Economics at the Open University. He is responsible for the courses You and your money:personal finance in context  (DB123) and Personal investment in an uncertain world (DB234). 

Cartoon by Gary Edwards