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Debt Crisis Update

It’s time for an update on the sovereign debt front. Contrary to what politicians want you to believe, analyzing and understanding the sovereign debt crisis is not that difficult. The WWW is a wonderful source of economic data. Everybody with a computer and internet connection can go to Eurostat.org and download all the data you need to see why Europe is in the doldrums.

The key factors to watch are, a) the difference between economic growth and debt growth, b) the ability to quickly turn the primary budget (excluding interest payments) into surplus, and c) most importantly the current account balance (trade balance plus fiscal transfers). In a monetary union like the Eurozone (or a gold standard, for instance), current account deficits (i.e., you financed your consumption with foreign wealth) need to be reversed if foreign investors lose confidence in your ability to sustain such deficits. This loss of confidence usually happens when your economy starts to grow more slowly or when there is fiscal or banking crisis in your country.

After some Excel-analysis, I come to the conclusion that the situation of Italy and France (!) is more serious than I previously thought. Italy’s problem seems to be that the banks are not very healthy (as indicated by collapsing stock prices) and that the Italian economy is not growing fast enough to finance the huge debt burden. As the following chart shows, Italian Nominal Gross Domestic Product (NGDP) is growing slower and slower, while debt keeps growing:

Furthermore, one can see that the Italian government wasted it’s solid primary budget surplus once they joined the Eurozone in 1999. Simple economics math shows that with approximately 2% average NGDP growth and 6% average interest rate on debt going forward, they need a primary surplus of 5% of GDP to keep the debt-to-GDP ratio stable. Reaching similar levels does not solicit a herculean effort, but it needs a determined change from past politics, especially considering the demographic problems that are going to hit European countries in the next 10 years.

But the probably most serious issue for Italy is its trade performance. The current account deficit has grown to 4% of GDP, surpassing the USA. Assuming that Italy has not much to offer to compensate foreigners, Italy’s economy cannot grow without having stronger export growth from now onwards.

If investors totally lose confidence in Italy, like they did with Greece, Ireland, and Portugal, then Italy would need to balance the current account immediately, like they had to in 1992 during the last Lira crisis. That, however, would pull the economy into recession and make the debt even more unsustainable, immediately.

France looks a little bit better, but the recent trend with exploding deficits is certainly something to watch for:

Spain is still afloat, but the tide of debt is rising fast. Furthermore, the final bill for cleaning up the housing and banking mess is still unclear:

With markets being fed up with sovereign debt, interest rates start to increase rather dramatically. History has taught us that countries choose to receive financial assistance from the European resuce fund as soon as the rate on their 10-year bonds reaches 7%. Italian and Spanish 10y ‘govvies’ are above 6% by now…

Now let’s see the US debt crisis in comparison. At first sight, the US’s situation looks worse than that of France, or maybe even Italy. However, there are two very important differences that are not captured by the charts. First, the US enjoys having its own currency. Thus, they do not need to suffer deflation and recession in order to balance the current account. They simply ‘devalue’ their currency.

Now, to finish let’s see how a country looks that tried to rescue its helplessly broken banking system:

Last, but not least, based on above findings I update my debt ratings, ‘downgrading’ France from B to C and putting Italy and Spain on ‘negative watch’:

A: Australia, Denmark, Finland, New Zealand, Norway, South Korea, Sweden, Switzerland

B: Austria, Brazil, China, Germany, Netherlands

C: Belgium, France, Great Britain, Italy (negative), Japan, Spain (negative), USA

F: Greece, Ireland, Portugal



A: Debt financing is sustainable over the long-run, probability of default during the next 10 years is near zero.

B: Currently stable, but may become unstable, if increasing budget deficits or higher real interest rates on debt. Probability of default during the next 10 years may be higher than 10%.

C: Default may happen within the next 5 years without structural reforms that lower deficits and increase competitiveness. If you happen to live in such a country, it may be wise to park your money in another country.

F: Run as fast as you can.

Disclaimer: I am not a financial advisor! I talk lots of rubbish every day!! Make up your own mind about investment strategies!!! These ratings are just my personal opinion, they are not a financial advice!!!!


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