The European Debt Crisis Decoded

If you’re tired of hearing about and the European sovereign debt crisis, you’re not alone. It has been hanging over the global financial markets for well over two years now and progress on developing a comprehensive solution to address it has been painfully slow. German Chancellor Angela Merkel, one of the key architects working on a solution, even likened solving the crisis to running a marathon. For spectators of this grueling event, such as Canadian investors, the crisis has not only been tiresome due to its length, but confusing because of its complexity.

Background

The European sovereign debt crisis is rooted in three elements. First, there is the amount of public debt carried by the 17 members of the euro area (countries that have adopted the euro). Second, there is the risk of Greece defaulting on its debt obligations and thirdly there is the issue of European bank solvency. The ratio of public debt to gross domestic product (GDP) is an indicator that gauges the sovereign country’s fiscal health and the ceiling for this ratio for euro area countries is 60 per cent, as agreed upon in the Stability and Growth Pact in 1997. However, the pact has not been respected or enforced. As the table below shows, countries are well above the ceiling and some, such as Italy, Ireland, and

Greece, even surpass 100 per cent. If countries in Europe continue to run budget deficits and increase their already massive debt load, it will become increasingly difficult for them to grow their economies, to borrow money at sustainable rates (yields on their bonds), and to repay their debts. Greece, the most indebted country in the euro area, has already succumbed to its debt. The country has needed to implement austerity measures, required bailouts, and even written down its debt by 50 per cent. If other sovereign nations in the euro area wind up in the same situation as Greece, the solvency of European banks would be threatened, since they hold large amounts of sovereign debt.

Impacts

Given the interconnectedness of the global financial system, the impacts of the unresolved debt crisis in Europe would be significant. The core risks include default among euro area countries, European bank failures, contagion within Europe and potentially outside the continent, contracting and freezing of credit markets and global recession. In addition, if a concrete solution is not implemented in the short term and the situation continues to deteriorate, sovereign credit ratings could be downgraded, which could raise borrowing costs for countries and deepen the crisis. At the beginning

of December, Standard & Poor’s placed 15 members of the euro area, including Germany and France, on “credit watch negative”, a warning they could be downgraded in no more than three months.

Current State

Despite seemingly countless meetings between global and European leaders there still isn’t a solution. Even more troubling is that leaders have mainly focused on plans to address the longer term issue of fiscal union. So far, they have essentially agreed to put a new pact in place by March 2012 that will restate and put procedures in place to enforce the criteria in the 1997 Pact. The criteria include annual budget deficits no higher than 3 per cent of GDP and a national debt lower than 60 per cent of GDP. However, even if a new pact is agreed upon, it would take years for countries to reduce their debt from current levels.

Although, the steps taken by leaders to move towards fiscal union are positive, the actions taken to address the immediate crisis of debt and confidence have so far been limited and insufficient. There has been much talk of the need for a so-called emergency funding ‘bazooka’ to combat the crisis, calm markets, and restore confidence, but agreement on putting this in place has been elusive. At present, the marathon’s finish line still appears to be far in the distance. Therefore, even though tired and disillusioned, investors should not turn a blind eye to the developments in Europe. I believe markets will continue to remain volatile and “buy and hold” will be less effective. More than ever, it is important for investors or their advisors to take an active approach to managing investment portfolios.

Kash J. Pashootan is a Financial Advisor with Raymond James Ltd. The view and opinion of the author do not necessarily reflect those of Raymond James. This article is for information only. Raymond James Ltd. Member – Canadian Investor Protection Fund