European Sovereign Debt: Crisis That Isn't Going Away

Europe’s sovereign debt crisis is back — if it ever went away.

Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.
Thomas Lohnes | AFP | Getty Images
Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.

Less than a month after bailing out Ireland, and after a holiday lull in the markets that may have looked mistakenly like calming, the European Union is again struggling to persuade investors that it has the cash and the will to address the root cause of its travails: a growing debt burden that is strangling governments and their banks.

On Friday, the yield on Portuguese 10-year bonds hit a recent high of 7.1 percent, the cost of insuring the debt of banks in Italy and Spain rose sharply, and the euro hit a three-month low against the dollar.

Driving the recent market weakness was a report by the European Commission that proposed that holders of senior bank debt be required to take a loss when a bank fails.

European authorities took pains to say that the rules would not apply to the more than 1 trillion euros ($1.3 trillion) in current bank and sovereign debt in the 17-member euro zone.

But investors were not biting. They chose instead to interpret the report as a signal that they would be forced to take losses on their obligations.

It was hard to blame them.

“It is clear that the debt which will take a haircut is the current debt, not the future debt,” said Willem Buiter, chief economist at Citigroup, who on Friday published an 80-page report explaining why debt restructuring in Greece, Ireland and Spain was inevitable. “All bank and sovereign debt is now at risk — that is the reality.”

Mr. Buiter refers to the latest sell-off as the result of the persistently high level of government debt in Greece and bank debt in Ireland, which prompted Europe and the International Monetary Fund to come up with close to 200 billion euros ($262 billion) to keep these countries from going under.

But with Greece and Ireland now paying out 80 percent of their export revenue toward external debt, governments will find it much harder to justify further squeezing their hard-pressed citizens in order to pay foreign creditors.

In Ireland, pressure is building for holders of senior bank debt to take losses, and the Greek government has had to deny rumors that it has approached its creditors about revamping its own debt.

As a result, jaded investors have become increasingly reluctant to lend to faltering countries like Portugal and Spain.

With an economy growing at just 1 percent and hampered by noncompetitive exports and steep deficits, Portugal is entirely dependent on outside investors for financing. But no one expects it to keep borrowing money at 7 percent — a level that led Ireland and Greece to exit the bond market and seek financial rescue packages.

Spain entered the crisis with a low level of government debt, but when its bank-financed real estate boom failed, the banks were stubbornly slow in recognizing their losses.

Top Spanish banks have been aggressive in securing outside financing, but like banks in Portugal, they have had to pay a higher price for the capital they need to survive. B.B.V.A. and Santander, the two most profitable Spanish banks, issued debt this week at higher-than-usual spreads, or risk premiums.

And while these two banks benefit from having large parts of their business outside of Spain, the rest of the Spanish banking sector is not so lucky: A large proportion of the banks’ loan books is tied up in sinking Spanish real estate.

Spanish real estate prices are continuing on a downward spiral, yet the country still has one of the most overvalued housing markets in the world. And while the government has set up a bailout fund, it has devoted only 1 percent of gross domestic product to bailing out the banks — compared with a government commitment of more than 30 percent in Ireland.

“The Spanish government will need to put more money on the table for its banks,” said Marcello Zanardo, an analyst at Sanford C. Bernstein in London. In a report Friday, Mr. Zanardo said he expected real estate prices in Spain to fall 8 percent in 2011, and he pointed out that nonperforming loans at Spanish banks now represented 5.67 percent of total lending, an all-time high. “There is more pain to come,” he added.

Mr. Buiter, a former member of the Bank of England’s monetary policy committee, has long warned that Europe’s debt levels are not sustainable, so his latest offering of gloom is not a surprise.

One of his main criticisms — that Europe has been perpetually slow to grasp the seriousness of the problem — has become increasingly difficult to refute. That skepticism is set to grow if Portugal and then Spain have to tap the 440 billion euro ($577 billion) rescue facility that Europe established last spring in the wake of the Greek crisis.

“The problem is that the facility is not big enough,” Mr. Buiter said. “So you will be forced to find ammunition elsewhere.”