Sovereign Debt Crisis

While S&P 500 is having a hard time breaking the 1,111 resistance level, emerging-market stocks fell for a fourth consecutive day. Over the last couple of weeks, few events have shocked the financial world: Dubai World is struggling to restructure its debt, Greece’s bonds faced a downgrade by Fitch and Standard & Poor’s lowered its outlook on Spain to negative. The MSCI Country Index for Greece declined almost 12 percent in December, Dubai’s equity index fell 6.4 percent yesterday, while MSCI Spain sank 2.4 percent.
The cost of credit-default swaps (CDS) on Dubai’s state-controlled DP World implied a 33 percent risk that the company will default on its debt. It is known that, oil-rich Abu Dhabi is loaded with liquid assets, possibly as much as $800 billion. They could pay off Dubai World’s $60 billion debt without a problem. But Abu Dhabi wants to send a message by forcing Dubai World to restructure its debt. There might be some collateral damage coming from the unregulated CDS products, especially from those that are long risk.
Greek 10-year government bonds slid for five consecutive days, driving the yield up 22 basis points to 5.67 percent. The yield spread between 10-year Greek and German bonds soared to 254 basis points Wednesday. This credit spread widening signals that investors remain very scared about the Greek economy after Fitch Ratings on Tuesday downgraded Greece’s sovereign rating to BBB+ from A-. The biggest downfall, in my opinion, is the government’s marginal funding cost. Let me remind you that the ECB has adopted the self-imposed rule which stipulates that it cannot accept as collateral in repo transactions and at the marginal lending facility (its discount window) sovereign debt rated lower than A-. On top of that, investors sold-off shares in the biggest two banks, such that National Bank of Greece tumbled 7.4 percent and EFG Eurobank lost 9.5 percent.
Standard & Poor’s on Wednesday lowered its ratings outlook on Spain to negative, saying the country will probably see significantly lower economic growth and persistently high fiscal deficits over the medium term. Subsequently, the cost of insuring Spanish sovereign debt against default rose to its highest level in over five months. The country’s CDS spread widened seven basis points to 96.5 basis points on the news. The downgrade of Spain’s credit outlook comes after S&P cut Spain’s rating to AA+ from the AAA ceiling in January 2009.
In a Bloomberg interview, Willem Buiter, professor at the London School of Economics, suggested that a bailout by the EU may be a last-resort option at some point for Greece. But certain German officials have warned against this, asserting that it could set precedents for other EU members such as Ireland, Italy, Spain, and Portugal to expect the same. It is true that Greece has failed to contain its budget deficit, which this year is expected to total 12.7% of GDP. Meanwhile, the European Commission estimates that Greece’s total government debt will exceed 112% of GDP. In a similar situation, we find Spain with a budget deficit level for 2009 at 11.2% of GDP.
What is next for Europe? Fitch Ratings said Latvia and Lithuania’s sovereign ratings remain under downward pressure, as these Baltic countries witness large deficits and growing debt levels. Latvia’s BB+ rating and Lithuania’s BBB rating, are more at risk of a downgrade than Estonia’s BBB+ rating, Fitch said in a statement today. The Baltic states are suffering the deepest economic contractions in the EU after their debt-fueled property bubbles burst and their governments forced through tough austerity measures. Everything but good news.