Who’s driving who in the complex interplay between European bond markets and sovereign ratings?
Deutsche Bank’s Bernd Volk aptly summed up the situation late last week:
In its downgrade of Spain to AA from AA+, S&P said: “We have taken into account the possibility that Spanish public and private sector borrowing costs could remain elevated in 2010-2011.” This suggests that S&P was driven by the market development. Funding conditions may have to improve further or support may be needed to avoid further rating actions in the Eurozone and to prevent a vicious circle further freezing public market access . . .
Every time one of these sovereign downgrades happens it becomes more difficult for sovereigns to sell their bonds, and harder for governments to service their existing debt. That increases governments’ borrowing and debt servicing costs and leads to . . . more ratings cuts. A vicious circle indeed.
On that note, if you’re wondering which European peripheral could be most ‘at risk’ in terms of a blow to its debt affordability, Morgan Stanley’s Daniele Antonucci and Elga Bartsch have some interesting charts:
The graphs show 2007 – 2011 public debt as a percentage of GDP on the horizontal axis, and interest expenditure as a percentage of total revenue on the vertical axis — all based on Morgan Stanley forecasts. In short, they show the sensitivity of interest rates to a country’s debt trajectory.
What you want is a relatively flat slope (like Germany or France) since it implies the better that nation’s ability to finance debt at an affordable cost. You don’t want the kind of steepness seen in Greece.
Here’s what Morgan Stanley says:
So, Italy may well be the core of the EMU periphery. However, the difference between the solid debt affordability of Italy from the less robust one of other peripherals (with the exception of Portugal, which looks like a core EMU country from this perspective) does not necessarily make Italy and, say, Germany alike. Indeed, the starting point in Italy (higher debt and interest) is different from that of core EMU countries (and less favourable). Still, the steep debt affordability curves of Greece, Ireland and, to a lesser extent, Spain do indicate that, as the debt/GDP ratio rises, so does the cost of servicing the debt as a share of revenues (which gives an indication of a country’s ability to cover interest expenses) – and quite quickly.
. . .
The scale of the fiscal problems in Greece is truly remarkable, as shown by virtually all debt sustainability simulations. Clearly, these are long-term simulation exercises by nature and – quite naturally – the further ahead you look in time, the more the uncertainty around the calculations increases. In spreadsheet-land, back-of-the-envelope calculations indicate that debt stabilisation would require a combination of primary budget surpluses (the primary balance is the overall budget balance excluding interest payments), low debt servicing costs, and/or high growth to avert a debt trap – i.e., ever-increasing debt-to-GDP – or, at the very minimum, to try to change market expectations that a debt trap is necessarily the endgame.
Related links:
Barnier considers EU rating agency – FT Alphaville
Merkel’s calls for ‘orderly insolvencies’ threaten more disorder - FT Alphaville
Sovereign woes are a pain in the periphery – FT Alphaville