After more than three years of economic, financial, and budgetary stress in the European Economic and Monetary Union (eurozone), especially on its so-called “periphery”, some signs of stabilization emerged in the latter half of 2012. Is this a sign that the financial and economic troubles leading to the rating downgrades of 12 of the 17 eurozone member states since the onset of the crisis may have run their course? We believe that 2013 could be a watershed year for the eurozone debt crisis. It could mark the start of the region sustainably overcoming the market volatility and fragmentation that has affected it over the past few years. It could also see the return of some so-called “program countries”–member states that have borrowed from the European Stability Mechanism (ESM) or the European Financial Stability Facility multilateral loan programs–such as Ireland and Portugal, to more substantial primary issuance in the capital markets.
Still, we see several qualifications to this positive scenario. We believe that investor confidence will only return if member states continue to make progress in rebalancing their economies, both through structurally stabilizing public debt and by further reducing external deficits. Achieving this will take a disciplined and transparent response from policymakers both at national and European levels. Safeguards to the social contract may also be necessary to assist in the cohesion of those member states suffering from high unemployment, excessive private leverage, and stagnating or falling living standards. In our view, this is a challenging but achievable agenda, although implementation risks loom large. These risks are the main reason that the majority of our outlooks on our eurozone sovereign ratings are still negative (see table 3, including one sovereign, Slovenia, on CreditWatch Negative). Nevertheless, European leaders have laid, or at least announced, much of the groundwork for the eurozone to emerge from its lingering crisis.
- We expect 2013 to be a watershed year in determining whether the eurozone can emerge from its sovereign debt troubles.
- European policymakers have, in our view, laid some of the groundwork for a recovery.
- The eurozone’s success in reversing its credit trends will depend on national and pan-European policymakers’ responses to the eurozone’s continuing economic, political, and social risks.
2012: A Year Of Two Halves
The past year was another eventful one for eurozone sovereign creditworthiness and ratings. 2012 included the first default of a rated sovereign that is now part of the eurozone, Greece (B-/Stable/B). The year began with the downgrade of nine eurozone sovereign ratings in mid-January, including the loss of the ‘AAA’ ratings that Austria and France had held for more than three decades. The rating actions were primarily driven by our assessment that the policy initiatives taken by European policymakers insufficiently addressed numerous eurozone systemic stresses. In early 2012, European policy seemed based on a consensus that the eurozone’s financial problems stemmed primarily from fiscal profligacy at its periphery. In our view, however, these problems were rooted at least as much in the increased external imbalances and competitive divergences between the eurozone’s core and its periphery. We think the periphery has only sustained its competitive underperformance (manifested by the periphery’s sizable external deficits) by funding from the banking systems of the more competitive core eurozone member states. We believe that our remarks made in January 2012 still apply: that “a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues” (see: “Credit FAQ: Factors Behind Our Rating Actions On Eurozone Sovereign Governments,” Jan. 13, 2012).
In our view, it was thus unsurprising that sovereign bonds of peripheral sovereigns continued to come under pressure, especially once the effect of the €1 trillion long-term refinancing operations (LTRO) conducted by the European Central Bank (ECB, unsolicited ratings AAA/Stable/A-1+) had worn off. For example, the yield of the 10-year bond of the Kingdom of Spain (BBB-/Negative/A-3) hovered just over 5% during the first quarter of 2012, supported by what we believe to have been intense buying by Spanish banks, which themselves borrowed heavily from the LTRO. With that support gone and the crisis showing no signs of abating, Spanish sovereign yields peaked above 7% over the summer.
As matters worsened, threatening to engulf larger nations like Italy (and, as suggested above, Spain), the European policy reaction took on a broader perspective. Policymakers began to recognize that a strategy based on fiscal austerity alone could have other negative economic and social consequences. We believe that policymakers began to realize that they were confronting not only a budgetary problem of excessive public debt and deficits, but a series of balance-of-payments problems as well–a view, incidentally, in line with our own long-held opinions (see “Who Will Solve the Debt Crisis,” published Nov. 10, 2011).
From today’s vantage point, it appears there were two events in 2012 that helped begin to restore credibility in European policymakers’ approach:
- The June 29 eurozone summit that granted flexibility to the ESM, the eurozone’s permanent bailout fund that became operational in the second half of 2012, to directly purchase bonds in the primary market. Once a single bank supervisory mechanism is established at the level of the eurozone, the ESM would also be allowed to directly recapitalize banks, thus breaking the vicious circle between vulnerable governments and weakly capitalized banks. The summit also decided to expedite progress toward a banking union, starting with the establishment of a single supervisory banking authority (see “The Tide May Be Turning For Eurozone Sovereigns Following The June 29 Summit,” published July 3, 2012).
- The Sept. 6 ECB announcement that it would introduce “outright monetary transactions” (OMT). This allowed for unlimited bond purchases of sovereign distressed bonds by the Eurosystem (ECB and member state central banks) subject to the distressed sovereigns agreeing and adhering to explicit policy conditions see “The European Central Bank’s Policy Initiatives Could Benefit Some Sovereigns, But Implementation Risks Remain,” Sept. 7, 2012). At the same time, the ECB stressed that it would not seek to be treated as a preferred creditor in a future case of sovereign restructuring. The possibility that the ECB could be a preferred creditor had, in our view, previously undermined investor confidence when the Eurosystem had exempted itself from the distressed sovereign debt exchange that was a central component of Greece’s workout in early 2012 (see “ECB Greek Bond Swap Results In Effective Subordination Of Private Investors,” published Feb. 24, 2012).
In our opinion, both events contributed to a broad-based recovery of bond yields. The recovery was further supported in September 2012 by the German Constitutional Court’s affirmation of the constitutionality of the ESM. Portuguese 10-year sovereign yields dipped below 7% in December 2012 for the first time in almost two years, after peaking at twice that level in early 2012. Greece’s 2% bonds maturing in 2023 (issued as part of its distressed debt exchange), fell to 13% of face value in May, but recovered to (a still heavily discounted) 48% by year end. The Spanish 10-year benchmark ended 2012 near where it started, at just over 5%. Nevertheless, the pricing of credit default swaps (CDS) suggests that the market still considers Spain’s default risk as elevated. By Standard & Poor’s “Market Derived Signal”, the CDS market prices Spain like a ‘BB’ credit, two notches below our own sovereign credit rating on Spain at ‘BBB-‘, although this is the smallest difference in over three years. CDS market pricing for other periphery sovereigns also suggests that in spite of the market recovery of late 2012, parts of the capital markets remain more pessimistic about default probabilities on the periphery than Standard & Poor’s. Capital market pessimism about eurozone sovereign credit fundamentals has been apparent for several years now and continues into 2013–in contrast to its preceding optimism prior to 2008, which led to a multiyear bond price overshooting and fundamental risk underappreciation.
In the same vein, cross-border payment imbalances within the eurozone, as expressed by Target 2 balances of the Eurosystem’s national central banks, peaked in the third quarter. While the moderate decline of the imbalances in the fourth quarter signals that cross-border funding stresses may be subsiding, we consider any improvement to be tentative and at risk of reversal should risk aversion of financial agents forcefully return. In fact, outstanding levels of the Target 2 imbalances remain extremely large by historical standards. For example, at end of December, the Target 2 balance of the Bundesbank stood at positive €656 billion (from a peak of €750 billion in August), while the Banco de España’s was a negative €366 billion in November (from a peak of close to €440 billion in August). What’s more, these imbalances, which have provided an important buffer against reversing private sector capital flows, have only reverted to the levels reached in early 2012. The fragmentation of the eurozone financial market thus remains extraordinarily high.
Risks In Store In 2013
Capital markets have reacted positively to the progress made by eurozone policymakers since mid-2012 in designing a more effective policy response to the eurozone’s sovereign debt troubles. Nevertheless, 13 out of 17 eurozone sovereign ratings still carry a negative outlook (or CreditWatch negative) largely due to our view of the risks associated with the implementation of those policy responses. These risks may be exacerbated if our current estimate of economic prospects were to prove too optimistic. We expect the eurozone to shrink in 2013 by a further 0.1% (after a 0.6% contraction in 2012), as restrictive fiscal policies, high unemployment, and falling real wages, as well as tight credit conditions act as important drags on domestic demand in peripheral Europe. This should allow for only a mild recovery of positive 1% in 2014 (see “The Eurozone Enters an Uncertain 2013 As The New Recession Drags On,” published Dec. 13, 2012). We expect the economies of Italy and Spain to contract by 0.7% and 1.3%, respectively.
There are in our view three main areas of risk: the economic response, the policy response, and the social response.
1. Response to economic risk
We reiterate our view that the source of the periphery’s problems (with the exception of Greece, where the root cause was largely fiscal profligacy) lies in excessive private sector borrowing and loss of competitiveness, leading to high current account deficits. As cross-border funding flows suddenly stopped and then reversed, a rapid economic rebalancing was required. The ensuing recession, in several cases complemented by the need for the government to recapitalize domestic financial institutions, led to large increases in public debt and deficits. How these twin deficits are corrected will be an important factor in our assessment of eurozone sovereign ratings during 2013 and beyond.
But it is not only the extent of the correction (for example, percentages of GDP) that matters, but also its social, political, and economic sustainability. For example, eliminating a current account deficit through import compression as a consequence of a deep and prolonged domestic recession is, in our view, more problematic than achieving the same improvement by boosting competitiveness and exports. Similarly, “one-off” financial transactions or wholesale cuts to growth-enhancing public capital expenditure are in our view less likely to lead to sustainable consolidation and debt reduction than a balanced approach that includes broadening tax bases and containing consumptive spending.
Despite important progress already achieved, in our opinion, there is no viable alternative to additional rebalancing of the eurozone’s troubled economies. The credit-fueled growth model has ended and the volume of outstanding credit to the private sector is now falling in many affected member states. Achieving rebalancing is a complex and slow process, often taking ample doses of political courage. Governments in many countries, including Greece, have implemented adjustments, especially in the budgetary field, that are among the most ambitious undertaken by OECD countries in half a century. We currently expect net general government debt ratios as a share of GDP to peak in Ireland and Italy in 2013 and those of Portugal and Greece to grow only marginally in 2014. Nevertheless, with all those ratios well above 100% (and close to 200% in the case of Greece) we believe that economic rebalancing has still some way to go and will seriously challenge political leaders.
We are also of the view that the economic and social costs of economic rebalancing could be more easily contained if a higher degree of policy coordination were to lead to a more symmetrical adjustment shared between the eurozone’s core external surplus and peripheral deficit countries, rather than with most of the burden falling on the latter.
Our assumptions regarding the development of current account and general government fiscal balances are summarized in tables 1 and 2. For more indicators and other sovereigns, see “Sovereign Risk Indicators,” published Dec. 19, 2012). If during 2013 we were to conclude that individual sovereigns underperformed relative to those assumptions, the relevant ratings could come under pressure in accordance with our sovereign rating methodology (see “Sovereign Government Rating Methodology And Assumptions,” June 30, 2011). On the other hand, sovereigns whose economic performance generally meets or surpasses those assumptions could see a stabilization of their respective ratings in 2013, other things being equal.
2. Response to policy risk
While there have been noteworthy new policy developments, such as OMT and the ESM, none of these tools have yet been used and implementation risks remain. Another key risk, in our view, would be the sense of complacency that could develop along with an improvement in market conditions. Complacency could lead to the fragile agreements among European policymakers unraveling if some consider that the eurozone’s troubles have passed and previously agreed actions can be shelved or watered down. If nothing else, such behavior would suggest a degree of unreliability and unpredictability of eurozone economic policymaking which could have negative consequences for the relevant ratings. Such a policy retreat could, especially if accompanied by disappointing adjustment progress in the periphery or rising social tensions, lead to sell-offs in government bond markets, intensify funding squeezes, and force policymakers to contemplate an even more costly rescue than what would have been required had they stayed the course.
We consider that it is too early to firmly state that complacency risk has materialized. We are of the view, however, that the consensus among European policymakers may be more brittle than generally appreciated. For example, by stating in late September 2012 that banks’ legacy problem assets should remain under the responsibility of national governments regardless of progress with a single eurozone financial supervisor, the trilateral declaration of the finance ministers of Germany, The Netherlands, and Finland seemed to distance those countries from the essence of the June 2012 summit agreement. The slower process in moving toward a banking union than had been indicated at the outset could also be interpreted as a sign of a waning sense of urgency.
As far as OMT is concerned, we believe that it has partially addressed the moral hazard problem that can be a side effect of external financial support by linking ECB intervention to borrowing member countries meeting key policy benchmarks. The effectiveness of the OMT, which effectively leverages the ESM, will, critically, depend on the willingness of the governments of such borrowing member countries to carry through with what will likely be politically and socially contentious measures. We believe that the risks for the credibility of the ECB could be significant should a situation arise in which conditionality was breached due to lack of domestic political resolve. While the ECB stated that in such cases its intent would be to cease secondary market purchases, such an exit from intervention could, in our view, expedite the materialization of tail-end risks that OMT had been designed to mitigate in the first place. This emphasizes our opinion that the key to a lasting solution of the eurozone’s troubles lies with national politicians, not with the ECB. Without resolute and sustained reform progress, the ECB by itself can achieve only temporary respites.
We also believe that a symmetric application of OMT could contribute to a more robust solution of the crisis. OMT was designed to reduce the possibility that a eurozone sovereign with satisfactory economic fundamentals could lose market access, with Spain as the most frequently mentioned example. But we think the OMT could also be relevant in cases in which sovereigns (such as Ireland) currently compliant with the conditions of a Troika program had lost, but are currently attempting to regain, primary market access. Facilitating the successful return of “first-generation” program countries to sustainable market funding could, in our view, enhance confidence in the overall crisis management strategy and, other things being equal, positively affect reform incentives and market conditions for other sovereigns under pressure.
With the key of successful crisis resolution in the hands of governments, the electoral calendar remains a vital factor in assessing the future course of policies as well as progress in crisis resolution. The main elections in 2012, in Greece, France, and The Netherlands, resulted in governments that took an overall constructive view on crisis resolution efforts. These elections, in our view, reduced the possibility of contentious discussions among policymakers that could have undermined the delicate confidence of market participants in political leaders’ consensus and commitment to the crisis resolution strategy. It is our base case that the elections we consider the most important in 2013–Italy in February, Germany and Austria in the autumn–will similarly lead to a continuation of the current policy path.
In our view, a victory of populist and anti-European forces in Italy would have a detrimental effect on the corrections taking place in the eurozone, especially if eurozone membership itself were to be put in question. We note, however, that the polls do not currently signal such an outcome as likely and we continue to consider that a member’s exit from the eurozone remains unlikely. Our assumption therefore remains that broad policy continuity will prevail in Italy. The outcome of the German election is at this point uncertain, but we believe that all plausible coalition governments would support the current policy approach, as evidenced by broad cross-party support of the relevant parliamentary votes in the past. However, should the crisis intensify in the run-up to the German election, we believe that the incumbent coalition could be reluctant to promote additional measures. It would not want to render itself subject to accusations that it is appropriating German taxpayer funds to an ever deepening crisis with diminishing prospects of recovering those resources. Whether additional measures or bailout operations could be passed in the Bundestag during the pre-electoral campaign appears to us highly uncertain.
3. Response to social risk
Many countries are experiencing the most severe economic crises in living memory. Growth remains elusive, while official unemployment figures have crept up to levels that, if sustained, could signal the possibility of acute social conflict. We expect unemployment to rise in all major economies but Germany’s, and in the eurozone overall to peak this year at a very high 12.1%, from 11.6% in 2012. However, this average masks considerable national and sectoral differences, with, for example, youth unemployment surpassing 50% in Greece and Spain. Many family incomes have been affected by falling real wages and property values as well as by unavailability of credit, leading us to believe that the social contract around which a country coalesces may become increasingly strained. In the longer term, we expect the already adverse demographic profile in many countries to deteriorate further as families have fewer or no children in light of uncertain personal economic situations. European history well illustrates how discontent and economic hardship can lead to support for populist or nationalist recipes that promise easy solutions. In a worst case, such solutions could include repudiation of public debt, nationalization, or an outright unilateral exit from the eurozone. A prevailing sense that a country’s internal security is deteriorating alongside the population’s economic prospects could accelerate the advent of populist movements.
As public resources become scarcer, we believe that regional or nationalist voices may also become more alluring for the electorate. The most visible example of this tendency was the surge in support for independence-minded parties in the late 2012 regional election in the Autonomous Community of Catalonia (BB/Negative/B). Although we consider a break-up of current sovereigns as unlikely for various political, economic, and constitutional reasons, we nevertheless acknowledge that escalation of fundamental constitutional conflicts will complicate the implementation of unpopular economic policy measures considered necessary to curtail the twin external and fiscal deficits.
While populist parties have sprung up in several countries, the partisan landscape in Greece has radicalized most, concomitant with the deepest economic depression in the region. While voters have hitherto endorsed more centrist coalitions, the risk of radicalization rises the longer a tangible recovery fails to occur. Further radicalization, while not in our 2013 base case, could make its effects felt across the eurozone, leading to a return of doubts about the irreversibility of eurozone membership, which had been pushed to the background since the unveiling of the OMT initiative.
Sovereign Creditworthiness Is In The Hands Of Policymakers
All things considered, we believe the challenges in the eurozone remain formidable. Our current ‘CCC+’ rating on Cyprus signals our opinion that we could see another eurozone sovereign being forced to restructure its obligations and effectively default under our criteria (see “Rating Implications Of Exchange Offers And Similar Restructurings, Update,” published May 12, 2009). With Cyprus accounting for only 0.2% of eurozone GDP and being considered as a special case most directly affected by the Greek crisis, we think it unlikely that the eurozone’s path to recovery will be determined by a restructuring in Cyprus, should one occur in 2013.
All the same, we expect 2013 to be a critical year in determining whether the multiyear downward trajectory of sovereign ratings in the eurozone, which had already begun in 2004 with the downgrades of Greece and Italy, will, at last, come to an end. We believe that as the year progresses, visibility of the economic, policy, and social responses to the crisis will become clearer. Should the abovementioned risks not materialize and social cohesion coexist along with disciplined policy implementation and progress in economic and fiscal rebalancing, the prospects would indeed be realistic for us to conclude that eurozone sovereign creditworthiness had “bottomed out”.
Nevertheless, Standard & Poor’s eurozone sovereign ratings have been lowered in a more measured fashion than the more volatile reactions of the sovereign bond and CDS markets. As we enter 2013, only three out of 17 sovereigns have a noninvestment-grade rating (Portugal, Cyprus, and Greece), accounting for less than 4% of estimated 2012 eurozone GDP. The GDP-weighted average sovereign rating is still at a very strong ‘AA-‘, down from ‘AA+’ at the onset of the crisis, indicating our view of the high degree of resilience of the generally prosperous and diversified economies and high levels of governance of member states. We believe that it is in the hands of policymakers and societies to prevent a further slide of sovereign creditworthiness and that 2013 will be a decisive year in that respect.