Fitch : Sovereign Credit Crisis

8/9/2019 Fitch : Sovereign Credit Crisis

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Sovereigns

www.fitchratings.com

Special Report Sovereign Credit CrisisCrisis of Confidence in the Euro Zone

Summary: How Bad Can It Get?As well as reflecting concerns regarding the fiscal solvency of some Europeangovernments, the market volatility and stress in European financial markets has alsobeen prompted by concerns over the sustainability of the euro zone. The crisis ofconfidence in the longrun viability of euro reflects the severity of macroeconomicimbalances within the region; scepticism over the ability of economies within theeuro zone to adjust in the absence of monetary and exchange rate flexibility; anddoubts over the strength of political commitment to the euro zone, given the

initially hesitant and reluctant support given to Greece.Central to understanding the global financial crisis and its impact on sovereigncreditworthiness was the excessive buildup of privatesector debt and leveragerevealed by the global financial crisis. As governments have sought to mitigate thefinancial and economic effects of privatesector deleveraging, their ownindebtedness has consequently risen. The most severe deterioration in publicfinances has generally been in those countries that have the highest levels ofprivatesector debt, with the notable exception of Greece, which is primarily incrisis because of fiscal mismanagement and loss of credibility.

Imbalances within the euro zone are much more than a simple story of the supercompetitiveness of Germany and chronic uncompetitiveness of the socalledperipheral economies. It also reflects differences in domestic demand and credit

growth, as well as the emergence of asset and real estate booms in some countriesover the decade before the crisis.

The most significant macro imbalances that have arisen within the euro zone arebetween Germany and Spain, with the latter accumulating substantial privateforeign debt, much of it owed to the former. It is the process of privatesectordeleveraging that implies the Spanish economic recovery will be weak rather than amore profound and structural uncompetitiveness of the economy.

Consequently, in Fitchs opinion, concerns over the solvency of the Spanish stateare exaggerated unless the risk of a euro zone breakup is materially greater thanassessed given its highincome and diversified economy, sound core financialsector, still moderate level of government indebtedness and the credibility of the

deficit reduction programme.In Fitchs opinion, the risk of a breakup of the euro zone over the short to mediumterm remains low. The policy response the EUR500bn European StabilisationMechanism and ECB commitment to purchase sovereign debt where markets aredysfunctional as well as accelerated deficit reduction by some Member States along with the legal, financial and economic obstacles and costs associated with abreakup, render such a risk remote in Fitchs opinion. Nonetheless, furtherepisodes of extreme market volatility are likely until economic recovery and deficit(and eventually debt) reduction are firmly secured and the European StabilisationMechanism is operational.

The current crisis has revealed weaknesses in economic policy framework andinstitutions, which failed to prevent the emergence of severe fiscal and other

macroeconomic imbalances, rendering the euro zone especially vulnerable to theglobal financial crisis and downturn. Such weaknesses must be addressed if the eurozone economy is to be successful and if confidence in the sustainability of the eurozone is to be established beyond doubt.

Analysts

David Riley+44 20 7417 [email protected]

Brian Coulton+44 20 7862 [email protected]

Related Research

Sluggish Recovery Key Risk for Spain(May 2010)

Greek Public Finances: Closing the

Credibility Gap (May 2010)

EuroZone Contagion: Common Challengesand Fundamental Differences (May 2010)

Improving Bank Liquidity Standards(May 2010)

Global Economic Outlook (April 2010)

'AAA' Sovereigns Under Pressure(March 2010)

This Special Report is based on thespeaking notes for a presentation,How Bad Can It Get?, given atthe Fitch Global Bank Conference inJune 2010. The latest datacontained in this report is as at4 June 2010.
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=505090http://research.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=509645http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=518045http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=525585http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=528809http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=530689


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Sovereigns

Sovereign Credit CrisisJune 2010 2

Cause and Consequences of Rising Sovereign Credit RiskThe policy response following the intensification of the financial crisis in theaftermath of the collapse of Lehman Brothers forestalled a broader banking

collapse. The scale of fiscal and monetary stimulus meant that another GreatDepression was avoided and, as expected, the global economy to begin to recoverduring the second half of the year. Nonetheless, Fitch forecasts that the recoverywould be weak by historical standards because of the headwinds from privatesector deleveraging.

It is also evident that sovereign credit profiles were weakened by the scale offinancialsector intervention, fiscal stimulus and the budgetary impact of recession.Fitch has cautioned that if economies and hence the tax base stagnated and publicfinances stayed on an unsustainable path, some highgrade sovereign ratings wouldlikely be downgraded.

The global recovery is underway, but fears of a doubledip recession are rising. The

financial sector was stabilised but remains fragile and signs of stress have reemerged, especially in Europe. The fiscal costs of the crisis and recession have beeneven greater than expected and sovereign creditworthiness has come under greaterscrutiny and market pressure sooner than anticipated.

Financial Crisis and Recession Damage Sovereigns

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1995 1999 2003 2007 2011f

(% GDP)

Chart 1: Government Debt

Source: Fitch

Mature

Emerging

Others

17%FI support

8%

Fiscal

stimulus

10%

Chart 2: Decomposition of Govt

Debt Increase, 20072014(35.5pp GDP)

Source: IMF

Higher interest

costs

11%

Fiscal stabilisers

29%

Lower asset

prices and FI

profits

25%

The shock to government balance sheets as a result of the financial crisis andassociated recession has been very much concentrated in socalled advanced ormature economies, while emerging markets have generally weathered the stormwell, especially in Latin America and Asia, less so in central and eastern Europe.Fitch projects government debt in mature economies the blue line in Chart 1 torise from around 70% of GDP before the crisis to more than 100% and rising by theend of next year.

IMF analysis that suggests that the direct fiscal costs of financial sector supportaccount for less than onetenth of the 35.5pp of GDP increase in debt between20072014 as forecast by the IMF (see Chart 2), although a further third arises fromthe loss of revenue due to lower asset prices and bank profits combined with fiscalstimulus measures.

Only onethird of the deterioration is accounted for by fiscal stabilisers thetendency of tax receipts to fall and government spending to rise during recessions and should unwind over the medium term as the economy returns to its fullpotential. But the rest of the increase in government debt over 25pp of GDP

will be permanent unless budget deficits are eliminated, interest rates stay low andeconomic recovery is sustained.


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Sovereigns


Understanding Sovereign Credit Analysis and RatingsPublic finances are a key element of sovereign creditworthiness and one of themost dynamic rating factors. Yet even before the crisis, governments in mature

economies tended to have higher public debt levels than the typical lowerratedemergingmarket sovereigns. This highlights the importance of other factors in thecredit analysis and ratings.

Financing flexibility reflects a sovereigns ability to borrow in its own currency at alow cost, a track record of sound money (ie has never wilfully debased itscurrency); the depth of demand for assets in the sovereign currency, includingwhether the currency enjoys reserve currency status; and the existence ofliquidity buffers (ie stocks of financial assets and/or contingency credit lines thatcan be drawn upon in the event of temporary financing stress).

Positive structural factors include a rich, diversified economy (and hence tax base),respect for property rights, rule of law, political and social stability, and anunproblematic debt service record.

Chart 3 shows the average weight of thevarious factors that influence Fitchsassessment of sovereigncreditworthiness, based on an empiricalanalysis of the agencys sovereignratings. Publicfinance factors canexplain a quarter of the dispersion ofratings, while structural factors andfinancial flexibility together have aweight of more than half.

The reason structural factors are so

important is simple: the key asset thatsovereigns benefit from is current andfuture tax receipts. The size, stability and dynamism of the tax base are thereforecentral to the assessment of sovereign creditworthiness.

For highgrade and especially the major benchmark sovereign issuers, financingflexibility is also an important fundamental credit strength. Their deep domesticcapital markets imply a high degree of debt tolerance, as do strong underlyinginternational as well as domestic demand for sovereign assets and, more generally,assets denominated in the sovereigns own currency. Such a government is also ableto borrow in its own currency at long maturity and low cost something that manyemergingmarket sovereigns are still constrained from doing.

For emerging markets, financial flexibility typically derives from holding largestocks of liquid, usually foreigncurrency assets that can be used in times of stress.

For smaller sovereign borrowers that are not benchmark issuers, that are largelyreliant on foreign investors and that do not have large stocks of financial assets andother liquidity buffers, financing pressures can arise if investor confidence in theirlongrun solvency is eroded. This is not to suggest that nonresident investment is abad thing, but the absence of a strong domestic investor base and lack of homebias do render the borrower potentially more vulnerable to confidence shocks, asGreece has learned to its cost.

PrivateSector Deleveraging, Increasing Sovereign IndebtednessCentral to understanding the global financial crisis and its impact on sovereign

creditworthiness was the excessive buildup of privatesector debt and leverageprior to and revealed by the crisis.

External

finance

11%

Structural

34%

Macro

11%

Public

finance

24%

Financial

flexibility

20%

Chart 3: Decomposing the Ratings

Contribution of broad rating factors derived from

model of Fitch sovereign ratings (preliminary

estimates)

Source: Fitch


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Sovereigns


0

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30

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0 50 100 150 200 250 300

(Privatesector debt excl. FIs, % GDP (2008))

Chart 4: PrivateSector Deleveraging, Rising Public Debt

Source: Fitch

Ireland

Portugal

SpainUKJapan

US

Germany

Greece

France

Brazil

Italy

S Korea

Canada

RussiaIndia

(Public debt, % GDP (20072011f))

R2

= 0.56

Chart 4 plots on the vertical axis the change in the government debt/GDP ratioforecast for 20072011 against the stock of privatesector debt, excluding banks, on

the horizontal axis. It shows that the higher the level of privatesector debt goinginto the crisis, the greater the increase in government debt. While certainly notone for one, it fits the story that privatesector deleveraging does effectivelyinvolve some transfer of private liabilities onto the government balance sheet.

Some of the major emerging economies, Russia, Brazil and India, are in the bottomleft corner. All have relatively moderate levels of private nonfinancialsector debtand the increase in government debt as a result of the global financial crisis isminimal.

Of the four euro zone sovereigns that have had rating downgrades since thebeginning of 2009 Spain, Ireland, Portugal and Greece Greece was the only onenot to go into the crisis with high levels of privatesector debt by international

standards. As Chart 4 highlights, Greece does not really fit the story. Fitchconsiders that this is because the Greek crisis primarily reflects fiscal indisciplineover several years that was disguised by misreporting. Once exposed, there was aloss of credibility and confidence in the ability of the Greek government to manageits finances, hence why it needed not only the financial support of the rest of theEU and the IMF, but also the credibility that the latter brings to its economic andfiscal programme (see Appendix 1).

MarketImposed Policy Tightening: A DoubleDip Recession?The yellow line in Chart 5 shows the annual change in global GDP lagged two years(ie shifted left by two years) and plotted against an index of monetary and fiscalpolicy stance. A twoyear lag is introduced because it takes time for the full effectof monetary and fiscal policies to feed through to the real economy.

The chart shows the unprecedented scale of global monetary and fiscal stimulus in2008 and 2009 in fact, this chart understates the extent of such easing, as it doesnot include measures adopted by China and other major emergingmarketeconomies and coordinated through the G20. The scale of macroeconomic stimulusprevented the recession from being even more severe than it was and underpinnedthe recovery in the global economy and trade in the latter half or 2009, andcontinues to be supportive for growth this year.


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Policy index (+ = easing) (LHS) Real GDP, % change (t2), (RHS)

Chart 5: Index of Policy Stimulus and Growth in Advanced Economies

(Index)

Note: Based on change in fiscal deficits and changes in real interest rates in US, Japan, UK and

euro area (Germany prior to 1995)

Source: Fitch

(% change)

Fitch had expected some monetary and especially fiscal tightening beginning in2011. But there will be significant headwinds for the global economy in 20112012,

with advancedeconomy governments under increasing market pressure to rein inbudget deficits sooner rather than later, and risk premiums and yield curves rising.While a doubledip recession (highlighted by the dotted red line in the chart) isnot Fitchs base case, it cannot be wholly discounted, as evidenced by mountingconcerns over policy tightening and financial risks in China as well as Europe.

The Coming Sovereign Debt Crisis?International and historical experience suggests that systemic banking crises oftengo hand in hand with sovereign debt crises. Few financial sectors can survive adefault by a home sovereign, and banking crises invariably result in severeeconomic and financial dislocation that puts enormous pressure on sovereignbalance sheets and creditworthiness.

0

9

18

27

36

45

1900 1906 1912 1918 1924 1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008

Systemic crises New external debt crises(% of countries, GDP weighted)

Chart 6: The Coming Sovereign Debt Crisis?

Note: Dotted line added by Fitch for illustrative purposes

Source: Reinhart and Rogoff, 2009

The panic

of 1907

World

War I

The great depression

Less developed

countries debt crisis

Next sovereign

debt crisis?

Chart 6 is taken from the recent book by Professors Reinhart and Rogoff.1 The blueline is the number of countries experiencing systemic banking crises weighted bytheir share in the global economy; the yellow line is sovereign external debt crises,similarly weighted. Several commentators point to recent developments in the eurozone as the beginning of a broader sovereign debt crisis.

Banks and Sovereigns Stand and Fall TogetherIt is no surprise that claims on government are a material part of bank balancesheets volatility in the value and credit profile of these claims does havesignificant implications for bank balance sheets and profitability.

1 Carmen M. Reinhart and Kenneth Rogoff This Time Is Different: Eight Centuries of FinancialFolly, Princeton University Press, 2009.


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0

5

10

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25

Jan 73 Apr 82 Aug 91 Dec 00 Apr 10

US Euro zone(% of total bank assets)

Chart 7: Claims on Government

Source: Fitch estimates based on FDIC and ECB data

Banks are likely to become an increasingly important source of funds forgovernments, further tying together the credit profile of sovereigns and the

financial sector. As Chart 7 highlights, claims on governments as a share of totalassets have been higher in the past and have started to rise despite heightenedconcerns over sovereign credit risk. Fitch expects this trend to continue, not leastdue to pressure from regulators.

For example, proposed regulatory changes, such as those under Basel III regardingbank liquidity requirements, would increase the stock of highquality liquid assetsthat banks have to hold assets that regulators are likely to view as beingsecurities issued by governments, quasisovereigns, supranationals and centralbanks.2

Sovereign and Bank Credit Risk in TandemPerceptions of sovereign and bank credit risk have tended to move in tandem since

the start of the global financial crisis. During the height of the financial crisis inlate 2008 and early 2009, sovereign balance sheets were effectively used tounderpin and stabilise the banking sector, although at the cost of some weakeningof sovereign credit quality.

0

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450

May 08 Oct 08 Mar 09 Aug 09 Dec 09 May 10

Banks Sovereigns(bp)

Chart 8: European Credit Risk

Source: Bloomberg

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750

May 08 Oct 08 Mar 09 Aug 09 Dec 09 May 10

Banks Sovereign(bp)

Chart 9: US Credit Risk

Source: Bloomberg

However, since the turn of the year, rising perceptions of sovereign credit risk,especially in Europe (see Chart 8), have spilled over to concerns over bank creditrisk and financialsector stability more generally. Perceptions of US bank creditquality have also been adversely affected (Chart 9), although to a much lesserdegree and as a result of concerns over developments in Europe, rather thanconcerns over the credit quality of the US government or the banks themselves.

2 See Improving Bank Liquidity Standards under Related Research on the front page.


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Sovereigns


European Sovereign Debt CrisisIn some respects it is not evident why Europe and in particular the euro zone shouldbe at the centre of concerns over sovereign creditworthiness. The euro zone in

aggregate did not have a credit boom, toxic assets or as severe a banking crisis asin the UK and US. The aggregate fiscal deficit of the euro zone is high at 6.3% ofGDP, but still almost half the level in the US and UK, while the stock of governmentdebt is comparable and is much lower than in Japan. Moreover, the euro zone islargely selffinancing in the sense that it has broadly run a balanced externalposition, and foreign debt and net foreign liabilities are relatively moderate.

Yet the euro zone is experiencing a financial crisis. In summary, Fitchs assessmentis that it reflects investor concerns over the sustainability of the euro zone becauseof:

macroeconomic imbalances within the region;

scepticism over the ability of economies within the euro zone to adjust in theabsence of monetary and exchange rate flexibility;

concerns about fiscal solvency given large fiscal deficits and weak economicgrowth prospects; and

doubts over the political commitment to the euro zone in the aftermath of thehesitant and reluctant support given to Greece.

In that sense, the current crisis is as much about a loss of confidence in thesustainability of the euro zone and the euro as it is concern over fiscal solvency.

Table 1: Key Financials, 2009e(% GDP) Euro zone US UK Japan

Government budget 6.3 11.4 10.9 8.8

Government debt 78.7 71.3 70.8 201.7Private debt (excl. FIs) 151.4 145.6 224.8 160.9a

Real GDP growth (%)Peak to trough 5.2 3.5 6.2 8.42010 forecast 0.9 3.0 1.2 1.8

Unemployment (%) 9.4 9.3 7.8 5.7Inflation (%) 0.3 0.3 2.1 1.4Current account 0.3 2.9 1.3 2.8Net IIP 16.3 24.0a 13.1 50.8a

a 2008 dataSource: Fitch

External Imbalances and Relative Demand in Euro ZoneFrom a balanced position in 1999, current account surpluses in the euro zone

steadily accumulated and peaked in 2007 at almost 8% of own GDP, while deficitcountries saw their current account shortfalls in aggregate approach 10% of theirGDP. Charts 10 and 11 highlight the imbalances that arose within the euro zoneover the last decade.


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15

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5

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Q101 Q202 Q303 Q404 Q106 Q207 Q308 Q409

Portugal Ireland

Germany SpainGreece Italy

(% country GDP)

Chart 10: Current Account

Balances

Source: Eurostat, Fitch

80

100

120

140

Q100 Q404 Q309

Germany Greece

Italy SpainIreland Portugal

(EMU domestic demand =100)

Chart 11: Demand Relative to EMU

Avg

Source: Eurostat, Fitch

Chart 10 illustrates the development of the current account positions of variouseconomies within the euro zone. Germany (the green line) has moved from a small

deficit to a substantial current account surplus over the last decade, thecounterpart of which within the euro zone has been widening trade deficits in socalled peripheral euro zone economies notably Spain (the grey line), Greece(the purple line), Ireland (the yellow line) and Portugal (the blue line). In fact,given the respective sizes of the various economies in the euro zone, the tradeimbalance between Germany and Spain is at the heart of the imbalances within theeuro zone as a whole.

Chart 11 shows domestic demand relative to the average for the euro zone as awhole. It suggests that part of the explanation for the widening of the Irish, Greekand Spanish current account deficits has been much stronger domestic demand inthose economies relative to the rest of the euro zone and especially Germany.

Price Competitiveness and Export PerformanceImbalances within the euro zone are much more than a simple story of the supercompetitiveness of Germany and chronic uncompetitiveness of the peripheraleconomies. Part of the story is also about relative domestic demand, credit growthand asset and housing booms, in part because of the common interest rate acrossthe euro zone.

This implies that economies like Spain do not necessarily have to deflate massivelyin order to restore competitiveness, even though the process of rebalancing theireconomy does imply a period of prolonged low growth.

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90

100

110

120

130

Jan 99 Oct 01 Aug 04 Jun 07 Apr 10

Germany SpainGreece Ireland

Italy Portugal(Q199 = 100)

Chart 12: Real Exchange Rate (CPI)

Source: ECB

60708090

100110120130

1999 2001 2003 2005 2007 2009

Ireland Greece

Spain Italy

Portugal Germany(2000 = 100)

Chart 13: Exports Relative to

Export Markets

Imports (goods+services) in main trading partners

Source: EC AMECO

Chart 12 shows (implicit) exchange rates adjusted for inflation for the same group

of countries. Note that an increase in the value of the real exchange rate implies aworsening of price competitiveness, although in itself this does not reveal theextent to which an exchange rate is fundamentally over or undervalued.


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Sovereigns


Ireland, in particular, had a very strong appreciation of its real exchange rate,reflecting higher inflation than the rest of the euro zone as the economy boomedover the last decade, although international competitiveness is improving as prices

and wages fall. The real exchange rates of Spain and, to a lesser degree, Portugaland Greece also rose over the last decade.

However, Chart 13 shows export market share and it is evident that the correlationwith price competitiveness is quite weak. Ireland has experienced gains in itsexport market share despite having the most significant real appreciation of itsexchange rate, while Italy experienced the greatest decline in market share,although it did not lose price competitiveness significantly over the period and itscurrent account deficit is moderate.

Corporate and Household Indebtedness

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UK Euro Spain US Italy

Gross debt Net debt

Chart 14: NonFinancial Corp Debt

(% GDP)

Note: Data related to 2008

Source: Fitch estimates based on national sources

50

0

50

100

150

200

250

300

US UK Euro Spain Italy

Gross debt Net debt Net financial wealth

Chart 15: Household Debt

(% disposable income)



As discussed under the section PrivateSector Deleveraging, Increasing SovereignIndebtedness above, central to understanding the global financial crisis has beenthe issue of privatesector and especially household indebtedness (see Chart 14).Again, in aggregate the euro zone compares relatively well with the US and the UK,as does Spain in terms of gross and net debt, although households in Spain are muchless financially wealthy than their US and British counterparts. Moreover, theSpanish corporate sector, which includes commercial real estate and propertydevelopers, is heavily indebted by euro zone and international standards.

Although Ireland is not shown in these charts, the level of household and corporatesector indebtedness is similar to the UKs. And while the Italian government isheavily indebted, its private sector is not.

External and Government Indebtedness

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430

Spain UK US Euro Italy

Gross Net

Chart 16: External Debt

(% GDP)



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Spain UK US Euro Italy

Gross debt Net fin. liabilities

Chart 17: Government Debt

(% GDP)




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In terms of external debt debt claims on the country by nonresidents the UKstands out, although the UK figure of 430% of GDP in large part reflects thepresence of international banks in the City of London. For the euro zone as a whole,

it has a near balanced net foreign debt position, but Spain does have a high level ofnet external debt relative to other euro zone countries, reflecting the large currentaccount deficits that have been funded by foreign borrowing, largely intermediatedthrough the banking sector.

The level of foreign debt and liabilities that can be sustained within a commoncurrency area should be higher than between economies with separate currenciesand direct (or indirect) restrictions on international capital flows. Nonetheless, theglobal financial crisis precipitated a sharp decline in crossborder financial flows,including within the euro zone, and hence those economies with higher levels of(net) foreign debt were more vulnerable. Moreover, if there are doubts over thesustainability of the euro zone and euro, then countries with high foreign debt areespecially exposed to confidence shocks.

Finally, Chart 17 shows that while Spain has a relatively highly indebted privatesector, the government despite recent very large budget deficits is stillmoderately indebted compared with some of its peers and the euro zone as a whole.

Fiscal and Current Account Deficits

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12

9

6

3

0

12 9 6 3 0 3 6 9

(Current account balance, % GDP (2009e))

(Fiscal balance, % GDP (2009e))

Chart 18: The Emergence of Twin Deficits

Source: Fitch

Ireland

Portugal

Spain UK

Japan

US

Germany

Greece

AustriaItalyAustralia

Canada Belgium

Switzerland

SwedenFinland Denmark

Luxembourg

France

Netherlands

Chart 18 shows the fiscal balance on the vertical axis and the current account ofthe balance of payments on the horizontal axis. It is notable that all four countrieswhich have had their sovereign ratings downgraded since the global financial crisisintensified in late 2008 have sizeable twin deficits, although in the case of Spainthe current account deficit has historically reflected private rather than public

sector dissaving.

Historically twin deficits often end in financial crisis, typically a currency crisis andsometimes a sovereign debt crisis. In the case of euro zone sovereigns with twindeficits without national currencies, the pressure immediately falls on theirdomestic bond markets and banking systems.

Part of the reason why Fitch has a Stable Outlook on Irelands Issuer Default Ratingfollowing the downgrade to AA last year is that the external adjustment is wellunderway, and this year it is on track to run a current account surplus.

High Foreign Debt Increases VulnerabilityChart 19 restates Chart 18 with bubbles that represent the size of net external debtrelative to GDP. Ireland drops out because it is a net creditor, although this reflectsthe fact that it is the European base for a large number of multinational andespecially US companies that have debt claims on their other operations in Europe.


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Greece, Portugal and Spain stand out but in contrast to Portugal and especiallySpain, it is the holdings of government debt rather than privatesector claims thataccount for most of the foreign debt of Greece.

The combination of twin fiscal and current account deficits and high levels offoreign debt, even within monetary union, increases the vulnerability of theeconomy to external and financial shocks.

83

8388

3455

41 26

17

2621 29

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12 9 6 3 0 3 6 9(Current account balance, % GDP (2009e))

(Fiscal balance, % GDP (2009e))

Chart 19: High Foreign Debt = Greater Vulnerability

Note: Ireland, Germany and Japan drop out of chart as they are net external creditors

Source: Fitch

Greece

Portugal

AustraliaItaly

Spain US UK

France

Canada Finland

Austria

Denmark

Sweden

Netherlands

The Fiscal ChallengeIt is very difficult to establish what is a sustainable level of government debt some economies have been able to sustain high levels for prolonged periods withoutcrisis (eg Japan, Italy and Belgium), while Argentina, for example, defaulted in2001 with a debt/GDP ratio of around 50%.

But it is relatively easy to identify an unsustainable budgetary position a fiscal

deficit that, if uncorrected, implies ever rising debt. And it is negative debtdynamics rather than the stock in itself that have been at the heart of Fitchs fiscalanalysis and investor concerns over the state of public finances in countries such asSpain and Portugal, as well as in the UK and US.

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(Change from 2009e primary balance, pp)

(Govt debt/GDP, % (2009e))

Chart 20: Change in Primary Balance to Stabilise Debt

Source: Fitch

IrelandPortugal

Spain

Japan

USGermanyGreece

FranceAustria

Italy

New Zealand

Belgium

Sweden Finland

Australia

Netherlands

Luxembourg

UK

Denmark

The horizontal axis reports the estimated change in the primary balance thebudget balance excluding debt interest payments necessary to stabilisegovernment debt/GDP ratios at their 2009 level (highlighted on the vertical axis).3

Nonetheless, Chart 20 does highlight that Spain, Ireland, Portugal and of courseGreece face major budgetary challenges if they are to stabilise debt levels as do

3 The estimates in Chart 20 are indicative in the sense that they are based on stylised assumptionsabout the difference between the rate of economic growth and interest rates. Other Fitchresearch offers a more detailed and precise analysis country by country.


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the UK, US and Japan. In contrast, Italy is very close to a budgetary position thatwould stabilise its debt level, albeit at a high level by international standards.

Thinking the Unthinkable: Euro Zone Break-UpA breakup and especially a disorderly breakup of the euro zone has since itsinception been an outcome that Fitch has considered to be a very low probabilityevent. The sovereign commitment is irrevocable there is no legal basis for leavingor being expelled from the euro zone while the strength of political commitmentto the euro was broad and deep.

However, Fitch believes concerns about the sustainability of the euro zone and euroare crucial to understanding the current crisis, and that is not simply a crisis ofconfidence in the fiscal solvency of euro zone member states. According to Fitchsown fundamentalbased analysis, market concerns over the solvency of theSpanish state, for example, would only be validated if the euro zone were tobreak up. The various scenarios described are for illustrative purposes only and

highlight how unlikely and profound the effects of a breakup of the euro zonewould be.

Withdrawal by the WeakOne scenario is that a weak country will voluntarily leave the euro zone (andlikely the European Union), launch a new national currency at a much lowerexchange rate and regain freedom over domestic interest rates. In Fitchs view, thepotential competitiveness benefits of devaluation are far outweighted by thefinancial crisis that would ensue.

Local households, corporates and banks would be exposed to huge currency mismatches on their balance sheets. Almost certainly there would be deposit andcapital flight as savers and investors sought to avoid being forcibly converted from

euros into a new depreciating currency, backed by a weak government and acentral bank that would lack credibility as a lender of last resort and itscommitment to low and stable inflation.

Such a scenario would also likely lead to a government default. Either thegovernment would forcibly redenominate its debt from euros into the newlycreated currency or, if it did not do so, the debt burden would becomeunsustainable as the economy (and tax receipts) shrank in euro terms, while thecost of fiscal and external funding in the new currency would also rise.

Expulsion of the WeakThere is no collective legal right and mechanism for weak or undisciplinedmember states to be expelled from the euro zone it would necessitatefundamental Treaty changes that require unanimity from all member states.

Moreover, Fitch considers that such an option could seriously undermine thecredibility of monetary union it would in effect change the euro zone fromeconomic and monetary union to something more akin to a fixedexchangeratearrangement that countries adopt or abandon when they (or their peers) deem fit.Expulsion could also be subject to legal challenge by creditors as well as themember state that was expelled.

Voluntary Exit by the StrongThe strong member states may be unwilling to make fiscal transfers to theweak. A more plausible scenario in this case, although still very unlikely in Fitchsopinion, is that a group of countries led by Germany arguably the only country,possibly along with France, that could successfully relaunch a national currency would leave the euro zone and set up a new zone based on a new Deutschemark.Again, there is no legal basis for leaving the euro zone, even voluntarily and it mayrequire the exiting countries to also leave the European Union. Ultimately, while a


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Sovereigns


sovereign can do as it wishes, it could face myriad legal challenges from othermember states and investors.

Moreover, if done over a short period, it would also lead to huge economic andfinancial dislocation across Europe, including in the strong member states. Theflipside of Germanys trade surplus with other member states is that it also hassubstantial financial claims on those countries.

An alternative might be to introduce a new national currency that would circulatefreely along with the euro. Over time, contracts and financial and trade flowswould gravitate to the new currency and the euro would wither on the vine.

MarketInduced BreakUpA fixedexchangerate regime, however strong, can ultimately be broken if theweight of money against it is sufficient. The market cannot break up the euro zonein the same way there is no Greek drachma to bet against. Instead, thepressure would come through the sovereign bond market and a sovereign default if

fiscal funding becomes unsustainably expense or the market closes to thegovernment.

An exit from the euro zone and starting again with a new currency might beconsidered the least bad option available if the government has already defaultedand is unlikely to receive any assistance from its European partners and theeconomy remains mired in recession. But a sovereign default and exit by a smallcountry such as Greece, Ireland or Portugal would not in itself necessarily lead tothe breakup of the euro zone as a whole although Spain and Italy might.

Economic and Bank Exposure to the Euro ZoneMost of the bank exposure is intraeuro zone: for example, banks in Germanylending to entities, including the government, in Spain. That said, noneurozonebanks exposure to the euro zone is still very sizeable, with the direct exposure ofUS banks to the euro zone some USD640bn.

As the financial crisis has demonstrated very clearly, the level ofinterconnectedness and complexity of bank and financialsector linkages meanthat a financial and sovereign crisis in the euro zone would have globalrepercussions.

0 1,000 2,000 3,000 4,000

MaltaCyprus

SloveniaLux.

SlovakiaPortugaIrelandFinlandGreeceAustria

BelgiumN'landsSpain

ItalyFrance

Chart 21: Member States' GDPEuro zone GDP 2009 = USD12.5trn

Source: Fitch (USDbn)

Germany

0 600 1,200 1,800 2,400

MaltaSlovenia

CyprusSlovakiaFinlandGreece

PortugalAustria

Lux.BelgiumIrelandN'lands

SpainItaly

France

France Germany

Other European UK

US Rest of world

Chart 22: BIS Bank Claims

Source: BIS (USDbn)

Germany

Banks in


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Sovereigns


Emerging Stress in Banking System

0

10

20

30

40

50

01Jan10

08Jan10

15Jan10

22Jan10

29Jan10

05Feb10

12Feb10

19Feb10

26Feb10

05Mar10

12Mar10

19Mar10

26Mar10

02Apr10

09Apr10

16Apr10

23Apr10

30Apr10

07May10

14May10

21May10

28May10

04Jun10

350

400

450

500

550

600

ECB bank deposits (RHS) EuriborOIS (LHS) US LiborOIS (LHS)

Chart 23: Emerging Stress in European Banking System

(bp)

Source: ECB, ECB, Bloomberg

(EURbn)

EU/IMF/ECB EUR750bn

package 10 May

3 mth USD liborOIS

3 mth EuriborOIS

Bank deposits

with ECB

The blue and green lines show threemonth Euribor and threemonth USD Liborversus the overnight swap rate respectively. Euro funding for banks has consistentlybeen more elevated than for USD funding until the last few months, when USD Liborhas begun to rise quite sharply. That said, it is important to keep recentdevelopments in perspective the current spread between threemonth Libor andovernight funding at around 3040bp remains substantially less than it was duringmuch of last year and, of course, of a wholly different order of magnitude than inthe aftermath of the collapse of Lehman Brothers.

Nonetheless, the rise in Libor and the increase in the stock of bank deposits withthe ECB do suggest that there is increased concern about bank credit risk and risingstress in European interbank markets.

EU/IMF Package and Euro Sovereign Financing NeedsWith the Greek crisis eroding confidence in the euro zone as a whole, the EU, ECBand IMF announced a EUR720bn package of loans and guarantees on 910 May thatwould be available to support euro zone governments (or EUR750bn if the IMFsEUR30bn commitment to Greece is included). This followed a previousannouncement of a EUR110bn EU/IMF package for Greece, of which EUR80bn was inthe form of bilateral loans from other euro zone member states. The ECB also saidit would buy euro zone government debt to stabilise the market (see ECBInterventions below).

At the heart of the package is the creation of a European Stabilisation Mechanismcapable of providing EUR500bn of financial assistance, with at least EUR220bn ofmatching funding from the IMF to euro zone sovereigns in financing difficulty. Theloans would be provided by a specially created financing entity that would raise

funds from the markets on the back of guarantees from euro zone member states.The modalities of the European Financial Stabilisation Facility are still subject todebate and it has not yet been established.

As Chart 24 illustrates, the total package of financial support could in theory fully fundSpain, Ireland and Portugal through to the end of 2012. But while the packagedemonstrates the commitment of European leaders to the stability of the euro zone, itonly buys time. It does not itself address the longerterm problems facing the euro zone:

reducing budget deficits and addressing fiscal solvency concerns;

strengthening the competitiveness and outlook for growth for the euro zone as awhole;

enhancing mechanisms for the monitoring and coordination of economic policiessuch that the macroeconomic and fiscal imbalances highlighted above do notarise again; and

taking measures to underpin confidence in the European banking system.


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Sovereigns


Chart 24: Financing Needs

EUR702bn

Note: Gross financing needs estimated for period May

2010 to end2012, including shortterm debt and net

borrowing requirement

Source: Fitch

Portugal

EUR66bn

Ireland

EUR102bn

Spain

EUR534bn

Chart 25: Financial Support

EUR720bn

Note: Not included is EUR30bn from IMF for Greece

Source: EC/ECB/IMF

EU

EUR60bn

IMF

EUR220bn

Guarantees

EUR440bn

ECB InterventionsECB purchases of government debt securities in secondary markets are an importantelement of the European support package announced in May. The ECB emphasisedthat purchases under its Securities Markets Programme did not imply the adoptionof quantitative easing the purchase of government securities funded by thecreation of base money in an effort to expand the money supply. ECB purchaseswould be in those segments described as dysfunctional and any purchases wouldbe sterilised; that is to say, the monetary impact would be offset by operationsto withdraw liquidity elsewhere.

In addition, the ECB said it would reactivate measures to supply unlimited threeand sixmonth liquidity to banks and extended bilateral arrangements with the USFederal Reserve to provide USD liquidity to European banking markets.

0

500

1,000

1,500

2,000

2,500

Jan 07 Feb 08 Apr 09 May 10

Other assets Banks

Other claims residents Foreign claims

Other securities

Chart 26: ECB Assets

(EURbn)

Source: Fitch estimates based on ECB

0

20

40

60

03Jul09

24Jul09

14Aug09

04Sep09

25Sep09

16Oct09

06Nov09

27Nov09

18Dec09

08Jan10

29Jan10

19Feb10

12Mar10

02Apr10

23Apr10

14May10

Covered bonds Sovereign

Chart 27: ECB Purchases ofCovered Bonds and Sovereign Debt

(EURbn)

Note: Sovereign debt purchases under Securities

Markets Programme

Source: Fitch

Chart 27 shows cumulative weekly purchases of covered bonds the blue bar and(assumed to be) government bonds under the Securities Markets Programme (theyellow bar) up to the week ending 4 June 2010. ECB purchases of covered bonds areapproaching the target of EUR60bn and have been successful in providing liquidityand restarting that market.

However, given the scale of outstanding sovereign debt and the fragile confidencein the political will and capacity of governments to bring public finances undercontrol, especially if economies stagnate, the ECB may find that it is pressed toexpand its purchases of government securities significantly from the current tempoof EUR10bn a week tiny relative to the ECBs overall balance sheet (Chart 26).


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Sovereigns


Cost of Fiscal Funding Remains Low, Although Rising

0

100

200

300

400

500

Dec 09 Feb 10 Apr 10 May 10

Spain GermanyItaly PortugalBrazil Mexico(bp)

Chart 28: FiveYear Sovereign CDS

Source: Bloomberg

0

2

4

6

8

10

12

14

Dec 09 Feb 10 Apr 10 May 10

Mexico SpainPortugal BrazilGermany Italy(%)

Chart 29: 10Yr LC Bond Yields

Source: Bloomberg

While not understating the severity of the situation in Europe and the marketpressure that some euro zone sovereign governments are under, it should be notedthat the cost of fiscal funding is certainly not as explosive as the credit defaultswaps (CDS) market might suggest. Moreover, the widening of cash bond spreads inthe euro zone also reflects the decline in German bond yields to record lows (theyellow line in Chart 28).

While CDS for Brazil (BBB/Stable), for example, is lower than for Spain(AA+/Stable) and Portugal (AA/Negative), their cost of funding remains muchlower than for Brazil, as Chart 29 illustrates. That said, given the much weaker real(and nominal) economic growth prospects in Europe compared with emergingmarkets, nominal yields in high single digits would likely be unsustainable over themedium to long term for euro zone governments.

What Next?The risk of a euro zone breakup remains low, at least over the short to mediumterm, for the following reasons:

the coherent and strong policy response that combines an acceleration of fiscaldeficit reduction in several countries and active debate on how to strengthenthe euro zone economic policy framework;

the EUR720bn EU/IMF financial support package and ECB interventions; and

the potential financial, legal and political obstacles and consequences of theeuro zone, which are so severe that the political will and commitment tosustain the euro zone remain strong.

That said, until economic recovery and deficit (and eventually debt) reduction arefirmly secured, further episodes of extreme market volatility are likely. And it maywell be the case that the market tests the commitment of European governments,and Germany in particular, by forcing the activation of the European StabilisationMechanism and the ECB to expand dramatically its purchases of government debtover the coming months.

The current crisis has revealed profound weaknesses in the economic policyframework and institutions, which failed to prevent the emergence of severe fiscaland other macroeconomic imbalances, rendering the euro zone especiallyvulnerable to the global financial crisis and downturn. Such weaknesses must beaddressed if the euro zone economy is to be successful and if confidence in thesustainability of the euro zone is to be established beyond doubt. This implies some

greater pooling of sovereignty on fiscal and economic policy matters, as well asputting in place effective mechanisms for providing fiscal and financial transfersbetween member states.


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Sovereigns


Pressure on the euro zone could intensify if, for whatever reason, the global orEuropean economy falls back into recession; there is a systemic banking crisis inEurope; or European policy authorities do not respond as expected to any further

deepening of the crisis.


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Sovereigns


Appendix 1: GreeceGreeces LongTerm Issuer Default Rating was downgraded by two notches in Q409:to A/Negative Outlook from A/Negative on 22 October in response to fiscal

misreporting and to BBB+/Negative on 8 December following an insufficientlystrong response set out 2010 draft Budget.

The European and international response was to strengthen credibility by imposingstronger fiscal measures on Greece and to express solidarity with Greece, butthere was uncertainty over the political commitment and mechanism for EU andeuro zone financial support.

The IDR was downgraded by a further two notches on 9 April, to BBB/Negative,reflecting lack of clarity over financing and adverse debt dynamics. Greecesubmitted a formal request for an IMF programme and euro area support on 24 April.Nearterm funding concerns have reduced, and the key focus is on staying on trackwith fiscal targets and the economy.

0

200

400

600

800

1,000

Dec08

Jan09

Feb09

Mar09

Apr09

May09

Jun09

Jul09

Aug09

Sep09

Oct09

Nov09

Dec09

Jan10

Feb10

Mar10

Apr10

May10

Chart 30: Greek 10Year Bond Spread Over Bunds

(bp)

Source: Datastream and Fitch

Outlook revised

to Negative

Downgrade to

'BBB'

Downgrade

to 'A'

Downgrade

to 'BBB+'

Greek EUR110bn

support

announced

EU/IMF/ECB

EUR750bn

package

Chart 30 shows Greek bond yields the rate of interest on Greek government debt and the dates when Fitch took rating actions. It shows that following theannouncement of the EUR110bn rescue package for Greece and shortly thereafterthe EUR750bn package for the euro area as a whole, the yields on Greek debt fellsharply, although they remain extremely high by European and historical standards.

010203040

506070

8090

2009e 2010f 2011f 2012f 2013f 2014f 2015f

Debt repayment Budget balance

Chart 31: Gross Financing Need

(EURbn)

Source: IMF

80

90

100

110

120

130140

150

160

2008 2009 2010 2011 2012 2013 2014 2015

IMF (May) SGP (Feb)(% GDP)

Chart 32: Debt/GDP Projections

Source: IMF

Chart 31 shows the Greek government gross financing need over the next five years.Gross financing need is defined in terms of the new borrowing required to fund thebudget deficit as well as repayments on existing government debt (the yellow partof the bar). Greek governments financing needs are around EUR50bn a year

between now and 2014 before they then start to rise again, in part as loans fromthe EU and IMF begin to fall due for repayment.


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Sovereigns


Chart 32 shows the original government projections for the debt/GDP ratio theyellow line and the latest projections shown by the blue line. Even if Greecemeets all its targets, the debt is expected to reach 150% of annual income (GDP)

within the next couple of years before declining, assuming the economy expandsand primary budget surpluses are sustained.


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Sovereigns


Appendix 2: SpainFitch downgraded Spain to AA+/Stable Outlook from AAA in late May, reflectingthe assessment that the process of adjustment to a lower level of privatesector

and external indebtedness will materially reduce the rate of growth of the Spanisheconomy over the medium term, placing additional pressure on public finances andthe financial sector.

Although the rebalancing of Spain's economy is firmly underway, the inflexibility ofthe labour market and the restructuring of regional and local savings banks (cajas)will, in Fitch's opinion, hinder the pace of adjustment, particularly in the aftermathof the real estate boom. Consequently, and despite a strong commitment toreducing the budget deficit as demonstrated by additional recent measuresannounced by the government such as the 5% reduction in civil service pay government debt will likely reach 78% of GDP by 2013, compared with under 40%before the onset of the global financial crisis in 2007 and the subsequent recession.

Nonetheless, Spain's sovereign credit profile remains very strong and is underpinnedby a highincome and diversified economy, a core financial sector that is sound, arelatively high national savings rate, and a track record of responsible publicfinances, including an unblemished modern debtservicing record.

The fiscal consolidation programme setout by the government is ambitious andsupported by specific and detailedmeasures, some of which have alreadybeen implemented. However, Fitchbelieves that the economic recoverywill be more muted than that forecastby the government. Servicing the

significant external interest burdenimplied by Spain's large negative netinternational investment liabilityposition will reduce disposable incomeand require a shift of resources to thetraded sector of an economy, whoseexports are a relatively smallcontributor to GDP.

In addition, the final costs of restructuring the caja sector could be substantial,although even in a highly stressed scenario they would be significantly less than thepotential EUR99bn set aside under the Fund for Restructuring of Banks. In addition,under Fitchs basecase scenario, these costs would be less than those incurred by

several other governments, reflecting the strong financial profile of Spains largestfinancial institutions.

Despite these expectations, the Stable Outlook on Spains sovereign rating reflectsFitch's view that the countrys credit profile will remain very strong and consistentwith its AA+ rating, even in the event of some slippage relative to official fiscaltargets. Moreover, measures by the ECB and the creation of the European FinancialStability Fund reduce nearterm funding risks.

90

95

100

105

110

Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Q111

Q211

Q311

Q411

Spain US

UK Euro zone

(Real GDP Q197 = 100)

Chart 33: "LShaped" Recovery

Source: Fitch


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Sovereigns


Appendix 3: Euro Zone Sovereign Debt and Bank Assets

020406080

100120140

Spain

Germany

France

Italy

Ireland

Belgium

Portugal

Greece

Nonresidents CB and public Resident FICh 34: Government Debt by Holder

(% GDP)

Source: ECB and Fitch estimates

0

20

40

60

80

100

Belgium

Germany

Ireland

Greece

Spain

France

Italy

Portugal

Loans to hshlds Loans to banksLoans to NFC NoneuroOther Government

Chart 35: Euro Zone Bank AssetsApril 2010

(%)

Source: ECB and Fitch estimates

Chart 34 reports the euro zones stock of government debt relative to GDP for 2009,broken down by category of holder. The blue segment of the bar is nonresidentholders of government debt, which for Greece and Portugal are high both relativeto the total debt stock and as a percentage of GDP. In contrast, half of Spains debtis held by nonresidents, equivalent to around 28pp of GDP. The yellow [art of thebar is central bank and nonbank financial institutions (ie holdings by the public)and the green is holdings by banks resident in the country.

Again, it is worth noting that many of these nonresident holdings areinvestments by other euro zone residents for example, Dutch pension fundsholding Italian government debt. For the euro zone as a whole, investors outside ofthe euro zone hold around onethird of euro government debt.

Chart 35 provides a breakdown of bank assets and shows that claims on government the red part of the bar is significant but not dominant at around 10%, althoughit tends to be higher the larger the stock of government debt in the home country.

Table 2: Selected Economic and Financial Indicators, 2009eAAA

medianaUS

(AAA)Spain

(AA+)Portugal

(AA)BBB

medianaGreece

(BBB)Brazil

(BBB)

GNI per capita (USD) 37,360 46,970 31,130 22,080 11,650 28,470 10,070Unemployment (%) 6.5 9.3 18.1 9.5 9.6 9.5 8.1Gross domesticsavings (% GDP)

22.4 11.3 22.8 11.5 24.2 11.1 20.6

Budget balance(% GDP)

0.0 11.4 11.2 9.4 2.4 13.6 3.4

Interest payments

(% revenue)

5.0 10.4 5.2 7.0 7.1 13.6 14.4

Govt debt(% revenue)

118.0 300.0 153.3 184.7 118.6 312.5 180.6

FX debt (% total) 0.0 0.0 0.7 0.3 46.6 3.2 5.6Commoditydependence (unit)

12.0 10.1 13.1 14.1 19.9 14.2 40.2

a 10year median for rating categorySource: Fitch


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Sovereigns

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Fitch : Sovereign Credit Crisis