Economy & Market Simplified For You-Feb-2010

Overview of sovereign debt issues in Portugal, Italy, Ireland, Greece & Spain (PIIGS) and Eastern / Central Europe

Introduction

The above economies are plagued by red flags on sovereign balance sheets, high fiscal deficits, high levels of public debt-to-GDP, high proportion of short-term loans, insufficient income along with a lack of liquidity The above factors have increased fears that the next credit crisis is likely to be triggered by the highly indebted economies of Central and Eastern Europe, and more recently, in the economies of PIIGS.

In Greece the massive upward revision of its 2009 deficit to 12.7% of gross domestic product - more than four times the European Union's 3% cap - triggered downgrades of the euro member's sovereign credit rating and spurred a sell off in Greek government bonds. While a quiet crisis is brewing in Eastern Europe, where Bulgaria, Hungary and the Baltic states that face a staggering foreign debts in excess of their GDP. While sovereign default is unlikely having occurred only in Ecuador and Argentina in the past decade – it is increasingly clear that these governments face a rather uphill task in fulfilling their debt obligations.

Budget deficits

European governments will need to borrow €2200 bn or US$3100 bn from the capital markets this year to finance their budget deficits. As a percentage of GDP, borrowing is expected to be the largest in Italy, Belgium, France and Ireland at about 25%. An expected surge in issuance of short-term treasury bills in France, Germany, Spain and Portugal increases the market risk facing these countries - most notably the exposure to interest rate shocks. Amongst Europe’s top issuers of sovereign debt this year, the major borrowers in aggregate will be:

• France - > €450 bn
• Italy - > €390 bn
• Germany - > €385 bn
• UK - > €275 bn

In Eastern Europe, the spreads on sovereign credit default swaps has shot up several-fold since last year, with Latvia's rate of 530 basis points approaching that of Dubai's right now.

The previously stalwart economies of Greece, Ireland, and Portugal are increasingly being compared as to those of their Eastern European counterparts. Greece needs to borrow Euro 47 billion in the next year, a possibly insurmountable task given that its public debt load already exceeds 135% of GDP, and its 12.7% budget deficit this year is the highest in the euro zone. The prices of credit default swaps on Greek sovereign debt have already reached astronomical levels, rising to a record high of 410 basis points, twice as high as that in December 2009. Ireland, with its foreign debt now more than 800% of its GDP, is in an even worse shape.

High unemployment levels

Stubbornly high unemployment rate is an especially serious problem in Eastern Europe, where a host of upcoming elections in 2010 could heighten tension, stoke unrest and increase the likelihood of instability. Even if the governments in deepest trouble manage to formulate credible spending cuts, the record levels of unemployment may yet trigger mass labour strikes.

Potential effect on Banks and Financial system:

Financial institutions in Europe have not fully recognized the losses on their toxic assets and have large exposure to Central and Eastern Europe, where the economic and financial crisis are not yet over. This brings us to another issue to worry about - if one of the big Western European banks active in Eastern Europe finds itself in trouble, its contagion effect could have widespread ramifications.

Euro Declining Due to Debt Crisis:

Fears of a debt default by Greece and some other European Union countries that have been hit hard by the financial crisis have caused the Euro to depreciate sharply in recent weeks. Views on likely EU support are divided: If they help Greece, they will spark a speculation race. There will be a domino effect in which other indebted states will also have to be bailed out. That will cost all euro countries - including the relatively stable ones such as Germany - a lot of money. Bailing out Greece with taxpayers' money would be deeply unpopular and difficult to sell to voters, but if euro zone countries abandon Greece, economic imbalances within the euro area would grow.

Impact on Capital inflows to Emerging Markets:

The resultant volatilities in global capital markets, have once again brought to centre stage, concerns regarding receding capital flows to emerging markets and so-called ‘flight to safety’. We believe that the current volatility in foreign capital inflows is only short-term in nature. Over the medium-to-long term, the better-than-expected macroeconomic performance of India during 2009-10 as well as during the coming years will maintain the positive sentiments of global investors about India’s growth prospects vis-à-vis those of the developed world, and lead to sustained capital inflows to emerging economies, including India

Conclusion

Undoubtedly, these economies will take a while to recoup, given the double whammy of the worldwide recession and domestic issues. While the concerns on the sovereign balance sheet of these European economies are quite real, the causes underlying those are not new or recent. Also, sovereign default is very unlikely and hence, the fears surrounding these concerns seem to be largely overdone.

Credit Research Team

Disclaimer

The comments made above are informed views rather than firm predictions. BSLI recommend that these general views should be cross‐verified and reaffirmed before being used for personal financial planning purpose. Neither Birla Sun Life Insurance Company Limited, nor any person connected with it, accepts any liability arising from the use of this document. The recipients of this material should rely on their own investigations. Prp No. ADV/02/09‐10/3822