Spain and Portugal Have No Clothes

12/20/2010 12:01 am EST


John Mauldin

Chairman, Mauldin Economics

Europe’s tattered fringe won’t be able to sew up new loans without massive aid from a reluctant Germany, writes John Mauldin in Thoughts from the Frontline.

Why is it that the Irish must take upon themselves the debts of their banks, which in reality are debts owed to German and French banks? Why should the Germans bail out the Greeks and the Spanish? Is the spread of "contagion" starting to taint the debt of Italy and even Belgium, the home of the European Union?

A lot of that Irish debt is owed to German, French, and UK banks.

And that chart is what is really going on in Europe. It is not about Germany and France wanting to help out Ireland and Greece (and eventually Portugal and Spain). They are not that benevolent. It is that they are worried about their banks going belly up.

Look how upset the UK got when Iceland decided not to back its banks. Never mind that the bank debt was 12 times Iceland's gross domestic product. Never mind that there was no way in hell that the 300,000 people of Iceland could ever pay that much money back in multiples lifetimes. The Icelanders did the sensible thing: they just said No.

Yet Ireland has decided to try and save its banks by taking on massive public debt. The current government is willing to go down to a very resounding defeat in the near future because it thinks this is so important. And it is not clear that, with a slim majority of one vote, it will be able to hold its coalition together to do so.

Down and Almost Out in Portugal
Portugal also has a rather staggering amount of debt. As my friend Jonathan Tepper wrote, Portugal is seeing all sorts of its economic dynamics go into reverse, except:

"The only thing that is not likely to move in reverse is debt levels. There are two main reasons for this. First, the measures the government are adopting to reduce the fiscal deficit will likely result in a deflationary dynamic, boosting the debt-to-GDP ratio.

"Second is Portugal's strong reliance on international investors to fund its debt. 80% of Portugal's public debt is held by foreigners (Portugal is very similar to Ireland in this respect), and its total external debt position amounts to 90% of its GDP. The deflationary correction elicited by the austerity measures will in itself be a reason for outside investors to stay away from Portuguese debt.

"Portugal's government debt, at 82% of GDP, currently sits at less than that of Greece (126%) and Ireland (almost 100%). Yet adding in corporate and private debt, Portugal's debt-to-GDP ratio rises to over 250%. Foreign investors are unlikely to tolerate such situations for much longer. It thus likely Portugal will have to apply for an EU/IMF bailout in a matter of weeks rather than months."

The Pain Is Plain in Spain
But then that brings up the problem of Spain. Unemployment at 20%. Large fiscal deficits. An external debt situation that is worse than Portugal's.

Yet Spain must figure out how to get €635 billion over the next few years to finance its deficits and bond repayments, which it hopes to roll over into brand new bonds

There are only a few paths in front of us. The peripheral European countries can simply default--Greece did so just 20 years ago. Rates got up to 20% for them. Banks would take losses, but the European Central Bank can be the backstop. And after a while people would forget and lend the Greeks money again.

Or some of the peripheral countries can leave and go back to their own currencies, taking the path to devaluation, like Iceland did. Or Germany can decide to go its own way.

Or the ECB can print euros and buy out the debt on European banks' balance sheets. Or create a massively large stability fund and combine that with some haircuts for euro bond holders.

There are no good solutions, just very difficult ones. And not one that I see that is euro-bullish in the medium term.

[Michael Shulman shares Mauldin’s skepticism, and is recommending short positions in two European banks as a result. John Bollinger also doubts the euro can survive, while Tom Slee was somewhat reassured by a recent visit to Europe—Editor.]

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