Europe: Not That Bad Actually

08/29/2011 12:30 pm EST

Focus: GLOBAL

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

While the markets have been in disarray regarding the European debt crisis and how bad it could get, it’s turning out to be something less than the Armageddon many feared, says Elliott Gue of Personal Finance.

From the outset of the EU sovereign-debt crisis, we’ve maintained that Greece, Ireland, and Portugal’s fiscal woes would have scant effect on the EU and global economy. The three bailed-out nations’ gross domestic products (GDP) accounted for only 6% of the Eurozone’s GDP in 2010.

But Italy is a different story. With a government debt-to-GDP ratio of 119% at the end of 2010, the country faces the second-largest debt burden of the fiscally weak PIIGS (Portugal, Italy, Ireland, Greece, and Spain). To worsen matters, Italy is the EU’s third-largest economy, and last year contributed about 16.8% of the Eurozone’s overall GDP.

If Italy is the next domino to fall in the EU’s ongoing sovereign-debt crisis, the resultant chain reaction could devastate the Eurozone’s economy, financial system, and stock markets. The global repercussions would be akin to the chaos that occurred after Lehman Brothers declared bankruptcy in 2008.

But fears that the Italian government will default on its debt are vastly overblown. Cynical investors have fixated on financial Armageddon rather than current conditions on the ground.

Although Italy is encumbered with an elevated debt-to-GDP ratio, the government’s 2011 budget deficit amounts to about 4% of its economy. Compare that to more than 9% for the US, about 8% in Greece, and 10% in Ireland.

The Italian government won’t need to enforce strict fiscal austerity to balance its budget, which should prevent the domestic economy from lapsing into recession.

In fact, Rome has already passed a budget that would balance Italy’s public finances by 2014. Prime Minister Silvio Berlusconi recently responded to mounting concerns about the country’s fiscal health by unveiling a plan that would accelerate deficit-reduction efforts by roughly one year.

Meanwhile, the doomsday scenarios that could occur if Italy were to default on its sovereign debt are, paradoxically, the same reason investors shouldn’t fear for the worst. Given the country’s importance to the EU economy and the potential for another global credit crunch, policymakers will pursue any means necessary to shore up confidence in Italy’s ability to service its debt.

In late July, EU leaders agreed to a deal that would expand the powers of the European Financial Stability Facility (EFSF), allowing the EFSF to purchase bonds issued by countries that have suffered a major uptick in borrowing costs. But national parliaments aren’t likely to approve these until September, when representatives return from their summer holidays.

When Italy and Spain’s borrowing costs spiked in early August, the European Central Bank (ECB) stepped into the void, buying the embattled nations’ debt in the secondary market. This intervention has worked in the short term, reducing yields on the countries’ ten-year government bonds to less than 5% from recent highs above 6%.

However, investors remain concerned that the 440 billion-euro EFSF isn’t large enough to prevent public finances from deteriorating further. Given what’s at stake, the EU will likely boost the size of the EFSF to shore up confidence, though you should still expect leaders to pursue a gradualist approach.

Now, the market has grown skeptical of France’s creditworthiness. Although Standard & Poor’s recently reaffirmed the nation’s AAA rating, many consider France the most vulnerable to a downgrade.

These fears reflect innuendo and overwrought nerves rather than reality. France has devised a credible plan to reduce its deficits over the next few years.

In early August, concerns about French banks’ exposure to troubled debt issued by the PIIGS contributed to the sell-off that gripped global markets, and drove an uptick in the rates EU banks pay to lend to one another. But French banks have improved their capital positions significantly over the past few years, and stabilizing EU debt markets would alleviate these worries.

Fortunately, the EU sovereign-debt crisis has yet to affect US credit markets. Although Standard & Poor’s downgraded the US government’s credit rating, sales of Treasury bonds have been massively oversubscribed and yields have hovered around multi-decade lows. Meanwhile, US corporations continue to borrow money at the lowest interest rates in decades.

With the EU and ECB committed to preventing the Continent’s sovereign-debt crisis from picking up steam, the global economy should dodge a reprise of the 2008 credit crunch.

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