Europe Is Not in Financial Crisis

 | Nov 30, 2011 | 12:18 PM EST  | Comments
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There are two principal ways ratings agencies consider the creditworthiness of sovereign countries: sovereign debt as a percentage of GDP and sovereign debt service as a percentage of tax receipts.

On both counts the EU members, except Greece, are nowhere near crisis levels.  Portugal, Ireland, France and Germany are either equal to the US or better on both counts.

As opposed to debts a country owes itself (internal), external debts are represented by loans taken out by countries through the issuance of publicly traded sovereign treasury loans. They must be paid and are the focus of the rating agencies.

For our purposes here we are going to roughly distinguish between them as about 60% external and 40% internal across the board for EU member countries.

As such, when considering a country's debt-to-GDP ratio and its sovereign debt service as a percentage of tax receipts, we are only concerned with the 60%.

This is extraordinarily important to understand because most of the financial media lump these two together and it is causing enormous confusion among the retail investing community. That confusion is spilling into the institutional markets because they are concerned about the public's concern, which could give rise to bank runs.   

It's like shouting "fire" in a crowded theater. It doesn't matter whether or not there is actually a fire if it causes a stampede to the exits. 

With the exception of Greece, there is no imminent real financial crisis facing Europe. But the EU leaders have handled the Greek situation so poorly that it is scaring investors all over the world.

So, let's get some perspective. 

The level of terminal default trajectory as measured by sovereign debt to GDP is about 150%.

The closer to that level a country gets, the more investors anticipate crisis though and it becomes a self-validating process with the cost of borrowing debt capital rising as investors flee.

The level at which investors begin to flee is about 100%, with 70% being the red line.

At the 70% to 100% level investors begin looking to political leadership and their peers in the financial markets for clues as to whether or not this is a crisis in the making.

And this is where European leaders have dropped the ball.

The external debts to GDP in Germany, France, Italy, Spain, Portugal, Ireland and Greece respectively are about 85%, 82%, 120%, 60%, 90%, 95% and 145%.

By this measure most are above the 70% red line, but only Greece is clearly in default territory. Spain is only at 60%. The reason their included in the fear flight is because their private-sector debt is high and they had the biggest real-estate bubble.

Now, let's get to sovereign external debt service as a percentage of tax receipts.

The terminal default trajectory level for this measure is 25%. That means that when more than 25% of tax revenue is being used to pay the interest on existing loans there is no way to adjust fiscal or monetary policies to avoid sovereign bankruptcy.

Again, except for Greece, no country is above 10%, with Germany, France, Italy, Spain, Portugal, and Ireland respectively at 6.5%, 5.5%, 9.5%, 5.5%, 7.5% and 9.5%. 

The US, by comparison to both measures, is at about 100% and 10%. It's in worse shape than most of Europe.    

Investors are fleeing Europe because European leaders are creating a crisis.

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