Europe’s Devastating Debt Downgrade

Brett Hammond, Senior Economist

Brett HammondOn January 13 the Standard and Poor’s Ratings Services announced that it was downgrading the sovereign debt of nine eurozone countries. This move reflects the difficult times these and other eurozone countries continue to experience in the absence of a clear resolution to the overall debt and economic problems many of them face. Coming amid an economic slowdown, the downgrade only reinforces the widely held impression that 2012 is going to be a very difficult year for many European economies. For investors, the turbulence bears close monitoring, and may present an opportunity to rebalance one’s portfolio to reduce exposure to Europe.

A downward spiral
The backdrop to the downgrades is the high sovereign debt levels across Europe. Adding to the problem is that the fiscal positions of these countries show no signs of improvement. In fact, conditions are getting worse. One reason is that governments across Europe have been pursuing austerity measures by curtailing spending and raising taxes. While these policies can help to meet the long-term objective of reducing a nation’s budget deficit, the near-term impact is to reduce incomes as well as the amount of money circulating in the economy, which in turn reduces tax receipts, prompting calls for still more austerity measures. This is the downward spiral into which numerous European countries have fallen.

The downgrades will also undermine the European Financial Stability Facility (EFSF), which exists to provide support to financially strapped EU countries, such as Greece. The EFSF doesn’t have capital of its own; instead, it borrows against the credit of 14 member countries. In order for the fund to maintain a triple-A credit rating (thus enabling it to borrow on the most favorable terms), all of the member countries must also have triple-A credit ratings. If France and Austria (two of the countries that had their debt downgraded) are no longer part of the EFSF, its guarantees will decline from €451 billion to €271 billion, according to The Wall Street Journal. With Greece alone expected to consume about one-third of this lower figure (assuming it qualifies for stabilization funds), and with other countries potentially needing to tap into the rescue fund, its resources could be depleted in short order.

Attempts at reform
Underpinning the downgrades is the fact that many EU countries are sliding into a recession. Against this grim outlook, governments aren’t trying to kick-start their economies, and Germany refuses to underwrite a comprehensive pan-eurozone rescue package. According to S&P, this approach is misguided. “A reform process based on a pillar of fiscal austerity alone risks
becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues.”

Throughout 2011, Europe held emergency summits, which invariably led to announcements of new rescue packages. Intended to inspire confidence, the results have been underwhelming. The rescue package European leaders announced last month, said S&P, “has not produced a breakthrough of sufficient size and scope to fully address the eurozone's financial problems.” Moreover, said S&P, the agreement, “does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those eurozone sovereigns subjected to heightened market pressures.”

A wakeup call?
If there’s any silver lining to the downgrade, it may serve as a wakeup call for European countries to revise their thinking about austerity measures and rescue packages. Promulgating austerity during lean times tends to be self-defeating, and the evidence for that is reflected not only in the history of economic cycles, but can be seen right now in the European slide into recession. Recognition of this relationship could provide fresh incentives for governments to pursue labor market reforms that can help to liberalize economies, attract investment and trigger higher growth. In the long run, it might also reinforce the need to strengthen eurozone economic institutions, such as the central bank and a central fiscal authority with the powers to more vigorously intervene to stimulate or reign in economic activity when conditions call for intervention.

In the meantime, investors would be wise to watch the eurozone for signs that policymakers are beginning to sort out their priorities in a more constructive fashion. One sign would be a focus on austerity, in the long run, twinned with a willingness to stimulate growth in the short run. Such a focus would represent a potential buying opportunity. In the interim, investors should not neglect equities of countries outside the eurozone, including those in North America, Asia and Scandinavia. In these trying times, a long-horizon investment attitude may actually prove advantageous as other investors compete for short-term trading opportunities to the neglect of the long term.