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Prospects Weekly: Debt crisis has pushed up borrowing costs worldwide

Global Macroeconomics Team's picture
The European Union’s €750bn aid-package—supported by the ECB’s purchase of lower-rated securities, IMF funding, and the U.S. Federal Reserve’s reopened euro-for-dollar swap-lines—has calmed global financial markets. However, the long-term solvency of heavily-indebted European sovereigns remains a concern, given the extraordinary adjustments that will be required to achieve sustainable debt-levels. Spillover effects into the banking sector are also a tension, with a number of European banks carrying large exposures to the highly-indebted European countries. Banks in Latin America and emerging Europe that are reliant on banks in these countries are also exposed. Sustained high European sovereign-debt and impaired bank balance-sheets will constrain credit growth, depressing investment and consumption, and could portend a difficult period of relative stagnation for Europe.

While the EU/IMF €750bn aid-package has eased immediate concerns about the liquidity of debt-burdened sovereigns, longer-term solvency issues remain. Even with planned deficit cuts of 10% or more in Greece and Ireland by 2014, debt-to-GDP ratios will continue to rise in Greece (albeit at a moderating pace) and only stabilize in Ireland. In part this is because cuts in government spending will slow economic activity and cut into tax revenues. Years of additional restraint will be required to bring debt-to-GDP ratios down to the 60% level required by the Maastricht Treaty. 

The sovereign-debt crisis has sparked concerns about knock-on effects on the already fragile European banking system. If the debt crisis in heavily-indebted European countries were to destabilize the broader European banking system, this could have significant impacts in Latin America and Central and Eastern Europe. European banks hold government bonds and loans of heavily-indebted, high-income countries (Greece, Ireland, Italy, Portugal and Spain) totaling $2.8trn or 18% of Europe’s GDP. A default or large-scale restructuring could eat heavily into the banks’ capital and solvency. Banks in the debt-burdened high-income European countries have been an important source of capital for the public-and private sectors in Latin American ($320bn or 8% of GDP) and emerging Europe ($400bn or 13% of GDP). In some cases, exposures are marked, as for example, Spanish banks own over 25% of bank capital in Mexico, Chile, and Peru. A cut-off of these flows could be seriously disruptive for these countries. 

The debt crisis has pushed up borrowing costs worldwide on perceptions of heightened counterparty-risk. The dollar Libor-OIS spread (a gauge of banks’ willingness to lend to one another) widened to above 20 basis points this week, the most since August 2009, indicating that commercial banks are concerned that other banks’ exposure to Greek debt might impinge on their ability to repay loans—even those of very short maturity. Nevertheless, interbank spreads are lower than they were in 2H-2007 and 1H-2008, during the initial phases of the sub-prime crisis. Tightening of corporate debt-markets is also evident. Global corporate bond issuance fell 62% in early-May (as of May 11) over the same period in April. 

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