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A tale of two PIIGS (cont.)





A little over a month ago, I highlighted the extreme divergence between Greece and Ireland, both of which have been on the short list of major sovereign debtors that are likely to default. Both Greece and Ireland faced crushing debt and deficit burdens, but Ireland's prospects had improved dramatically relative to Greece's (since it's 2-yr government yields were far lower), thanks to Ireland's credible efforts to cut government spending.

In the past month, the yields on 2-yr Irish government debt have dropped almost 130 bps, while comparable Greek yields have soared 2600 bps. (Top chart shows Greek yields, while the bottom chart shows Irish yields.) Perhaps more interestingly, Irish 2-yr yields have dropped 180 bps in just the last week, and are now back to levels not seen since late February, while Greek yields remain stratospheric. This is change you can believe in; these market-based indicators are telling us that Greece is now almost certain to default, while Ireland stands a good chance of surviving intact. The likelihood of an Irish default is now significantly lower than it was just two months ago, because Ireland is on the road to salvation thanks to credible austerity measures.


Only two PIIGS now stand out as serious candidates for default: Greece ($475 billion of debt), and Portugal ($200 billion). Spanish yields ($800 billion of outstanding debt) are now down to a mere 3.33%, only 275 bps above comparable German debt—thanks in part to efforts to restructure and shore up its banking system. That's a spread that's only barely troubling. Italian yields are 100 bps above Spanish yields, so there's still some angst there, but it is amplified by the huge size of Italian government debt ($2.1 trillion), and the Italians' less-than urgent response to addressing their budget difficulties.


Some light is appearing at the end of the sovereign debt tunnel, and it is reflected in the recent drop in 2-yr Euro swap spreads. Even if Greece and Portugal go bust, it's not too difficult to believe that the Eurozone banking system and economy can survive as long as the other PIIGS continue to work towards credible solutions.

UPDATE: John Cochrane has a coherent argument in the WSJ ("Last Chance to Save the Euro") for why the best solution would be to just let Greece default. Greece is incapable of credibly advancing an austerity agenda, and trying to paper over the problem with ECB debt purchases only delays the inevitable. Allowing Greece to default would preserve the ECB's balance sheet and its credibility. And it might even teach Greece a valuable lesson.

UPDATE: The WSJ has good article which puts meat on the bones of just how effective Ireland's austerity measures have been.

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