Eurozone: Dangerous sovereign debt bubble

International media reports that the Italian 10-year bond yields exceeds 6.6 percent with a spread over the benchmark German bond of 400 basis points, percentage too close to 7% that triggered the debt bailouts in Greece, Portugal and Ireland.

The Spanish bond yield hovers around 5.64% with a spread of 390 basis points and it is assumed that European Central Bank would intervene in the sovereign bond markets to stem the rise of the bonds in both countries.

However, the news is not the rise in yields or spreads, the news is that Italy, as well as Spain, and other euro area partners continue to pay debts with more debt.

It is common practice that governments rollover debts at maturity; that is, pay a debt due with a new debt; something similar to renewal or refinancing a loan or a credit. Lenders take the new debt at a certain interest rate. In normal times that rate allows the country to easily service its debts, but when a country is in trouble, like Italy now, most lenders call for higher yield to take these bonds, because the country risk is also too high. The country risk is measured by the spread between the German (the benchmark bond for the same terms) and Italian bond yields; the higher the worse for the latter.

When the yield rises over 7%, debt default is highly likely (as it was in the case of Ireland, Greece and Portugal). It is not an “automatic” trigger, but it is very close to it.

At this level of yield on its sovereign bond the country is unable to pay its debt service, because it is unable to rollover its debts and does not have cash to pay off – so, is in default– and then appears the last resort lender, like the IMF (International Monetary Fund), who pay lenders and afterwards, in a more calm environment, imposes on the country ways to dealing with the huge debts, mainly by adjustment package.

In the European case, the situation is more complicated, and will have certainly a domino effect – raising the yields of the other countries bonds, like France and Spain – because the problem is not only inside Italy (bad local decision, huge public expenditures, delays in adopting reforms, political crisis, and so on) but also in the whole of Europe, whose leaders do not have or do not find a credible plan for recovery, or at least for stopping the fall.

Vicious circle

So that the rise of yields and spreads mean two things: either the country places new sovereign bonds at higher rates, i.e., that its borrowing costs is higher, or rollovers at those rates the debts that are becoming due.

In either case, the country is being financed with more debt at levels that make its debt service burden unsustainable, which in turn makes it impossible to meet next payments, and costlier its next rollover, in a vicious circle that ends in a bubble: a huge bubble of sovereign debts, which sooner or later burst, like any bubble.

It is evaluated that the Italian debt, of about 2,000 billion euros, is sustainable with yields of up to 4%, but at the present rates of about 7%, Italy is literally on the verge of bankruptcy, because for those amounts there is no last resort lender; neither the European Financial Stability Facility nor the IMF have funds to deal with a bailout of such magnitude.

Eurozone faces painful debt distress

If Italy does not fall anytime soon, because of a change or because of a last minute emergency initiative, Europe is still nearing the end of the road, almost all the euro area countries appeal to the same mechanism of debt financing, and the debt overhang and greater debt service burden make unviable any chance of recovery.

And without recovery in sight the European future is bleak and painful.

With two years of failed plans, so-called plans, and announcements of plans, with all the well-known condiments and political confrontations, Europe has bought a huge pile of debts and a decade of agony.

Even if the bubble stands, the old continent faces a long decade of debt distress, with all the hardships involved.

Raul de Sagastizabal