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01/09/2012

The Hero or the Villain of the Euro


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For more than two years, we have witnessed the demise of several European countries, starting with Greece’s shocking assertion in early 2009 that its deficit to GDP was more than double what had been presumed. Most investors and analysts were still not concerned since all major European countries enjoyed high investment grade ratings from the financial market’s watchdog—the major rating agencies. And, the traditional metrics for measuring sovereign debt performance, essentially all top-down macroeconomic indicators, were only just starting to signal a deteriorating scenario. The world’s financial community then began to systematically assess the health of several peripheral southern European countries (the so-called PIIGS [Portugal, Italy, Ireland, Greece and Spain]) leading to a spike in those nations’ required rates of returns on their Government’s debt. Finally, those lofty investment grade ratings began to tumble in 2010 and eventually the European Central Bank and its leading contributing countries were forced to set up rescue packages, first for Greece, then Ireland, now Portugal (still a work in progress).

Which countries will be next to suffer these financial “attacks” and will, in fact, the carnage soon stop, and the euro itself survive? Most European politicians dearly want the “run” on several of its “club” members to end and its rescues to restore confidence. This is, unfortunately, a dream that is likely to be shattered as the next domino—Spain—suffers the scrutiny of intense solvency analysis. Spain, which has almost twice the amount of government debt outstanding as Greece, has well known infirmities—namely an anemic economy, an unemployment rate over 20%, a devastating real estate debacle, and a consequent banking crisis. The need for a potential bailout of Spain is not only possible, but feasible, even with the mounting aggregate debt assumption by the other, stronger euro partners, its Central Bank, and the IMF.

Some analysts feel that Spain is the last bastion for the euro’s survival. We do not. We believe that the final battle will be fought on the picturesque shores and cathedrals of Italy, the second “I” in the so-called PIIGS mess, resulting in Rome’s emergence as either hero or villain with respect to the survival of the euro. The outcome of this confrontation is anything but clear.


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Throughout this recent period of sovereign financial distress, we have been estimating the financial health of sovereigns using a totally new metric developed by one of the authors. It is a measure of the health of each nation’s private sector. Technically, it is called the Z-Metrics 5-year median firm probability of default of each nation’s private sector. The idea is really very simple. In addition to the standard sovereign risk “top-down” macroeconomic analytics, whose variables are consistently reported and debated, we believe that most nations can be evaluated by the health and robustness of their private sectors. Our Z-Metrics measure is a new and more powerful version of the well known “Altman Z-Score.” It involves the calculation of a company’s credit score distilled from three types of variables: (1) fundamental performance and risk ratios, like profitability, leverage and liquidity, (2) stock market equity measures and (3) capital market and economic statistics, like corporate debt risk premiums and unemployment rates. We applied our model to nine European countries, and the USA, before the crisis was apparent in early 2009 and again in early 2010, and found that for the most part, the now well understood hierarchy of sovereign risk was observed. Greece and Portugal were at the top (highest risk), followed by Italy, Spain and Ireland as amongst the most risky countries. France and Germany, the UK, and the Netherlands rounded out the list and demonstrated the lowest private sector risk. The US looks very healthy, incidentally, by our metric. If Spain’s economy wasn’t already staggering, it will be even worse once the Government is forced to enact further austerity policies to increase cuts in spending and increase its revenues from wealthy individuals and companies. Whether these traditional measures will eventually work is debatable, but what is almost certain is that the contagion of financial distress amongst European countries will not abate, especially if Greece ultimately defaults, as seems likely. And, austerity programs seem to be exacerbating, rather than aiding, the several countries that have created such measures.

So when will the contagion end and will the euro survive? While ultimately the euro’s survival will come down to political realities, such as if the stronger European nations conclude that they will or will not continue to support the weaker peripheral Euro countries (witness the recent ascendency to power of anti-bailout sentiment in Finland), we feel that the euro’s financial market “battle” will come down to the plight of Italy. Italy has far more sovereign debt outstanding, almost US$2 trillion, than any of the other heretofore problematic governments and its debt, if added to the mounting EU and IMF’s responsibility, may simply be too much, and the euro, we believe, will then crumble. In a sense, Italy is the “fulcrum” country for the euro.

The result of this last “battle” is not clear. While we know that despite its huge public debt, sluggish economy, aging population, and political uncertainties, Italy enjoys a wealthy consumer and corporate reservoir of capital (more than 65% of its outstanding public debt is held by Italian private individuals and institutions). In addition, Italy has several global comparative advantages that are not evident in most, if not all of the other PIIGS, namely tourism, fashion, some very strong companies, and an improving banking sector, not to mention its dynamic, but fragile, small- and medium-sized firm sector. Still, our overall credit risk metric places Italy amongst the most risky private corporate sectors and if the stock market in Europe, especially in Italy, suffers another downturn, our risk measure will surely deepen and leave the Italian Government debt vulnerable to the same type of financial market attack as other peripherals have had to endure, with the attendant increase in interest rates and credit insurance premiums that we have observed several times before.

So far, the credit default swap (CDS) insurance market and other market measures have not shown concern with Italy. Its 5-year implied probability of default based on CDS spreads is relatively average (15% as of April 25, 2011). But, in our opinion, it is just a matter of time before we will see whether Italy becomes the euro’s hero or villain.

–E. Altman, NYU Stern Max L Heine Professor of Finance and Senior Advisor to Classis Capital, Sp.A; and M. Esentato, CEO and Founder, Classis Capital, Sp.A

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