Remember when Lehman or Bear Stearns was 'too small' to matter and 'subprime was contained', we we are getting same ignorant first-order analysis now with regard Spain (or more broadly-speaking Southern Europe). The whole of Southern Europe is only 6% of global GDP - how can that matter? (especially when we can eat iPads?) Michael Cembalest, of JPMorgan, provides some much needed sense on why these small countries pack a large disruption risk punch for global markets and economies. By breaking down the world into a few categories of disruption risk, the JPM CIO notes that the southern strain of Eurovirus has a much larger non-proportional impact thanks to transmission risk via its significantly greater share of sovereign and bank debt relative to the world and how these debts are financed. The transmission risk to the much-larger Northern Europe is material. We are already seeing Germany's new orders from within the Euro-zone slumping and this week's business sector surveys were very weak. As Cembalest concludes, from an alien's perspective, Earth may be able to outrun the collapse in Europe’s periphery if the ECB keeps printing money and the IMF increases its firewall, but it’s not going to be easy.
The table above breaks Earth down into a few categories, with the ones at the top representing less near-term disruption risk in our view. In principle, the strength of commodity countries, much of Asia and Latin America would offset Southern European problems. In addition, China has the scope to relax monetary and/or fiscal conditions, which we think will be necessary given the sharp decline in China’s private sector growth trend.
That being said, Earth’s problem with Southern Europe is one of transmission risk and non-proportional impact:
- While Southern Europe is only 6% of global GDP, it has a higher representation of the Earth’s sovereign debt and bank debt. In recession, the region causes more than a proportional problem for the leveraged financial system described on the prior page. Even with German and French bank claims on Southern Europe having fallen in half since 2007 (see page 6), potential losses on remaining claims still represent a large percentage of European bank capital.
- The table shows what each country reports as its sovereign debt, but these figures may be underestimated. Spain’s central government and regional debt is reported at 68% of GDP. After accounting for bank restructuring costs, write-downs on development bank loans, potential losses on government guaranteed private sector debt, and possible losses on Spain’s share of loans to other countries in Southern Europe, we estimate Spain’s debt as being ~85% of GDP.
- The table does not capture how countries finance their sovereign debt. Japan’s sovereign debt is large relative to its GDP, but is 93% owned domestically; and the US is (for now) the world’s reserve currency. Southern Europe’s reliance on crossborder capital required the ECB to take extraordinary steps to offset it when it fled.
- The transmission risk to Northern Europe is material. As shown below, the collapse in Germany’s new orders from within the Euro area is substantial. This week’s business sector surveys in Europe were very weak, and the only surprise to us was that people were surprised. The French and German economies are stagnant right now.
Economic strains in France contributed to increased polling for the National Front, and the Netherlands is struggling with the fiscal compact just agreed to last year. Germany may have to decide sooner rather than later if, how and when it will pay the freight of European fiscal integration if it wants to preserve the Euro. Earth may be able to outrun the collapse in Europe’s periphery if the ECB keeps printing money and the IMF increases its firewall, but it’s not going to be easy.