Fear Of Debt Is Stalking EuropeBill Javetski
Swedish exports are booming, the krona is undervalued, and inflation is running below 2.5%. So smart investors ought to be flocking to snap up 10-year government bonds paying a hefty 10.5%, right? Well, not exactly. Instead, Swedish officials were shocked in July when Skandia Insurance Co. Chief Executive Bjurn Wolrath declared that his company, the region's largest insurer, had sold off its portfolio of government debt. Not only that. He also vowed to boycott further purchases until Sweden's politicians get a handle on runaway public-sector finances.
With national elections and a referendum on joining the European Union looming over Stockholm markets, the Swedish boycott may be an extreme case. But across Europe, traders are reading it as a cautionary tale. From Italy and Spain to Belgium and France, the same troubling tandem of bad public finances and shaky politics is instilling a kind of inflation psychosis in markets that is making demand for government debt tough to muster. It's a much more serious problem than in the U.S., because Washington's annual budget deficits are shrinking.
COMING CRISIS? The result is that European governments must continue to delay debt issues, push back funding schedules, and compete increasingly with corporate borrowers for scant buyers. Traders worry that the supply imbalance could prolong high real interest rates that will truncate Europe's recovery. Some even envision a AAA-rated version of the Latin debt crisis. In Europe, says S.G. Warburg Group PLC international economist George Magnus, "the issue of first-world debt is running very deep."
Those worries are keeping European bonds from breaking free of the pattern of rising interest rates now under way in the U.S. (chart). Reflecting the supply imbalance, Germany and Spain have had to shelve bond issues this summer, and Britain had to resort to nontraditional methods, such as issuing floating-rate debt to entice buyers. Despite the tactics, though, buyers still gave a lukewarm welcome at best to German and British bond issues in late July. The shaky bond market has also spread to equities, forcing some companies to postpone new stock issues or sell them at a discount to attract buyers.
But for now, it is governments that are paying the biggest price. In Italy, fears of political turmoil have pushed 10-year bond yields 400 basis points above comparable German bonds. That has led Prime Minister Silvio Berlusconi's government to delay refunding plans for bond redemptions due next year. In Spain, officials have sidestepped long-term markets by borrowing more at short-term rates. But those issues will have to be refinanced within 12 months.
Who will buy the backlog is a question that perplexes traders. Hedge funds, battered in this year's market sell-offs, are nowhere to be seen. Japanese and other foreign investors, burned by currency devaluations in Europe, are staying on the sidelines. And borrowing demand isn't letting up. Kirit Shah, London-based international bond strategist at First National Bank of Chicago, figures German public-sector debt will reach $1.2 trillion by next year, double its level of five years ago.
COLLISION COURSE. To make up for fleeing foreign investors, European banks are being put in the potentially inflationary situation of being obliged to buy more and more government debt. Last year, 47% of German government debt was sold domestically. Banks bought 41% of it. But governments will likely find themselves on a collision course with corporations heading back into markets to raise funds. The bidding war will likely push up rates.
All of this means traditional market psychology has been stood on its head. In the past, good economic fundamentals, such as low inflation, would bring rates down and spark a bull run in bonds. The reason it doesn't seem to be working that way these days is that European leaders simply haven't demonstrated to markets that they can contain, much less dismantle, the European welfare state. The EU estimates that of a budget deficit amounting to 6% of its gross domestic product, some 90% is structural--meaning it will not be reduced by the economic cycle.
As deficits push up bond yields, Europe's second year of recovery in 1995 could take on a distinctly lackluster hue. Lower growth could speed the need for more revenues, thus boosting the financing burden. "We're probably in a vicious circle here," worries First Chicago's Shah. And one that Europe's politicians will either break or be broken by, as recovery withers on the vine.