Readers of these reports know that I have long believed that mid-2012 will likely be a decisive period for the European debt crisis where the regional leaders’ ability to muddle through without a lasting solution comes to an end. Consequently, investment opportunities for global investors would start to look attractive. Recent developments are in line with such expectations. As this paper will discuss, the push toward capitulation is occurring, not so much from the election in France of a President from the Socialist party, but from developments in smaller countries — Spain and Greece.

Spain: Banking Crisis Mutating into Sovereign Crisis
Even though Spain’s debt/GDP ratio is a relatively low 70% – roughly comparable with Germany – it suffers from a serious banking problem resulting from the financial institutions’ large presence in the housing sector during the boom years through 2006. Nonperforming loans on the books of banks have surged with the downward spiral in Spanish real estate prices over the past five years. With a national unemployment rate of almost 25%, and a youth unemployment rate in excess of 50%, housing demand continues at depressed levels. On May 9, the Spanish government infused capital in Bankia, a financial institution formed out of the merger of seven savings banks. Rather than end the banking crisis, rumors of massive deposit withdrawals from Bankia led to a 29% decline in the bank’s share price yesterday despite government assurances that there was no deposit flight. While bank share prices soared today, the financial sector continues to be in investors’ crosshairs. In other words, the crisis is starting to feed on itself.



The weak economy and the worsening banking situation are causing Spain’s country risk to rise. The ten-year bond yield has increased by some 75 basis points over the past month as fears grow that the growing need for the government to recapitalize financial institutions will result in a larger public sector budget deficit and a rise in the debt/GDP ratio. This was the path that Ireland followed in 2008 to its detriment – the Irish government guaranteed the debts of the banking sector and, thereby, suffered a sharp rise in its own sovereign risk. The rise in Spanish country risk is also suggested by the widening of the ten-year debt spreads between Spain and Germany, touching 5 percentage points at one point this week.

The weak economy and the worsening banking situation are causing Spain’s country risk to rise. The ten-year bond yield has increased by some 75 basis points over the past month as fears grow that the growing need for the government to recapitalize financial institutions will result in a larger public sector budget deficit and a rise in the debt/GDP ratio. This was the path that Ireland followed in 2008 to its detriment – the Irish government guaranteed the debts of the banking sector and, thereby, suffered a sharp rise in its own sovereign risk. The rise in Spanish country risk is also suggested by the widening of the ten-year debt spreads between Spain and Germany, touching 5 percentage points at one point this week.



These developments in Spain suggest that the contagion from Greece’s problems is spreading to larger European economies. Spain’s GDP of €1.1 trillion is about two-thirds of Italy’s €1.6 trillion, and more than four times Greece’s €232 billion (all figures from 2010). Europe’s taxpayers, especially from Germany, may have to transfer substantially greater sums of money to bail Spain out, if necessary, compared with the total amounts involved in the repeated bailouts of Greece.

Greece: Growing Defiance
Despite repeated efforts by Greece’s President to locate a new political leader after the May 6 elections, the two centrist parties and the far-left Syriza coalition have not been able to form a government. The main stumbling block has been the position taken by Syriza leader Alexis Tsipras that he would not sign on to the European Union-mandated austerity program that the centrist leaders have indicated they would follow if either of them became Prime Minister. Mr. Tsipras’s stance that signing such an agreement would be a betrayal of Greek voters’ interests appears to have boosted his popularity ahead of fresh elections set to occur June 17. Syriza now expects to win the top number of seats in the Greek parliament, rising from its second ranking position in the May 6 elections.

In a strong message to EU leaders during the course of an interview with the Wall Street Journal, Mr. Tsipras suggested that if Europe cut off funding for Greece, his country would respond by stopping debt payments. In playing this game of chicken, Mr. Tsipras has history on his side. Countries such as Peru and Argentina which have unilaterally stopped debt payments in recent decades have typically enjoyed a surge in economic growth, at least for a while. This is because funds that had previously been destined for debt service can be channeled toward making wage and pension payments, thereby boosting domestic demand. And Chancellor Angela Merkel has refused to loosen the German purse-strings, making a showdown with Greece inevitable, especially if Mr. Tsipras becomes Prime Minister following next month’s elections.

In light of the deteriorating political situation in Athens, ECB and German leaders have increasingly been discussing the growing probability of Greek default and a possible exit from the Eurozone. Rather than end the European crisis, a Greek exit would only cause the overall situation to deteriorate by increasing speculation on the next country that may be forced to leave the single-currency area.

Germany: Bund Yields Plummet as Funds Seek Safe Haven
Signs of crisis are apparent in more than just rising debt yields for Spain and Greece. They also manifest themselves through plunging German bund yields. The ten-year note dropped below 1.4% today as European investors sought a safe haven. With the German inflation rate at 2.1% for the year ending April 2012, the fear element is contributing to investors leaving their funds in German sovereign paper despite the negative real rate of return. Low bund yields persist even though German economic growth has remained surprisingly strong despite the recession developing in many of its neighbors.



Bund yields could drop further if the Greek elections next month again provide an inconclusive result, i.e., still no entity able to form a government, or if Mr. Tsipras becomes the Prime Minister and carries out his threat of stopping debt payments. A further deterioration in the Spanish debt situation, with the ten-year yields rising from a bit below 6.5% today toward 7.0% would also lead to more capital going to the German bund market.

These developments – political in the case of Greece, financial in the case of Spain – may be the spark that finally induces the powers in Europe to consider debt reduction for some of the countries as a means of ending the crisis. In turn, since such a move would be a precursor to the resumption of economic growth, it would be a bullish signal to investors.

Komal S. Sri-Kumar, a senior fellow at the Milken Institute, is chief global strategist at TCW.