Free exchange | Sovereign debt

The outer limits

How much more borrowing can major economies handle?

By R.A. | WASHINGTON

I HAVE struggled a bit to come with something interesting to say about conditions in Europe at the moment. The conclusion of both markets and commentators would seem to be that the outcome of the recent summit has not meaningfully changed the dynamic in the euro zone. It appears that funding conditions for banks and sovereigns continue to worsen. But no one really wants everything to blow up around the holidays, so markets and governments seem to have crawled out of their trenches to sing Silent Night for now, and will resume the bloodshed in the new year. Unless of course the ratings agencies decide to interrupt the party. No one likes a party pooper, ratings agencies.

We won't have to wait long for trouble in 2012. Early in the new year, auctions of sovereign debt will crank back up. And as a new report from Moody's Economy.com indicates, much of Europe is moving past the point of no return. Consider this chart:

The middle column indicates the room between a country's current debt-to-GDP ratio and the maximum sustainable ratio, according to this analyis. And the right column indicates the maximum yield which, if sustained, will not result in a spiral of collapse (in which rising interest costs make debt less affordable, contributing to rising interest costs). One can quibble with the results; I'm sure there are many people who think markets would abandon America long before its debt-to-GDP ratio topped 200%. But the yield calculations are very interesting.

Greece, Portugal, Italy, and Ireland already sport 10-year yields above the make-or-break level. Now, these yields don't bring everything crashing down right away. They have to be sustained, so as to have an impact on actual debt costs as countries are forced to roll over existing debt as it comes due. Spanish yields have been above the critical threshold at times but have since fallen back below it.

I wouldn't count on that remaining true, however well behaved Spain's government is. Rising yields elsewhere will impact Spain—and other parts of the euro zone—in any number of ways. As Italian yields rise, debt costs for Spanish banks, which have substantial exposure to Italy, may also rise. That, in turn, will place more pressure on the sovereign's borrowing costs. As the most troubled economies embrace austerity and plunge into recession, the growth outlook for their neighbours worsens, hitting the GDP side of the debt-to-GDP ratio and contributing to a deterioration in debt sustainability.

This is the vortex into which we will resume our descent come January. Happy holidays! (Ratings agencies permitting.)

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