For over two years, we have witnessed the economic demise of certain European countries. This soon led to the financial community systematically assessing the health of several peripheral southern European countries, followed by tumbling investment grade ratings and spikes in required rates of return on the government debt of these sovereigns. As the European Central Bank continues to dole out rescue packages, many are now looking for the next country to suffer a financial attack and wondering if the euro will even survive.
Some analysts feel that Spain is the last bastion for the euro. We do not. We believe that the final battle will be fought on the picturesque shores of Italy, resulting in Rome’s emergence as either hero or villain with respect to the survival of the euro. Most European politicians dearly want the “run” on several of its “club” members to end and its rescue 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 percent and a devastating real estate debacle and consequent banking crisis. The need for a potential bail-out of Spain is not only possible, but likely and manageable even with the mounting aggregate debt assumption by the other stronger euro partners, its central bank and the International Monetary Fund.
Thus, we turn to Italy. The country has far more sovereign debt outstanding, almost $2,000 billion than any of the other problematic governments. While ultimately the euro’s survival will come down to political realities, we feel the euro’s financial market “battle” will come down to the plight of Italy. Its debt, if added to the mounting responsibility of the EU and IMP, may simply be too much, and the euro will then crumble. Our theory is rooted in the use of a new metric to estimate the financial health of sovereigns.
“Our overall credit risk metric, while better than two years ago, places Italy among the riskiest private corporate sectors”
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. The metric we developed is simple and a 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 variable: (1) fundamental business performance and risk ratios, such as profitability, leverage and liquidity, (2) stock market equity measures and (3) capital market equity and economic statistics, such as corporate debt risk premiums and unemployment rates. We applied our model to nine European countries, and the US, before the crisis was apparent in early 2009, and again in early 2010, and found that, for the most part, the hierarchy of sovereign risk was observed.
The result of the Italian “battle” is not clear. We know that despite its huge public debt, sluggish economy, ageing population and political uncertainties, Italy enjoys a wealthy consumer and corporate reservoir of capital, and that perhaps as much as 65 percent of its outstanding public debt is held by Italian private individuals and institutions.
In addition, Italy has several comparative advantages, namely its tourism and fashion industries, some very strong companies and an improving banking sector, not to mention a dynamic but fragile small- and medium- sized companies sector. Still, our overall credit risk metric, while better than two years ago, places Italy among the riskiest private corporate sectors. If the European stock market, and Italy’s especially, suffers another downturn, our risk measure will surely deepen and leave Italian government debt vulnerable to the same type of market attack the other peripherals have had to endure, with the attendant increase in interest rates and credit insurance premiums.
Even today, despite low interest rates, the European Commission reports that Italy’s government interest payments as a percentage of gross domestic product are 4.8 percent and considerably higher than all other major European countries and the US (2.9 percent). Even Portugal’s ratio is lower, at 4.2 percent.
So far, the credit default swap insurance market and other market measures have shown some, but not excessive, concern about Italy, despite the warning from Moody’s on Friday that it could downgrade Italian debt amid fears about contagion from Greece. Italy’s five-year implied probability of default based on CDS spreads is relatively average (13.4 percent, up from 9 percent about one month ago). But it is just a matter of time until we see whether Italy becomes the euro’s hero or villain.
Edward I. Altman is the Max L. Heine Professor of Finance at the Stern School of Business, New York University. This article was co-authored by Maurizio Esentato, Chief Executive and Founder of Classis Capital