CDS prices for European nations show high chances of default
It is becoming clearer with every passing day that European Union nations might default on their debt payments in coming years. A look at the Credit Default Swap prices tells us that if markets have to be believed there are high chances that countries like Greece can default within next 5 years.
CDS prices of most of the European Union nations are hovering around all time high.
In a paper presented by Peter Boone and Simon Johnson- Europe on the Brink, they say:
Market prices currently imply an 88 percent chance of default in Greece within five years. More worrying is the rise of Italian CDS prices to near–record levels on July 11. These now imply a 25 percent chance Italy will default within the next five years. (These calculations assume a 40 percent recovery rate post–default.)
Look at chart shows payment which EU nations have to make in the next 1 year as percentage of GDP. Greece would need as much as 33% of GDP for the payments. these countries would surely not be able to pay from the revenues and they will need some kind of financing, bailing outs, etc.
According to the recently published European Banking Authority stress test results, the 90 banks covered in that test owe €4.772 trillion within 24 months, equaling 38 percent of European Union GDP and 51% of euro area GDP (European Banking Authority 2011, 17). In France, Italy, and Germany, the largest two banks alone need to roll over 6 percent, 9 percent and 17 percent of national GDP in debt, respectively within 24 months. This compares to just 1.6 percent of GDP for the largest two banks in the United States.
Paper further argues:
Investors must then decide what interest rate they need on Italian debt, where the debt/GDP ratio is 120 percent, in order to bear the risk of default. If we assume a 25 percent risk of a 40 percent loss over five years, then Italian CDS would need to trade at 325 basis points. However, at 325 basis points, or roughly a 5 percent yield on five–year bonds, to maintain a stable debt/GDP ratio, Italy would need approximately a 2.5 percent GDP fiscal improvement (i.e., increase in primary surplus). Can the country achieve this quickly in the midst of rising interest rates and credit tightening? If not, the debt/GDP ratio will continue to rise and markets may be further concerned about defaults or restructuring. Since Italian commercial banks own approximately one–third of Italy’s debt burden, their solvency too must be questioned.
Same analysis may be extended to all the other nations of European Union.
It is high time that countries start putting their house in order before they find themselves into catastrophic situation. Measures like sale of government assets, cut in no. of government employees and reduction in salaries are very unpopular measures but they are the need of the moment now. Austerity measures might be of no use after sometime from now when things will go out of control.