The quantitative dimensions of the Eurozone?s sovereign debt problem are depicted in Figure 1. What is tabulated here is not the whole story. No one knows what the full story is. Sovereign debt, though enormous relative to output and debt servicing capacity, is only part of a picture of overall Eurozone internal and external indebtedness (including private corporate and interbank debt) that has reached intractable proportions. It is causing episodic (but increasingly frequent) seizures in the European interbank market (e.g. Spanish and Greek banks are no longer able to borrow readily in the European interbank market) which the ECB is attempting to resolve defensively through sporadic interventions to keep that market liquid.

A major problem is the lack of transparency in knowing the full extent of bank exposure and bank vulnerability to euro-denominated debt whether sovereign, private corporate or interbank. Odd that, Europe has not learnt the importance of those key lessons of transparency and disclosure two years after the collapse of Lehman. European regulators have been permissive, if not lax or blind, in not forcing full disclosure and complete transparency. As the IMF puts it: ?Another key policy challenge relates to Europe?s financial sector. To the extent that they remain unresolved, banking sector issues will likely hamper the credit supply (see Chapter 1 of the April 2010 GFSR). These include the need for continued deleveraging to rebuild liquidity and capital buffers, the uncertainty about future bank restructuring, and the need to absorb additional write-downs. Moreover, growing sovereign risk poses another challenge for financial systems in Europe. These issues call for completion of the restructuring and recapitalisation of vulnerable financial institutions, stabilising funding, and reevaluating bank models.?

Figure 2 depicts the worrying trend that is now firmly in train, with the angle of incline in the increase of public debt steepening further in 2009-14, if that is imaginable. Clearly, the trajectory shown in the increase of European public debt in 2005-09 is unsustainable. Its steepening in 2009-14 is unimaginable, yet inevitable. That is the ugly situation that the Eurozone, EU and its banks and other financial institutions confront. Worse, the maturity and duration of European sovereign debt is relatively short at around 5 years (compared to 14 years for the UK). A large rollover estimated at 500-600 billion euros is imminent this year. That will have to be almost entirely ECB-financed or supported.

The UK, which is at the conservative end of the European maturity spectrum, must roll over debt worth 5% of output this year. Spain must roll over debt this year amounting to 12% of GDP while for Greece the amount is 13% of GDP. They are in the middle of the maturity range.

Belgium and Italy have to roll over debt of about 20% of GDP apiece. They may be more vulnerable than the market realises. In extremis, an inability on the part of capital markets to finance such large rollovers of paper could translate into a liquidity crisis or ?buyer?s strike?.

For the problem to become manageable, for European sovereign debt to be regarded as serviceable without a risk of sudden default and for nominal face value of sovereign bonds to be protected, restructured obligations will need to be stretched out. They will need to be held to maturity and financed at less than real interest rates, for debt service to become affordable under constrained circumstances. Politically, governments will face a problem with their electorates of allocating a larger portion of their total budgets to servicing rapidly increased burdens of public debt while, at the same time, constraining social expenditures currently regarded as sacrosanct and untouchable under Europe?s unaffordable ?social market? model.

As shown in Figure 1, the sovereign debt of the PIIGS was $3.93 trillion at the end of 2009. By May 2010, it was estimated to be $4.21 trillion. Of that amount, and excluding Italy for the present, at least $1.7 trillion (or 43%) is regarded by the IMF and credit rating agencies as ?troubled?.

(S&P gave an estimate of the likely ?recovery rate? should the worst happen. It said bondholders were likely to get back only 30-50% of their principal were Greece to restructure its debt or to default.) Valued properly based on CDS spread signals, that troubled debt today should be marked-to-market at no more than $800 billion with the difference being provided for.

European banks (including those in the UK) are estimated to hold about 25% of all EU and Eurozone sovereign debt outstanding. Hence they would account for 25% of any value loss that occurred. That would require a capital write-down in the European banking system of around $225 billion if things were done the way they should be: i.e., by recognising real value losses and writing down capital to adjust.

But exposure to the sovereign debt crisis is not confined to the size of banks? bond portfolios. Widening CDS spreads have led to increased bank borrowing costs as well. Spreads for Greece have quadrupled and trebled for Spain and Portugal. In January 2010, Santander and BBVA issued 3-year floating rate notes at 42-45 bps over 3-month Euribor. They were trading at 85 bps in mid-February and 125 bps in mid-May. Banco Comercial Portugues issued a 2-year bond at 72 bps over mid-swaps in January 2010. It was trading at 240 bps over in mid-May. The same point is made in a different way by looking at what has happened to yields in Figure 3.

The PIIGS are not the only problem though they are the most obvious ones. There was another $4.5 trillion of EU sovereign debt?issued by Belgium, France, Italy, the Netherlands and the UK?all of whose public debt-to-GDP ratios are worse than Spain?s?outstanding at the end of 2009. It was estimated to be $4.85 trillion in May 2010. That debt could become troubled swiftly if the market was panicked by Spain going into administration (under the aegis of the IMF and ECB). A putative 20% value mark-down on that debt would result in the European banking system?s capital base having to be written down by a further $245 billion.

Thus, the total amount of European bank capital at risk purely from holdings of sovereign debt could increase from $225 billion to $470 billion almost overnight if market panic and contagion were to take hold. That would wipe out about a third of the capital base of the EU banking system. The capital base of the US and Japanese banks (which are together estimated to hold about 10% of EU sovereign debt) would take a further hit of $90 billion rising to a possible $185 billion as a result of the EU sovereign debt value impairment through contagion.

European banks, much vilified for two years by their governments, are locked in a macabre embrace with those same governments. The more banks and financial institutions suffer from continued, demented government criticisms and misguided banking structure reform policies, the more governments themselves will suffer as banks and financials become less profitable, and less inclined, probably even unable, to buy their own government?s paper! Sustained vilification of securitisation and derivatives as the culprits for the global financial crisis has resulted in the securitisation market drying up and the world?s major central banks being left holding all kinds of dubious paper. You have to be careful what you wish for. You might get it!

(To be concluded)

The author is an economics and corporate finance expert