The Cypriot Domino
As an island nation, Cyprus is more properly considered part of Asia than of Europe. Cyprus, though, may prove the first domino in a collapse of the Eurozone financial system, whose falling pieces will almost surely affect America.
Analysts have known for some time just how badly things are in Cyprus, although it has tended to slip under the radar because of its size. Standard & Poor's gives Cyprus sovereign debt a lousy CCC+ rating with a "Negative" outlook. Fitch gives the troubled nation as BB- rating and a "Negative" outlook. Moody's gives Cyprus a Caa3 rating and a "Negative" outlook.
All of these are awful ratings and show a strong possibility of default on sovereign debt. If the problem were limited to Cyprus, then the cause for worry would not be that great. But most of Southern Europe looks almost as bad as Cyprus.
Italy has a BBB+ rating from Standard & Poor with a "Negative" outlook; Fitch gives the same rating, and Moody's gives a Baa2 rating with a "Negative" outlook. Spain has a BBB- credit rating from Standard & Poor with a "Negative" outlook. Fitch gives Spain a BBB rating with a "Negative" outlook. Moody's gives the Spain a Baa3 rating with a "Negative" outlook.
These nations are "too big to fail," as the left likes to say. Italy is the eighth-largest economy in the world, ranking just behind Great Britain. Spain is the twelfth- or thirteenth-largest economy in the world, with a GDP the size of Canada. Greek sovereign debt is at junk bond status, and Portugal is near that deadly level, too. Rating services view Portugal with alarm: the nation has either a "Negative" or a "Negative Watch" outlook. The combined economy of these four nations exceeds $4 trillion, which would make the aggregate the fourth-largest economy in the world, after America, China, and Japan.
It gets worse. The credit rating of France is not awful, but all three rating services give France a "Negative" rating, which means that the analysts expect French sovereign debt to become less creditworthy. France is the fifth-largest economy in the world, and if it falls into the straits of Spain and Italy, the size of the danger zone would be half the size of the American economy.
The problems are more complicated than simply Greece or Portugal not paying the full value of their bonds. Banks throughout Europe include as part of the investment portfolio sovereign debts from these nations. As the real value of Italian or Spanish bonds drops, the value of the banks' holdings drop as well.
This affects bank profits, of course, but it also affects how much money the banks are allowed to lend, so banks throughout Europe may have to tighten up credit on businesses. Particularly hard-hit will be the banks in those nations which face default like Italy and Spain. This is happening already. Monte dei Paschi, a large Italian bank, was recently bailed out by the Italian government.
This affects not only those who need credit from banks, like businesses for the sake of their operation, but also people who have deposits in these banks. Last year, Spanish banks received $48 billion from the European Union to prevent a partial collapse of the Spanish banking system. Can depositors count on big bailouts in the future?
Another consequence of the decline in the credit rating of sovereign debt is that nations like Italy and Spain have to pay higher interest rates to investors who purchase these debt instruments, just like people with a bad credit rating have to pay higher interest to lenders. Italy recently found that the interest it had to pay to sell its bonds was at a three-year high. The extra tens of billions paid in higher interest are ultimately paid by the taxpayers of those nations, which depresses economic activity even more.
The dominoes in Southern Europe could fall at any time -- Cyprus could well be that first domino -- and the absence of real political leadership in Europe, much like we are seeing here with the Obama administration, only defers the inevitable and makes the fall harder when it comes. Today there seems little doubt that that fall will come.