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Weak economy means Belgium could be next to join the Pigs

GREEK public deficit worries have been widely reported in the mainstream media. The government’s problems with its budget led to severe pressure on Greek sovereign bond yields and credit default swap spreads, which at one point were over 400 basis points over equivalent German sovereign yields. On 3 February the European Union executive announced that it had requested the Greek government to take steps to address its public spending, with a timetable that targets the end of 2012 to get the budget deficit to 3 per cent of GDP.

The Greek government must report to the EU within six weeks detailing how it intends to trim the deficit (the target is 9 per cent of GDP by the end of 2010, from the current 12.7 per cent), with regular follow-up reports. The administration must also reform its statistics office, which suffered a loss of credibility after it was reported that previous official statistics had underestimated the extent of the budget problem.

This announcement appeared to cool down investors, but only temporarily. The pressure on Greek bond yields will remain, and will get acute once the European Central Bank starts to unwind some of the “emergency” liquidity facilities that were introduced to ease the banking crisis. Already the ECB has withdrawn its one-year repo tender and at some point, possibly as soon as this year, it will announce higher collateral requirements. If this removes Greek government bonds because of their rating (A2/BBB+), then yields will rise further.

Worries about Greek debt have spread to other deficit-troubled economies in the Eurozone. Last week the Portuguese three-year CDS spread hit historic highs of 220bps. Italy, Spain and Ireland have all been similarly troubled, although the Irish government’s response to its deficit problems has met with approval from investors and that country’s spreads are off their highs. But for now, the deficit problems with these countries will remain at the fore, putting pressure on the euro and weakening it against the US dollar. The euro-dollar rate is 1.36 right now, but expect it to target first 1.34 and then 1.28 this quarter.

THE COMING STORM
Looking ahead to the next deficit crisis in the Eurozone, the market may be underestimating a similar risk for Belgium. The three-year CDS spread for Belgium is currently around 62bps. Compared with Ireland, Portugal or Spain this is low (see chart). However considering the macroeconomic situation in Belgium, this spread may widen, in which case one potential trade is a relative value position in which one sells protection on Germany and simultaneously buys protection on Belgium. Such a trade would gain if the Belgium versus Germany spread widens from its current 27bps, but in the meantime it has a negative carry.

The Belgian economy has suffered from a weak industrial sector and decreasing economic competitiveness, which suggests potential difficulty with funding the fiscal deficit (already approaching 100 per cent of GDP). In addition the Belgian banking sector remains in a fragile state. Fortis, Dexia and KBC Bank all required takeover or state bailouts of one form or another. These banks accounted for a significant share of the country’s corporate loan market, and the sector remains constrained by reduced lending capacity. The slow recovery in this area will hamper efforts to control public sector debt. Given these macroeconomic problems it is just possible that the Belgian sovereign credit spread will start widening in the manner of Ireland, Portugal, Spain and Greece.