S&P Did Its Own Stress Test For Europe, And It Looks Pretty Grim

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Standard & Poor’s GlobalRatings team has updated its own European sovereign stress tests, and the results aren’t pretty.In fact, if Europe as a whole stops growing or if Spain and Italy need a bunch of help from the EU and IMF, everyone looks sunk.

 

Base-line scenario:

Their base-case scenario still assumes positive — though lackluster — growth in the eurozone of 1.0% to 1.5% over the next year. In this case…

– The IMF and the EU would be able to support 100% of Greece’s, Portugal’s, and Ireland’s borrowing requirements.  They would also be able to support up to 10% of Spain’s and Italy’s.

– They would not be able to support 30% of Italy and Spain’s borrowing (along with 100% of PIG borrowing), however. In fact, they would be €287 billion ($398 billion) short.

– This scenario corresponds with S&P’s current long-term ratings, under which Germany and France are both AAA, Spain is AA-, and Italy is A.

 

Double-dip scenario:

But if the eurozone sees a double-dip recession, then the prognosis looks much more grim. In this scenario, S&P subjects Italy, Spain, and Portugal to a “substantial” level of stress, Ireland, U.S., and Latin America to a moderate level of stress, everyone else — including Western Europe — to a “modest” level of stress:

– France, Spain, Italy, Ireland, and Portugal would all see sovereign downgrades of one to two notches.

– 20 out of 47 banks tested could fall below a 6% tier 1 capital to liabilities ratio. They would need about €78 billion ($108 billion) to be recapitalized to a 7% level.

– This would correspond with 60-85% of the Portuguese, Italian, Spanish, and Greek banking systems.

– The EU and IMF would not be able to provide adequate support under this scenario, which would probably equate to 100% of borrowing costs for Portugal, Ireland, and Greece, and up to 30% of borrowing for Spain and Italy.

 

Worst-case scenario:

But the team also analyses an even worse scenario — not only do countries see a double-dip recession, they also see an interest rate shock:

– France, Spain, Italy, Ireland, and Portugal would all see sovereign downgrades of one to two notches.

– With higher popular angst, government willingness to adopt reforms could be inhibited. If that happened, more sovereigns (even than those listed above) could be downgraded.

– 21 out of the 47 banks tested would fall under a 6% capital requirement, and it would cost about €91 billion ($126 billion) to recapitalize them.

– This would correspond with 60-85% of the Portuguese, Italian, Spanish, and Greek banking systems.

– Short term borrowing costs could rise by 150-200 baisis points for many borrowers.

– There would be a shortfall of €287 billion ($398 billion) between the EU rescue funds’ (EFSF and ESM) and IMF’s joint lending capacity and the amount of funding needed to support the PIIGS. That amounts to 2.7% of aggregate GDP for eurozone member states.

In both scenarios, S&P expects government borrowing to skyrocket as budget deficits and bank recapitalizations “balloon.”

In sum, the IMF and EU are incapable (at least in their current capacities) of maintaining a firewall around Italy and Spain in all but the best-case scenario.

Of course, S&P has promised to revise these projections based on the outcome of upcoming EU summits.

Their conclusion is terribly ominous (emphasis added):

Although our [adverse] scenarios take into account various debatable assumptions, we believe that they illustrate the likely general direction under given conditions. Beyond the likely downgrade of a number of sovereigns if such events came to pass, our scenarios suggest that current support mechanisms may not be sufficient if conditions deteriorate beyond current expectations.

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