Now as our more seasoned GaveKal reader will undeniably remember (see Divorce, Italian Style, or The End is Not Nigh), we have argued that spreads between Europe’s sovereigns were set to widen for the past few years. And yet, nothing happened. Until, that is, we started to see Asian central banks allowing their currencies to start appreciating faster.

But what happens if Asian central banks now stop buying up European government debt to the tune of recent years? For a start, European money supply growth should decelerate rapidly and with it, economic activity. A bigger problem will then be the ability of European governments to raise further financing. Indeed, as economic activity tanks in Europe, and the Euro starts to fall, it is likely that investors will all of a sudden realize that governments only go bust when they issue debt in a currency that they cannot print.

In the past fifteen years, France government debt to GDP has moved from 35% in French Franc (i.e.: a currency the government could print at will) to 70% in Euros (i.e.: a currency that only the ECB can print). No wonder that Francois Fillon, the current French Prime Minister recently declared: “I run a state which now stands in a situation of financial bankruptcy, which has known deteriorating deficits for fifteen straight years and which has not voted a balanced budget for twenty-five years. This cannot last.”

More importantly, the tightening-up of Europe’s financial situation, and the widening of spreads between the “good borrowers” such as Austria, Finland or Germany and the “poorer borrowers” such as Italy, Greece, or Portugal, could have a devastating impact on Europe’s commercial banks. Consider this piece of news from January 2008: “Landesbank Baden-Wuerttemberg, Germany’s biggest state-owned bank, said 2007 profit will be about 300 million euros ($438.9 million) because of a drop in prices of banking and government securities. LBBW said it doesn’t expect any defaults since the securities concerned have good ratings.”

Less profits because of a drop in government securities? The careful reader may be somewhat surprised by this statement; after all, everywhere one cares to look across the OECD, government bond yields are close to their 2003 lows. So how did Germany’s biggest state-owned bank manage to lose money on government securities? The answer, we believe finds its source in the funky regulations of Basel II. According to Basel II, an OECD country bank can sell a credit default swap on an OECD sovereign and this CDS:

• Does not have to be marked to market (since it is assumed that an OECD country will not default on its debt).
• Does not require the selling bank to put aside any capital on its balance sheet (since, once again, it is assumed that the country on which the CDS is written will not default).

In other words, for the past few years, clerks all over Europe’s banks and insurance companies have boosted the bottom line with the “free money” that the sale of CDS provided. Every now and then, a clerk at the Treasury department of ABC Landesbanken would call up Goldman Sachs or Deutsche Bank and say: “I want to sell US$ 1bn of protection on Italy at 15bp for five years”. And for five years, ABC Landesbanken would receive US$1.5 million without having to set aside capital on its balance sheet or take a “mark to market” risk on its income statement. Or so it thought…

Indeed, as the spreads between Italy and Germany start to widen something unexpected happens (a CDS will tend to reflect the spread between the issuer’s debt and risk free debt of the same maturity. Otherwise an arbitrage could be made. If Italy’s debt traded at 100bp over Germany and a CDS on Italy only cost 20bp, one could buy the Italian bond and buy the CDS and capture a “free” 80bp): ABC Landesbanken receives a margin call from Goldman Sachs and Deutsche Bank and, all of a sudden, what was a “risk and capital free” trade turns out to impact liquidity. Needless to say, this is the situation we are now in and this probably contributes further to the widening of spreads. All of a sudden, Europe’s commercial banks are no longer keen to sell the spread as they have been for the past decade… in fact, they are most likely trying to buy back some of the contracts they wrote before they move too far against them.

In other words, a widening of spreads represents the worst of both worlds for European banks. For a start, it puts their balance sheets under pressure. For seconds, it cuts down their income as the writing of CDS on Europe’s weaker sovereigns slows to a crawl.

For Europe’s policy-makers, the widening of spreads poses a serious challenge which, if left unchecked, could cut to the very credibility of the Euro and the European construction exercise. It could also trigger a negative spiral such as the one we saw in the US whereby as the cost of borrowing increases on the weakest signatures, rolling over debt becomes more problematic, hereby inviting higher spreads etc… So how will Europe’s politicians respond to this new challenge?

The widening of credit spreads across Europe reflects an economic reality. It makes no sense that say, Belgium and Ireland should borrow at the same rate.

The Euro 100bn question for investors should thus now be whether a) the recent widening is a one-off event and spreads are set to soon tighten again or b) the recent widening is the beginning of a more fundamentally-based re-pricing of risk across Euroland. The quandary now is whether politics can get us out!

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