Bank crisis looms as Europe's debt woes deepen The eurozone debt crisis has expressed itself in bond market "spreads" - yield differentials of different countries" ten-year government bonds vis-à-vis Germany's Bunds. The logic behind this is that even if a stricken country's debt problem lies in the private sector - as it does most spectacularly in Ireland and Portugal - the problem will show up as a banking crisis, requiring a government bail-out. So the government's credit is the ultimate loser. This focus on government spreads only too naturally, but wrongly, leads into treating government debt levels as the measure of a country's problem. In fact, however, though nobody in Berlin seems to realise it, the eurozone debt crisis is not a simple product of too much government debt, and/or too large deficits. In Ireland and Spain, budget balances were in surplus on average in the boom years up to 2007, the debt problem arising from excessive private sector borrowing - as was the case in the US, which triggered the crisis with its excesses in subprime mortgages. In Spain and Ireland, it was the "one size fits none" interest rate structure that had far more to do with the crisis than delinquent governments. Of course, the Greek crisis is focused on government debt and deficits, and can be expected "to run and run." In the most recent acute phase of it, culminating in the European Central Bank's decision to become "lender of first resort" to the eurozone banking system in December, the "next in line" was deemed to be Italy. The Italian bond spread, below Spain's throughout the crisis until mid-2011, shot up to a peak of more than 5 percentage points over Bunds, and nearly 2 percentage points over Spanish Bonos. It is true that Italy risks falling into the Greek trap - and investors can hardly be encouraged by its net government debt, 100 per cent of gross domestic product, being exactly where it was at the start of monetary union in 1999, since when the economy has hardly grown at all. The new Monti government's savage, 4 per cent of GDP, fiscal tightening means real GDP is likely to be down in 2012, and again in 2013, with nominal GDP also probably lower. The "primary" budget balance, ie ex-interest payments, was in minimal surplus last year, but is unlikely to improve much, if at all, for solid "Greek" reasons: recession will hit the tax base, offsetting higher rates and structural tax-raising measures. The interest charge meanwhile, forecast by the OECD at 5 per cent of GDP this year, could drift upward. Net debt could approach 110 per cent of GDP next year, heading toward Greece's 2020 target of 120 per cent: an interesting convergence. But if Greece is a slow-motion car crash, Italy's downhill slide is glacial. The threat from private debt, on the other hand, is subterranean. Adding together household debt, net non-financial company debt and net government debt gives a total of just more than 200 per cent of GDP for Italy. For Spain, as for Britain and Japan, the total is 240 per cent, even higher than Greece's 230 per cent (all of them being far behind Ireland and Portugal, at more than 300 per cent). In Ireland (and Britain) the bulk of the threat is in household debt, which is protected both by relatively stable personal income in time of recession, and by low interest rates - these countries having most mortgages on floating rates. In Spain, and even more in Portugal, the heavy private-sector debt burden is in business. For Portugal, non-financial company (NFC) debt is 16 times pre-interest cash flow, in Spain 12 times. In the mergers and acquisitions business, ten times is the threshold for "junk": not a pretty description for an entire country's business sector. In addition to this debt burden, which forms a large part of the banking system's assets, the Iberian asset values that collateralise the debt in many cases have hardly adjusted to post-crisis realities. Spanish commercial property, for instance, in total-value terms is only down some 10 per cent from end-2007 highs that were well over twice 2000"s. Spain's new government appears committed to "do the full Monti" in one year instead of two - a 4 per cent-of-GDP fiscal deflation, with the added twist of requiring banks to write their assets down to realistic levels. This shock treatment is more likely to kill than cure. It is axiomatic that a recession does more harm to profits than personal income - just as they rise faster in booms. Spain's domestic-demand recession (starting from unemployment of 23 per cent, 49 per cent amongst the young) will be compounded by falling GDP in Germany and the rest of Europe. The profit "denominator" of the debt-to-cash-flow ratio could dive, causing the debt ratio to soar. With asset values potentially sinking fast, the chances of inducing a bank crisis are high. In Spain, even more than in Greece, austerity will probably reduce, not increase, the cents in the euro collected by creditors. The Spanish bond spread deserves to shift back to substantially above Italy's, as eurozone orthodoxy destroys the continental economy. Charles Dumas is chairman & chief economist at Lombard Street Research