From the 1950s to the 1980s, a popular foreign policy theory was called the Domino Theory. This theory postulated that when one nation came under the influence of communism, then the surrounding nations would follow in a domino effect.
Arguably, we are starting to see the domino effect of sovereign debt downgrades. Greece . . . Boom. Portugal . . .Boom. And now, Spain . . . Ka-boom!
While downgrades are not defaults, they are likely somewhat of a leading indicator. Also, if sovereign debt crises of the past have taught us anything, it is that sovereign debt issues do not end with just one nation defaulting.
In the charts below, we’ve highlighted the CDS spreads and equity market performance for Spain over the last 6-months. The charts are not pretty. Risk, as in Bad, Bad Risk, has accelerated on both market measures of risk for Spain.
Why does Spain matter more than Greece? Well, simply put, it is substantially larger. According to the IMF, Spain has the 9th largest economy in the world with a GDP of $1.5 trillion.
The primary issue with Spain is that real estate was an astonishing 16% of the Spain’s GDP as recently as 2008. The decline of that boom has lead to massive growth in unemployment, which currently sits at 20%. Yes, 20% unemployment.
Currently Spain’s budget deficit as a percentage of GDP is north of 11%, which is well above the European Union limit of 3% and beyond the red zone line of 10%.
While Spain is still considered a AA investment grade credit by S&P despite this recent downgrade, the metrics outlined above suggest it will not stay there for long.
The Domino Effect of Sovereign Debt is happening at a country near you. Stay tuned.
Daryl G. Jones