Europe's Lingering Debt Crisis: Should Investors Worry?

On the face of it, the European debt relief pact appears to be a boon for debt-ridden European nations. The European Union leaders have designed the deal to tackle the sovereign debt crisis that has been haunting Europe for more than a year now. But let's put this pact through the wringer to see whether it can really end Europe's predicaments. The EU and the International Monetary Fund have announced that they will broaden the size of their $614 billion bailout fund, and also ease the terms of the deal. This announcement was greeted with a positive response from the markets.

The EU and IMF have proposed $890 billion to bail out the debt-laden nations. The bailout fund, with an enhanced lending power, can be used to buy bonds directly from governments in aberrant situations. But such European bailout plans seldom come without a catch. In this case, only those countries that have taken bailout money can sell their bonds. Besides, the bonds can only be bought at government auctions and not from the secondary markets.

PIGS will have to pig out
The high interest rates on benchmark bonds in Portugal and Ireland are almost unaffected; they still hover at an all-time high. And although Greece got a cut in its interest rate and an extension in the repayment period of the loans, the country will have to sell off its public property in exchange, says Alexis Tsipras, who heads the left-wing Syriza party.

Portugal and Ireland did not secure much relief from the pact. Ireland did not get a break in interest rates on the loans, and the stipulations of the pact disqualify a desperate Portugal to sell its bonds at a time when it needs to the most.

Portugal looks fragile at the moment, and if the burdensome debt is not taken off its back, it could very well be the next victim of the sovereign debt crisis. International credit rating agency Moody's (NYSE: MCO  ) has assigned a negative outlook on Portugal's long-term government bonds and cut its rating by two notches. Standard & Poor's has also been very busy lately putting out reports on the financial status of the region. Moody's expects Portugal's economy to shrink 2% this year, and it also believes that the bailout may actually worsen the country's creditworthiness.

Impact on the European banks
The debt crisis poses a serious threat to the banking sector across PIGS nations. According to the Bank for International Settlements, the central body for all central banks, the total exposure of foreign banks to PIGS nations comes to a humungous $2.5 trillion. Taking into account the bad condition of these countries, this figure should definitely raise an alarm. The BIS had recently said that U.K.-based banks dominated cross-border lending with $5.69 trillion followed by the U.S. at $2.92 trillion.

The European Central Bank has asked Greek banks to trim the size of the state bond guarantees to $83.6 billion from $132 billion. More than a million euros of deposits are being withdrawn from the Greek banking system every month. In such circumstances, the Greek banks will have 15 billion euros to 18 billion euros or $21 billion to $25 billion less in deposits by the end of this year. Moody's has downgraded six Greek banks, including National Bank of Greece (NYSE: NBG  ) and Eurobank.

Analysts believe Spain will require an extra $56 billion to $70 billion to restore its banking sector to full stability. This was one of the reasons Moody's downgraded its rating of Spain's government debt by two levels. This shortfall is forcing Spanish lenders to race for funds. But even big banks such as Banco Bilbao Vizcaya Argentaria (NYSE: BBVA  ) and Banco Santander (NYSE: STD  ) are having a difficult time raising funds because of investor concerns.

Irish banks are already in a mess, and the rating cuts of some of its banks such as Bank of Ireland (NYSE: IRE  ) and Allied Irish Bank (NYSE: AIB  ) by Standard & Poor's will only add insult to their injury. Moody's, in its report, has also warned that Portugal's banking system needs more financial support.

Consequences
The relaxation of the bailout terms may prolong the sovereign debt crisis, but I'm afraid it's far from over. While Portugal is neck-deep in debts, Spain is no better. And after Greece and Ireland, Portugal and Spain may likely come under the hammer. Even if this pact has provided some relief to a few nations, the underlying challenges of most of its members largely remain unresolved. Crucial issues like raising the effective lending capacity of the bailout fund have been overlooked, and the deal should broaden its scope to allow purchase from the secondary markets. The banking systems of the PIGS nations face similar challenges, perhaps of different magnitudes. I believe these banks need a lot more than what this deal offers to carve out a more secure future for themselves -- and a more worthwhile investment for us.

Zeeshan Siddique does not own any of the stocks mentioned in the article. Moody's is a Motley Fool Stock Advisor pick. The Fool owns shares of Moody's and National Bank of Greece. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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