Euro-zone: A Default-free Area?

This is the interesting question that Morgan Stanley's Vicenzo Guzzo asked a couple of weeks back. The key background details in question are what are known as the cross-country risk spreads. Now this may seem like a piece of technical obfuscation, so what exactly does he mean?

Well, one of the main consequences of the introduction of the euro has been the dramatic reduction in what are known as the 'interest rate spreads' on sovereign debt.

Again, what does this mean? Well the word 'spread' in this context, refers to the difference in long term interest rates charged between the stronger and the weaker economies. This difference for - say - Italy and Spain (using the 10-year German Bund as a reference rate) moved from over 6% in 1992 to less than 0.4% in early 1998. Since the late 90's differences in rates across countries have varied slightly, but basically remained negligible. This is what the common currency does. The stronger economies underwrite interest rates in the weaker ones.

However, given the demise of the stability pact, the question Guzzo is really asking is whether this honeymoon can last. It could be that if national debt in the different member countries is allowed to continue to go its own way, these risks spreads could once more increase.

Up to now the only vague indication of such a possibility is the fact that on July 7, Standard & Poor?s lowered its long-term sovereign credit ratings on Italy to ?AA-? from ?AA? - while the the spread between 10-year BTPs and other Euro area government bonds widened only fractionally - and that on September 13, following major upward revisions to Greece?s deficit and debt measures, the same rating agency revised its outlook on the country from stable to negative (while re-affirming the long-term rating at ?A+?). Again market reaction was muted.

The big question is just how long this will last. Another one of those pesky 'things to watch'.