Stocks went on a wild ride this week, first rallying furiously on the reality that the administration’s plan to penalize the big banks was unlikely to ever make it into law and then diving to new lows on fears about sovereign debt in Europe. Friday’s market was a microcosm of the week’s action as the Dow was knocked for a loss of 167 points on a continued “flight to safety” in the dollar, but then recovered in the last hour to finish higher.

Much of the selling this week was based on fear as traders flocked to the dollar as a safe haven, which, in turn, put pressure on stocks, commodities, and the emerging markets. The fear stemmed from concerns about the potential for a credit contagion to develop should a handful of the smaller Eurozone countries, now affectionately known as the PIGI’S (Portugal, Italy, Greece, Ireland, and Spain), default on their debts or experience further rating downgrades.

What may have been curious to many investors this week was the fact that none of this is new. The markets have known about Greece’s difficulties for some time now. In fact, we actually got good news early in the week on this subject as the EU commission endorsed Greece’s plan to cut their budget deficit. This served to quell fears about the region – until Thursday, that is.

On Thursday, we learned that Portugal had a little trouble with their t-bill auction. This little PIGI went to market and came home almost empty handed, so to speak. Apparently Portugal’s treasury held an auction for 500 million Euros and could only find takers for 300 million. Think about that for a moment. A member of the EU tried to sell short-term paper backed by the good faith and credit of the country and came up short when trying to roll over debt. Wow.

It didn’t take long for traders to play the extrapolation game with this situation. If a country can’t raise money by selling bonds and they don’t have enough revenue coming in to cover all the expenses, a default on future debt payments becomes a real possibility. Next, this would lead to a downgrade (or three) in terms of the creditworthiness of the country’s debt. This, in turn, would create big problems for the banks and investors holding the debt. And if the rating on the debt were to fall far enough, it might cause certain types of institutional investors to be forced to sell the paper. But the question, of course, is: Sell to whom?

Is this taking the situation too far? In a word, yes. A key point to keep in mind is that none of these countries has defaulted on any debt payments or is close to a default. But with investors fresh off the worst bear market in a generation that also just happened to be caused by problems with credit; the sell-first-and-ask-questions-later mentality displayed in the markets was certainly understandable.

Although the heat seemed to be taken off of Greece this week, the country isn’t exactly out of the woods. Greece has a budget deficit projected to be 12.7% of GDP in 2009. While this doesn’t sound too outlandish, it is the highest of the PIGI’S as Ireland’s deficit is at 12.5%, Spain’s is 11.4%, Portugal is at 9.3%, and Italy’s budget deficit is a mere 5.3% (according to Haver Analytics).

What’s worse is that Greece has government debt equal to 113.5% of the country’s GDP, which is second only to Italy’s 116.2%. The problem here, in layman’s terms, is these two countries have effectively maxed out on their credit limits. (This is akin to a family having credit card debt equal to a year’s salary.)

The other problem Greece has is its credit rating. At BB-, the analysts at Ned Davis Research worry that the country may not be able to use its own bonds as collateral at the ECB when the central bank returns to its pre-crisis requirement of an “A” rating or better. This too would make it very hard for Greece to borrow money.

The good news is that, according to Haver Analytics, Greece makes up just 2.7% of the Euro-Zone Nominal Gross Domestic Products. By comparison, Portugal is 1.8%, Italy is 17.3%, Ireland is 1.9% and Spain makes up 11.9%. Taken together, the PIGI’S are responsible for 35.6% of the Euro-Zone’s output.

But the lack of size is actually part of the problem. While the U.S. is able to borrow and spend its way out of the worst recession in a generation, the little PIGI’S won’t be allowed to even try such a maneuver. Put simply, the rest of the world won’t let them as was evidenced by Portugal’s auction this week.

The key take away from the situation is these countries are at risk from a financial standpoint. And since the markets did a very poor job of assessing risk prior to 2007, traders are making a point to get it right this time. Thus, any country that has too much debt is going to have a very hard time going back to the well and borrowing more.

Since the EU is not willing to bail out any of its members; Greece’s answer to their debt troubles is to enter into an austerity program. And while this sounds like the responsible thing to do, from a big picture standpoint, the country is effectively prescribing an extended recession/depression to cure their debt ills.

But let’s get back to the question posed in the title. As long as nothing bad happens anywhere around the world (think 9/11) and the economies of the world continue to grow at a healthy rate, we probably don’t need to worry too much about the PIGI’S turning into a huge problem. However, based on the less than robust recovery that is projected in most of the developed nations, it might be a good idea to keep the debt mess in the back of your mind. And should things start to deteriorate on the economic front, then we would probably need to worry a lot – and about more countries than these little PIGI’S.

 

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