Why does Greece matter to traders in Australia? Excess in Greece and the resultant debt crisis may seem a long way from the sunny shores of Australia, but it is likely to have far reaching effects for traders, investors and even those that are not interested in the markets at all.
In Greece the people have generally enjoyed a fantastic lifestyle since their entry into the European Union funded by borrowing money very cheaply, in Euros. These words from Diane Francis sum up Greece nicely: “Greece is not a country, it’s a party. Taxes have gone uncollected forever or have been short stopped by corrupt tax collectors. For decades, Greek governments have paid civil servants bonuses for showing up to work on time and 14 months’ pay for Christmas. Retirement has averaged at 53 years of age.”
But Greece’s hangover has hit and it is a doozie. Debt has reached unsustainable levels and as a result interest rates have risen sharply, making it even more difficult for Greece to service their debt. When no one wants to lend to Greece it costs them more to get funds and these costs have risen significantly. At present the Greek bond yield is above 300%, that means the Greeks are paying 300% interest to borrow and by the time you read this it could be even higher. It has been estimated that 90% of Greece’s debt has to be written off for Greece to reach a sustainable level. The recent “haircut” of 50% for private holders of Greek debt amounted to a 20-30% write off.
If the problem was contained to Greece, then the country would default on its loans and life would carry on for the rest of Europe. Unfortunately it’s not that simple, because most countries in Europe face a similar scenario to Greece. Portugal, Italy, Ireland, and Spain collectively with Greece, known as the PIIGs, also face a similar situation. But the effects are not limited to just these countries either and this is where the problem really is. At present Italy’s bond yields have risen above 7%, Belgium’s are over 5%, and France’s are rising towards 4%. Even Germany, normally seen as rock solid, experienced a weak auction this week and their bond yields began to rise from below 2%. Bailouts for the PIIGS occurred when they hit 7%, but the problem is beginning to spread and there is simply not enough money to bail out Italy, the world’s seventh largest economy. Is France next, the world’s fifth largest economy? Where is all the money going to come from?
Debt problems are not unique to Europe, even though the UK has similar problems. Japan is the world leader in sustaining unsustainable debt. And welcome to I.O.U.SA, where the government cannot reach agreement on $1.3 trillion of deficit reduction that is essential to prevent them following the path Greece and the other PIIGS have followed. And who is there to backstop the US?
What does this mean for us here in Australia, following the Australian markets? Well there are some obvious implications that you may be able to see. If Europe, Britain and the US stop buying goods manufactured by China, then that is likely to hit the resources sector hard. There has already been a slowdown in manufacturing in China, seen in data released in the last few days. The Materials sector has been one of the weakest sectors in recent time. The other sector that has been very weak is the banking sector, with all banks interconnected on the global stage. Fortunately Australian banks are well removed from exposure to the European crisis, but European and US banks are not so fortunate. Many of the European banks hold European government debt directly and in the event of a default they will lose large sums of money. In fact so much so that the governments will be forced to bail out the banks or let them fail completely. While US banks do not have a large direct exposure to European government debt, many have sold insurance against default to the European banks, known as credit default swaps (CDS). In the event of a government default both European and US banks are very vulnerable to collapse.
The bad news is that default is inevitable if you study the history of debt. Reinhart and Rogoff have compiled a massive amount of research on debt cycles throughout history, published in their book “This Time is Different” and their findings are interesting. A crisis in the private sector, which we experienced in 2008, is always followed by a crisis in the government sector as governments increase spending to bail out failing institutions and attempt to stimulate the economy. At the same time unemployment jumps and company sales slow, this results in higher costs and lower revenue from taxes. As a result government debt levels rise sharply. There are then only two solutions to the government’s unsustainable debt levels – inflation or default, that’s it. According to history there is no other way out.
Inflation means the government starts printing money to repay their debts, and if they print enough then their debts can be repaid, however this leads to a fall in the value of their currency and rising commodity prices. Some see gold as the ultimate protection against inflation as the government cannot make more of it. The rising gold price is a sign of this behaviour, which was euphemistically called Quantitative Easing in the US and it has also been occurring in the UK.
If inflation gets out of hand then hyperinflation can hit, with prices rising at ridiculous rates. Zimbabwe was the most recent case of this, where 3 eggs cost $100 billion and the price of your meal went up while you ate. Germany has experienced hyperinflation in the past and is very wary of taking this path for the European Union.
The other option is outright default, which Iceland has been brave enough to do. The government simply says we are not paying back the debt. Iceland has prospered since, as its massive debt burden was eliminated. The big problem facing European leaders is that if Greece defaults, it will severely impact other European countries who are holding the debt in its banks. MF Global collapsed after Greece defaulted on 50% of its private debt and fortunately there was no flow on effect from this, though many clients are caught up in the turmoil. The true danger is that one default could trigger a series of defaults and we could end up with a collapse in the global banking system.
There are only two ways out of this: inflation or default. Two choices, and neither of them are good. Politicians will choose the approach they wish to take, but only when forced to. Rising bond yields are a sign that they may be forced into this sooner rather than later.
By Jeff Cartridge
Education Manager
