Thursday, December 10, 2009

A Propos Greece's Troubles

The precarious shape a number of euro-zone economies have found themselves in recently has dominated financial market headlines in the last few days. Ireland, Spain, and Greece seem to have joined other "second-tier" European countries, like Latvia and Hungary, in experiencing widespread loss of confidence in the quality of their sovereign debt. The draconian measures to address the budget gap that the Irish government announced yesterday have received an initially positive response but uneasiness over their effectiveness remains high.

At the core of the attention-getting developments of the last few days is the massive budget deficits and total amount of debt that these countries have accumulated, mostly, but not exclusively, due to the financial crisis and global economic downturn of the last two years. Although, it is actually unlikely that a euro-zone country, like Greece (which is facing the most serious problems) will be allowed by the EU to default on its debt- with Angela Merkel reminding investors as much earlier today-credit default swaps have soared.

A few thoughts.

a) The reassurance offered by the powers-that-be in the euro-system about offering help to its members currently in trouble is obviously a positive development, but it may not be enough to resolve the issue. Greece is already resisting EU pressure to implement any major belt-tightening measures of its own as politically untenable and offers only promises of bringing its budget deficit from 12.7% of GDP this year to about 10% next year. That is likely to be viewed as a frustratingly slow pace to many. Against such obstinacy, it may not be too far down the line, where massive bets against the country's ability to contain its debt burden start being placed by global macro hedge funds- not totally unlike those that were already pushing Iceland (a non-euro zone country) against the wall as the financial crisis was erupting in 2008. (In fact the second of the above links describes exactly those emerging strategies by some). This would represent a major complication for any bail-out efforts by the EU.

2) Directly linked to the above point, the problems that Greece and Spain are facing- and, possibly, Ireland, Italy, and Portugal to various degrees- are not solely the result of the size of their budget deficits per se but more of the lack of credibility that those countries have in the eyes of global investors in terms of their determination to bring them under control. For example, Germany's budget deficit is surpassing 6% of GDP this year but Germany's sovereign debt still carries some of the lowest rates in the euro area and credit default swaps on such debt have not budged. Nobody questions Germany's commitment to reining in the deficit as economic growth picks up into next year. Of course, another key differentiating factor is the total amount of debt of the various countries involved, with Greece's exceeding 125% of its GDP, while other healthier euro-zone economies are only moderately exceeding the 60% cap mandated by the "growth and stability" pact.

3) In a way, the current predicament of the three main countries in trouble currently represents the moment of reckoning for reckless and short-sighted policies earlier in the decade, mostly driven by a goal of creating an aura of unusual prosperity largely built on sand (Ireland, Greece). The financial crisis and associated economic downturn simply helped expose the underlying fault lines of such growth.

4) Finally, it is tempting to highlight that there has been a reversal of past patterns and prevailing stereotypes as to the resiliency that different economies around the world demonstrate in the face of global financial market events of extreme stress. While emerging market economies used to be considered "high-risk" in such situations- and there is admittedly a long history of defaults on their debt to support that perception- it has been exactly those economies that have weathered best the financial turmoil of the last two years. Even Argentina, a serial offender in terms of defaulting on its debt in the last 30 years, is taking positive steps opening up its access to international capital markets again, by announcing today a decision to swap out of $20 billion of defaulted debt.

It is now, countries in the heart of Europe that are facing a particularly bleak predicament that represents a significant challenge for the cohesiveness of the euro system and testing the limits of patience of global investors.

All in all, another strong reminder, following Dubai's recent problems, that, although the global financial crisis has been by and large successfully contained, pockets of extreme fragility have been left behind and are not likely to disappear any time soon.

Anthony Karydakis