The markets seem to be pricing close to a 100 per cent probability that Greece will default on its debt. In the interim France and Germany have said they that “convinced” Greece to stay in the Eurozone. To back this up Central Banks around the world have established a three month credit facility to assist Euopean banks with any liquidity problems they might have.
So…how do we make sense of all this??
There is really no question that Greece will have to default on some if not all of its debt. The big question is how would it actually take place and what measures could be put into place to minimize the fallout.
The fact of a country defaulting on its debt is not something new. Even going back to the middle ages, Kings have defaulted on their debts to various bankers. The most notable being Edward III defaulting on loans to the Medici Bank of Florence in 1345. The Medici had lent money to the King to finance the Hundred Year War with France. Ultimately, King Edward did not have enough silver to mint enough money to pay back the Medici. Interestingly, this default almost caused the bankruptcy of the Medici Bank which was the largest and most powerful bank in Europe at that time. With modern rise of fiat currencies (money not backed by gold or silver) countries that have defaulted in modern times have had their own currency.
One of the biggest issues for Greece is that it no longer has its own currency..the drachma. Upon entry into the euorzone, all the drachmas in the country were converted into euros and everything in the country was converted to a euro price. All of the debt of the country was also converted to euros from drachmas.
Nobody really knows how Greece would default under these circumstances. Clearly anything other than a “technical” default..that is restructuring existing loans through a haircut by the banks and money from the other eurozone countries..mainly France and Germany is uncharted waters.
In fact the Treaty that set up the eurozone does not make any provision for a country to leave….there was no prenuptual agreement!!
Right now Greece is clearly in a death-spiral. The Eurozone countries and the IMF have imposed austerity programs as a condition for more money to service the national debt. These austerity programs..while needed..are quite draconian and just make matters worse. Just ask any country in Africa how the austerity programs of the World Bank worked out for them!!!
Economic activity in Greece has fallen about 40%. This in turn just makes it that much harder for Greece to meet its debt obligation….picture a rat in a cage on an exercise wheel!!!
Typically when a country defaults on its debts, the home currency is devalued significantly. This is usually accompanied by some form currency controls. The devaluation results in higher inflation and a lowering of the standard of living of residents of the country. On the plus side…exports become cheaper and so products can be sold around the world at a more competiive price. Over time the combination of lower imports and higher exports improve the economy and the wealth of the residents of the country increases. Eventually the country gains access to foreign debt markets..witness Iceland.
When other countries defaulted…the people in that country held bank accounts in the local currency and those that were employed were paid in the local currency. This is not case in Greece. People there hold bank accounts in euros and are paid in euros. For Greece to default and therefore leave the Eurozone the euro would have to be replaced by a home currency..the NEW drachma for example. All bank accounts and wages would have to be converted into a new currency.
This then raises all kinds of questions.
The question for Greece is that it would have to print new drachmas This would mean that all of the euros in Greece would have to be converted to the new drachmas. The big problem would be how to deterrmine the correct exchange rate for this to take place. The drachma was converted to euros on January 1 2001 at the rate of 340.75 drachma to the euro. Clearly with the current situation this rate would be bogus. The market exchange rate would likely be a much higher number but since there is no market for drachmas , it is anybody’s guess as to what conversion rate to use. If the conversion rate is too low then shortly thereafter there would be a devaluation of the drachma on world markets and the residents of Greece would face immediate inflationary pressure..the cost of all imports would go up and generating a lower standard of liviing…. so getting the exchange rate right at conversion is very important..but in practical terms impossible to do!!.
In order to do the conversion in an orderly fashion it would be likely that the Greek Government would have to impose currency controls prior to the conversion. Otherwise, all those with the capacity to move their money (euros) from Greek banks to foreign banks would do so in order to maintain a “hard” currency and protect themselves. If this were to happen there would be a run on all Greek banks and result in a severe contraction in the Greek money supply..a harbringer to recession or even depression..
In practical terms this would be very difficult to implement given the coalition government in Greece. Even the smallest hint that such a measure is being considered would generate a run on Greek Banks.
This leads to the next issue. Under almost any scenario the Greek Government would have to nationalize all Greek banks to provide some sort of stability.
Assuming that somehow these issues.. could actually be implemented in an orderly fashion..however unlikely… this stills leaves the Greek Government with a big problem. It is currently running serious budgetary deficits. Following a default it would not likely have access to credit markets to finance a deficit. This leaves basically two options or a combination of the two….cut spending programs…or….print money to pay for the deficit.
Either one would create a spiral of a declining standard of living for Greeks leading to severe social unrest and the underlying stablity that goes with it.
No matter how you you slice and dice it…it would be difficult to have an orderly default and with all the things that need to be put into place before a default. It could take months or years for them to be put into place. Can the international community buy them enough time…not likely
Soooo…where does this leave the rest of the eurozone?
In the short run..even if behind the curtain the leaders have decided that there will be a Greek default..they will need to pretend that it isn’t on the table and continue the bailouts while the other issues are worked out behind the scenes. This would likely take the form that we have seen so far…brinkmanship..small bailout to buy more time..promises that a big fix is coming.
A full default by Greece would result in a significant but not huge writeoffs by the major european banks..primarily French and German..and some Italian banks. These banks are levered 75:1 on average and are undercapitalized. Given the international decision last week to interventions by the US Federal Reserve..the Bank of Japan…The Bank of England..and promises by the Chinese to buy euro denoninated bonds…it is clear that the people “in the know” think that the European banks could have difficulty in dealing with a Greek default. These bank are already scared to lend to each other..hence the pumping of TARP-like liquidity into the system by these Central Banks.
The potential for a so-called contagion is quite high. But how could a small country like Greece cause such a thing??
It is clear from what I said earlier that the European banks are vulnerable to even a default the size of Greece. The ensuing writeoffs by the banks would ultimately lead to a further slowdown in economic activity ion Europe..where the growth is already basically zero. Hence a recession in Europe would put additional stress on the Eurozone national governments budgetary situation. In this scenario, Italy would be particularly vulnerable. Its national debt to GDP ratio is 120% and interest rates on this debt have already gone up and the credit default swap rates are high.
Italy being the third largest economy in the eurozone is simply too big for anyone to deal with. The Italian Government has been able..so far..to deal with the problems through austerity programs. A recession in Europe..triggered by Greece combined with these austerity measure would cause big problems for Italy to service its debts. A potential death spiral for Italy would then become a real possibility.
But..what about the United States??
From what we have been told..the US has very little exposure to Greece. US banks also seem to have very small exposure to European banks through CDSs and other derivative products.
So the US is home free…NOT!!
If the scenario I described above for Europe were to happen, there would a a deep recession in Europe (I am carefully avoiding the D word)…then there would be a recession in the US. About 20% of all US exports go to Europe. Further over the past couple of years much of the profits and earnings of US companies has come from their european operations..witness the trillions in cash US companies have tucked away in offshore operations. A recession in Europe would depress the earnings of the european operations of US companies. This would depress their stock prices..and so on. The Bank of America in my opinion is particularly vulnerable to such an event (read… http://www.associatedcontent.com/article/8366885/bank_of_america_ticking_time_bomb.html?cat=3 )
Right now all the governments in Europe plus..the US..Japan..are doing all they can to forestall the scenario I have described. Can they actually come up with a solution? In my opinion they can’t. Further, each time they throw more money at the problem to “kick the can down the road” they are creating yet a bigger problem
There is an old Chinese proverb..I used it extensively in my days as a professional negotiator..the proverb goes like this….”resist like water”
When you think about it..a river taking its natural course to say a lake is a strong force . If you put something in the way to block the flow..you can temporarily halt the flow. Once the obstacle is removed then the flow of the water to lake continues. The thing is however..that while you have temporarily blocked the flow..the water is building up behind the obstacle…so when the obstacle is removed the current is initially stronger than normal..creating a flood. Government are currently creating obstacles to the natural economic flow..once they can longer do it..you can only build the dam so high….we will see the stronger action of all that pent up force!!
When will this happen???…Beats me. But there is clearly a limit to how long the Governments can stop the flow of the natural economic forces. My guess and one which I am using to build/maintain my investment portfolio is that we will see it sometime in the second half of 2012 or the first quarter of 2013 at the latest…but that is just an intuitative guess on my part.
My strategy is quite simple. As I have stated in my other articles..I am 40% bonds..20% dividend paying stocks and 40% cash. I will use any decent market rally between now and the summer of 2012 to sell my stock portfolio and increase my cash position to at least 60% and probably higher by also taking profits on some of my corporate bonds.
Those of you who are short term traders and braver than me might be able to make profits by correctly playing the market volatility between now and then.
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As always..comments pro and con are welcome….