Friday, February 05, 2010

My Big Fat Greek Debt

Europe is in trouble. The signs are clear. Its financial system is shaking and bond markets are under pressure from speculators.

It began with the recession and the rush to create social programs, stimulus spending and social investments, which led to a great deal of European debt. This debt load is very high - public debt could reach 84 percent of GDP (gross domestic product) for the whole of the EU by the end of 2010, an increase of 18 percentage points from 2007 and 24% above the agreed limit of such debt within the EU. Gordon Brown, the British Prime Minister and former Chancellor, always argued that 45% was the desired deficit target. Britain will have public sector debts equal to 70% of GDP and a deficit of 13%.

So bad are debt levels that the bond rating agencies have all downgraded their ratings of Greece and some have also downgraded Ireland and Spain – they are also looking carefully at Portugal.

Greece is the problem child of Europe. Its current operating deficit is 12.6% of GDP and its debt levels are equal to 113% of GDP. The country is essentially one big Ponzi operation – borrowing money from new bonds to pay off older bond holders.

The European Commission warned this week that Greece will have to do far more than it is currently planning to curb its public finances in the longer-term, to reform tax collection and improve the way it keeps accounts. EU Economy Commissioner Joaquin Almunia said that EU officials would carefully monitor Greece's efforts and "will ask the Greek authorities to make additional measures" if it isn't on track to reduce a budget deficit from 12.7 percent last year to 2 percent of economic output by 2012.

Prime Minister George Papandreou of Greece, speaking during the annual meeting of the World Economic Forum in Davos, Switzerland, said his country did not need a loan from the European Union. Instead, he has cut public sector pay by 10% and frozen it for an indefinite period, cut public spending by 10%, found new taxes on carbon based fuels and changed the retirement age so as to cut social security spending. He has also warned that additional measures are possible. In particular, Papandreou pledged to go after tax evaders and those who could afford to pay may well be forced to do so.

Austerity is not a popular strategy. Not surprisingly, the governments measures were met with instant strike action by public sector workers. Farmers are blocking major roads across the country in a bid to get financial help from the government, which has so far refused. Further industrial action is proposed.

The fear is that Greece may default on its debts – refusing to pay bond holders. Should it do so, this would threaten the integrity of the Euro as a currency and the economic regime that lies behind it. Markets are already nervous about these developments, as has been seen in market activity in the last few days – the Euro is falling in value against other currencies.

Part of the problem is that Greece has very poor public accounts. Indeed, the public accounts it used to gain entry into the Eurozone have since been proven to be grossly inaccurate – had the accurate accounts been used, they would not have been granted membership and been able to use the Euro as their currency. Now that the heat is on, the EU intends to review every book entry to make sure the picture they provide of Greece’s finance are accurate. The betting is that they will be surprised at what they find.

There is a view, expressed by a minority of economists, that Greece should be allowed to fail and default on its debts. This would lead to an IMF intervention and strict external management of Greece’s finances, but would also send shock waves through global markets and force them to address the reality of unprecedented debt and really get to grips with how to deal with it. Such a strategy could, however, send the world into a second recession before it has recovered from the first.

What is also clear is that bond buyers will demand better interest rates to hedge their risk of default from a number of European countries. This will lead to the more rapid increase of interest rates world-wide, as Governments compete for funds. Several UK banks now confidently forecast interest rates in the UK at 6.5 – 8% by October 2010.

We should keep an eye on the Eurozone. What happens in Greece will not stay in Greece. It will come home to all of us as the markets respond.

1 comment:

Alexander (Sandy) McDonald said...

Interesting post Stephen!

I like how the last line of your post:

"We should keep an eye on the Eurozone. What happens in Greece will not stay in Greece. It will come home to all of us as the markets respond."

That was a very prescient post, given today's headline in the globe investor:

"As Greece debt crisis mounts, foreign capital eyes Canada."

Its going to be very interesting to see how this unfolds over the next 2-3 years.