A Bad Case of Déjà Vu: Why Greece Still Matters

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November 4, 2011
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Much has been made in the past few months about the debt crisis in Greece, culminating with Monday’s announcement of an International Monetary Fund (IMF) and European Union (EU) orchestrated $146 billion rescue package. This is much larger than was discussed a few weeks ago. Though it has reduced the probability of Greek default and has been clearly directed at shoring up market confidence in the 11-year old Euro, history suggests that this bailout may not mean the problem of sovereign risk will immediately disappear.”

As Greece’s woes continue and questions remain about the prospect of a splintering Eurozone, investors are anxiously monitoring the markets, with many scrambling to prepare for the potential financial fallout. Unfortunately, while efforts to bail out Greece and prevent their economic problems from spreading throughout Europe have caused markets to convulse and renewed fears of a recession, this latest news is neither surprising nor even particularly new. In May 2010, we authored a special report discussing the first round of Greek bailouts and the continued probability of a Greek default. As the quote above notes, we cautioned, “History suggests that this bailout may not mean the problem of sovereign risk will immediately disappear.” Today, we face the realization of that prophecy, with Greece’s history at the center of Europe’s debt crisis repeating itself.

After market reaction to the latest efforts at containing the Eurozone debt crisis last week, and speculation now rampant that its Citizen Vigilantes may lead Greece to leave the Eurozone, we find ourselves with a bad case of déjà vu. Only this time, as we warned, it is now not just Greece’s debt with which we are contending. The rest of the PIIGS countries are also at risk of catching the Greek default disease, and the system is relying heavily on a reluctant Germany to hold the European Union (EU) together. In just 18 months, how have we returned to the brink of the Eurozone’s economic collapse? What still needs to be done to resolve the crisis, and why is the outcome in the EU important for Balentine clients?

As stated in “Why Greece Matters,” “The real issue is not the direct fallout from [Greece]; it is more that a timid, untimely and inconsistent response [from politicians] could freeze the financial system again.” When Greece received its first bailout in 2010, they were charged with curbing their debt by cutting spending and raising revenue (i.e. taxes). A simultaneously humorous and sad article from a May 2010 New York Times article gave this alarming statistic: out of almost 17,000 pool-owning residents of a wealthy Athens suburb, only 324 noted their (taxable) pools on their tax returns. Indeed the last two years have proven incapable in changing that mentality, leaving them back where they started. However, the government has not taken the necessary hard-line stance since then, and Greece has chosen to continue many of its long-standing bad habits. While some progress has been made in other at risk countries such as Portugal, Spain and Ireland, Italy now appears to be the next major concern for markets.

Acknowledging the lack of progress so far, last Thursday’s agreement alluded to a 50% write down on Greek debt and provided a framework to implement a more consistent plan to address the outstanding issues, even if it was short on many important details. The agreement addressed the need to:

  1. Recapitalize the EU banking system to prepare it for the inevitable losses and debt write downs to come. Currently these banks carry sovereign debt at values higher than they are really worth at today’s market prices, and if forced to sell prematurely, the banks would experience a severe loss of capital, provoking a run on the banking system. Therefore, there have been suggestions to take bad assets off these banks’ books and swap them with higher quality assets such as private sector debt. The French and German governments are now presenting the issue to their electorates a little more honestly – the current crisis is not just about the behavior of profligate periphery countries, but about their own banks who failed to manage their exposures to these risky assets correctly. At its root, the Eurozone crisis is more than just a sovereign debt crisis – it is potentially another global banking crisis like we experienced in 2008. Already a “too small to matter” institution, MF Global, has filed for bankruptcy given its large exposure to European bonds since last week’s agreement.
  2. Increase the size of the European Financial Stability Facility (EFSF), which is designed to isolate Greece so that contagion doesn’t spread elsewhere. After all, the ‘bad’ sovereign debt is not just from Greece, but from Italy, Ireland, Portugal and Spain as well. If Greece did default, there could be a chain reaction of lower market values for the bonds of the rest of the PIIGS countries, creating an even direr situation for European banks than they are in already.

Even with this acknowledgement that the bill of the last 18 months has finally come due, this more consistent and comprehensive framework is worthless if it is not accepted and acted upon, and that is the unfortunate situation we have seen unfold this week. After a huge initial relief stock market rally last week following the announcement of the plan, its worrying lack of specifics led to several key questions: Where will the ‘bad’ balance sheet assets go? Where will the funds for the EFSF come from? From China? From Japan? From the IMF? Will the European Central Bank (ECB) be forced to expand its balance sheet and print money to bridge the gap (something they have so far refused to do)? Ominously, yields on Italian sovereign bonds have continued to rise, just as an Italian, Mario Draghi has taken the helm of the Central bank from Jean-Claude Trichet.

Perhaps the most important question is whether the people will accept it. Even though they have acknowledged the issues at hand, many do not want to accept the actions that are necessary in order to curb their inordinate debt. So far, Josef Ackermann from Deutsche Bank has said that his bank will do everything possible to avoid a forced recapitalization. And in a surprise move, Greece’s Prime Minister called for a popular referendum, allowing Greek citizens to vote on whether to accept the new debt deal, a move that has since been called off. If the process becomes disorderly, a global banking crisis could quickly materialize. Even if a crisis is avoided, the EU appears to be on the cusp of slipping into a recession, which will act as a drag on the global economy. The ECB today cut interest rates in response.

Beyond the immediate concerns, the final piece of this picture, yet to be articulated, is whether the EU will enact the necessary structural reform to ensure that the single currency system will remain a viable proposition once today’s fires have been put out. Governments and citizens will have to make hard decisions and sacrifices about whether greater fiscal integration is required across so many diverse countries to underpin the Euro dream.

While we don’t know where and how this will all ultimately end, we expect more drama to ensue. Balentine has been proactive regarding the investment implications of the European situation since we first wrote about it. We have held no direct European equity indexes since early 2010. Additionally, we pulled assets out of money market funds with any exposure to European bank bonds in June of this year as the situation continued to deteriorate. Indeed, the European Union crisis remains a key component of our heightened risk level over the last few months across all strategies. The thin silver lining is that this volatility is creating investment opportunities on which we can begin to capitalize. We will continue to keep you informed about our views on this situation and its effect on our policy, and we encourage you to ask any questions you may have.

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