Wednesday 13 July 2011

The Greek Debt Crisis and International Contagion

The Eurozone meeting in Brussels this past Monday confirms that the Eurozone leaders are as far apart as ever on reaching a resolution to the Greek debt crisis. Absent real decisions in the next two weeks, it is likely that contagion will spread not only to Italy and other Eurozone economies, but possibly to the United States and Japan as well.

In any turn-around management situation, the first priority is to diagnose the problem. Following this, a turn-around plan is needed which reduces the financial losses and focuses on creating income and profitability. The first plan for Greece, in the winter-spring of 2010, took far too long to agree, and then was flawed in that is maintained a deficit to 2015, but required a return to the markets even with small-scale Treasury borrowing in 2010.  The second plan for Greece, required by the IMF as a condition for lending, has still not materialised. In the meantime, Greece’s economic situation is worsening.

A key factor of a turn-around plan is to sustainably re-negotiate or restructure outstanding debt. There are two elements to this: reducing interest rates, and extending debt maturities. In a drastic situation, the debt is actually partially reduced, or a “haircut” occurs. These two elements, sadly, have not been addressed. The first bail-out package was a carte-blanche roll-over of private sector debt, with a 1:1 redemption rate and a higher interest rate payable by Greece on the EUR 110 billion sovereign loans. This was intended to buy time, but little else. It certainly didn’t buy confidence. The second bail-out has still not been agreed.

Over the past 2 days, judging by press reports, the Eurozone is debating a mix of policies which for the first time may lead to meeting the two conditions of a debt restructuring: interest rate reduction, and maturity extension.

One proposal under consideration is to use the European Financial Stability Fund to allow buybacks of national debt, presumably on the open market. It is not clear what effective discount this would deliver, since steady buying in large volumes would presumably eliminate the discount in time. Furthermore, it’s not clear what happens next: how long does Greece have to pay off the debt which would be held by the EFSF?

A second proposal, made by Mr. Martin Blessing, Chief Executive of Commerzbank, and reported today by the Financial Times, is to implement a 30% haircut on Greek bonds, and exchange the present bonds for new ones with a 3.5% yield and a 30-year maturity.  Again, it’s not clear whether this represents bonds which have already been purchased (or slated for purchase) in the EUR 110 bln bail-out, or if it refers to the remaining outstanding debt. In any case, this condition would be an excellent suggestion if implemented—far better than the French proposal.

The principle of private sector participation in setting the Greek debt crisis has been confirmed in principle by the Eurozone finance ministers, although the ECB remains opposed, and no one is quite sure what this means.

It is now extremely urgent that a resolution is reached, and it has to be reached in the next 2-3 weeks in order to calm the “bond vigilantes” and the wider debt markets. With contagion knocking on Italy’s door, and with the US embroiled in its own debt negotiations, the international climate is rapidly deteriorating.  Ireland and Portugal have been downgraded to junk by at least one rating agency (each). China’s growth is showing worrying signs of slowing: high inflation is observed alongside slowing imports. International sentiment is likely to worsen in the months to come.

A decision has to be made soon. Waiting until September, as German Finance Minister Schauble suggested, is the height of irresponsibility. 
Although news headlines have been dominated by the economic contagion affecting Greece, Ireland and Portugal, research by Navigator Consulting Group indicates that the public debt situation in major economies, including the United States, Japan, Italy, Belgium and France, is rapidly approaching the danger zone. This is exacerbated by the fact that in many countries, including the United States, the national debt has not been fully consolidated.

In the United States, for example, the debt:GDP ratio is already 98% at the Federal level. However, if state budget and local (municipal) deficits are added, as well as the sub-prime securities and mortgage-backed securities held by the Federal Reserve, then the true level rises to approximately 112% expected 2011 GDP (market values).

Federal Debt*
$ trillion
US Federal Debt
FY 2011 Deficit Forecast
Additional Debt: Federal, State & Local Systems
$ trillion
Federal Reserve: Mortgage-Backed Securities
Federal Reserve: Maiden Lane
US State Deficits, FY 2010
US Federal Deficit, FY 2011
Total Additional Debt
Total plus Federal Debt
2011 GDP Growth Rate Estimate
2011 GDP
* March 2011
Sources: US Congressional Budget Office; Bloomberg; US Federal Reserve; US Treasury

Of course, the US debt situation is not entirely similar to Greece for the following reasons:

a. It is not exactly clear what share of the Fed’s mortgage-backed securities are toxic or non-peforming, and what the actual market value of these securities are. In our opinion, the Fed’s practise of “investing” in these securities was as distortionary as the Greek government’s practise of guaranteeing the debt of state organisations such as the Hellenic Railways Organisation: it should be avoided if possible. (The same principle applies to the $ 5 trillion in mortgage guarantees issued by Fannie Mae and Freddie Mac: the government has in principle agreed to wind down these positions, but it is difficult to see how this will occur).

b.     A large part of the US debt is due to Federal government borrowings on the Social Security trust fund. In essence, one part of the government is borrowing from the other. Nevertheless, under standard debt consolidation rules, this has to be counted as debt (and does, in fact, count towards the current debate in raising the debt ceiling). Given the strength of demographic change in the United States, counting social security debt as central government debt is probable necessary.

c.     The United States dollar remains a global reserve currency; the US Federal debt remains a global safe haven in times of risk. It remains to be seen how much longer this situation will apply.

Each of these caveats about the United States, however, are overshadowed by the unfunded pension liabilities at the Federal, State and Municipal levels, as well as future costs of the Iraq and Afghan Wars. Together with declining competitiveness, a persistent trade deficit, demographic change and political gridlock in Washington, the future outlook is bleak.

By 2015, we estimate that the public debt in many leading OECD economies, including France, the United States, Spain, Belgium and Italy risk being in a range between 100-130% of GDP unless further, immediate structural adjustment measures are taken. The Debt:GDP ratio of Japan may exceed 220%.

The impact of higher public debt will have an immediate impact on a range of issues, including higher inflation, higher interest rates, and a crowding out of credit for private sector investments.

The situation is so fluid as to change daily. Italy has come under renewed fire this week, for perhaps the first time since the sovereign debt crisis began. The United States has a self-imposed deadline of early August before it reaches its debt ceiling and a technical default. Japan has been largely spared international difficulties, in no small part due to the fact that nearly all its debt is funded from national sources. But between demographic change, Chinese and Asian competition, the tsunami and a range of other factors, it is difficult to see a sustainable exit strategy in the next few years.

As a final note, my corporate and personal policy since late 2009 has been to diversify risk and take every step possible to protect assets. There is little in the economic forecasts of the next 2-3 years which has changed my opinion since then. I encourage everyone to take a very hard look at their financial situation, and see what the worse case scenario could be. It may be closer than we think.

© Philip Ammerman, 2011

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