During the past few months, there has been concern in the global economy that some countries in the European Union will not be able to honor their debt obligations due to their rapidly increasing budgetary deficits. In the case of Greece, in December 2009 they announced a budget deficit of 12.7% of GDP which was a result of existing budget deficits, election year spending and a stimulus plan created in response to the financial crisis. European Union member nations are supposed to keep their annual budget deficits to no more than 3% of GDP. Other countries that also may have issues with their budget deficits are Portugal and Ireland.
In response to this budget deficit, the yields (interest rate) on Greek bonds increased from 3.5% to 8% within months. Even though the the Greek government has wisely financed this debt over the long term, it still has to roll over US $30 billion in debt maturities and finance a US $30 billion deficit - for a total US $60 billion in annual funding requirements.
Last week, stock markets around the world moved lower after ratings agency Standard and Poors downgraded it's sovereign credit rating for Greece to "junk" status and also lowered Portugal by two notches. The downgrades reflected growing fears that the southern European governments will prove unable to implement promised reform measures in the face of determined domestic opposition, raising the danger of the sovereign debt crisis spreading to the world’s major economies.
With the adoption of the Euro, Europe's weaker countries like Greece, Spain, Portugal, Ireland and Italy saw their interest rates converge with the rest of the Eurozone falling from double to single digits. This interest rate decline triggered housing booms, leading to rising employment, growth, wage inflation, bigger government and more generous pensions and entitlements. This debt-financed growth was funded by financial institutions in the core countries of France and Germany, which enjoyed strong exports.
Germany and France ran current account surpluses (exports more than imports) while the countries on the periphery of the Eurpzone ran deficits. The surplus countries funded the property booms in the periphery. These imbalances were masked by the single currency, because the Eurozone as a whole was running current account surpluses. The access to funds for the borrowers is being cut off and these countries need to re-establish its competitiveness compared to Germany, but they lack the option of currency devaluation. As a result, wages and asset values in these countries need to fall, and this will be accompanied by government cutbacks and lower growth.
This past weekend Greece was able to secure a US $150 billion bailout that will help protect the country from debt speculators and restore confidence in the ailing Euro. The EU is contributing $80 billion of the total at an interest rate of 5% while the IMF is supplying the rest. These lenders have demanded sweeping reforms in Greece that will most likely cause the recession in Greece to last longer and cause a social backlash. This will include tough spending cuts and tax increases. The measures will include the extension of a public sector wage freeze until 2014, the elimination of a bonus equivalent to two months salary for many civil servants, a sin tax and a boost in the value added tax (similar to GST in Canada) from 21% to 23%.
Many critics would argue that there is no need to bailout a country which has brought on a lot of it's current difficulties itself. However, saving Greece from bankruptcy may be necessary for preserving the European economic union, countries have an even more compelling reason to prop up the debt-ridden state. Foreign banks are exposed to $236.2-billion (U.S.) of public and private debt in Greece, nearly a third of it ($75.2-billion) held by French banks. A Greek collapse would ripple throughout the EU and beyond.
When looking at the situation in Greece one must keep these events in context. A US $150 billion dollar aid package for the country is still smaller than the US $173 billion bailout of AIG - much of which went to Bear Stearns and a number of European banks.
WHAT ARE THE GLOBAL IMPLICATIONS
The Greek crisis highlights several important global trends. First, investors are now more attuned to sovereign credit risk, especially for countries with more generous social welfare schemes. The financial crisis resulted in a double hit to government finances through lower revenues and costly stimulus schemes, with the result that debt-to-GDP ratios have soared by 20% across the board.
In the same vein, differentials in the credit risk between countries are now becoming more pronounced. For example, Canada is perceived to have kept its fiscal house in relatively good order, so Canadian government bond yields are 30 basis points less than their U.S. equivalents. These shifts will continue. "(higher yields are attached to more risky bond issues)
The recovery has a structural weakness that poses a potential risk for investors. Government authorities have fired both fiscal and monetary bullets at the financial crisis. They appeared to have hit their mark, but there are no bullets left.
Source: Signature Global Advisor, World Socialist Website, Globe and Mail, Bloomberg News
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