Greece – will it all end in tears?

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The rampant violence and social unrest at Syntagma Square in front of the Parliament in Athens tells a tale of EU riches gone wrong. The dream of rich lifestyle, strong currency, single common market and above all an easy life have all come unstuck. The Government has been firing tear gas with an alarming regularity in a week where the Greek capital has witnessed extraordinary scenes of violence.  The people are protesting against the fiscal reforms and spending cuts and are not convinced about the economic reform measures.

All this creates a climate in which young people are struggling to see a future. Wages are low, the cost of living is high and they are wondering how they will find jobs. This generation is now looking for answers from the country's politicians, and they are not getting them from New Democracy and PASOK, which have ruled Greece since 1974.  The unemployment rate is currently at 16% with a total labour force of 5.5million.

So what's the problem in Greece?

Years of unrestrained spending, cheap lending and failure to implement financial reforms have left Greece in a financial mess. Greece currently runs a fiscal deficit of 10.5% against the EU limit of 3%.  Only 5000 people out of total workforce of 5.5 million declare income in excess of USD140,000p.a.!! Almost a million have managed to retire in their 50s while the official retirement age is 61 (rest of EU 65) with full state pension through nepotism.

Such is the state of tax evasion and corruption that almost USD 20bn is lost annually in tax collection as tax returns are accepted as filed facilitated by backhanders!  That amount represents 15% of its total revenues.  Technically Greece could run a surplus with proper tax administration but corruption is so deep rooted that it is nigh impossible!!

How big are these debts?

Greece’s debt (at USD 470bn), already the biggest in the euro’s history at 143 percent of gross domestic product last year, will jump to almost 158 percent this year and 166 percent in 2012 as per the European Commission.

Greece was badly exposed when the global economic downturn struck. Greece’s Finance Ministry blames the deeper-than-forecast recession for the government’s failure to meet its 9.4 percent deficit target last year and for a 1.9 billion-euro revenue shortfall in the first four months of 2011.  Greek GDP contracted 4.5 percent last year. The economy is forecast to shrink 3.5 percent this year, according to today’s report.

So what happens now?

The government next week will submit to parliament a 76 billion-euro package of spending cuts and asset sales to help meet its fiscal targets. The government has started slashing away at spending and has implemented austerity measures aimed at reducing the deficit by more than €10 billion ($13.7 billion). It has hiked taxes on fuel, tobacco and alcohol, raised the retirement  age by two years, imposed public sector pay cuts and applied tough new tax evasion regulations.

The country faces two pressing issues. First, although the fiscal deficit was reduced to 10.5% of GDP in 2010 from 15.4% in 2009, this year has seen a renewed deterioration due to weak revenue collection and higher-than-targeted spending. New austerity measures to cut EUR 6.5bn in 2011 and altogether EUR 28bn over five years need to be agreed.

Greece's credit rating -- the assessment of its ability to repay its debts -- has been downgraded to junk status, meaning it will likely be viewed as a financial black hole by foreign investors. This leaves the country struggling to pay its bills as interest rates on existing debts rise.

So in short, it has liquidity problem and solvency problem!  A state on the verge of declaring default!!

A Greek default is just a matter of how and when 

Greece was bailed out a year ago to the tune of USD150bn EU/IMF bailout, Greece has the lowest credit rating of any sovereign state (CCC at S&P) and the most expensive debt to insure (5Y CDS above 2,000bps). The government promised to slash the budget deficit - the annual shortfall of state spending minus the tax take. 

Yet lenders still didn't believe the country could service its existing borrowings. The debt pile Greece had already built up was just too great.  So they slashed the value of Greek government bonds, driving up the yield. If Greece tried to borrow today, it would have to pay up to a whopping 30% p.a as interest!! That indicates just how little faith investors have in the country's ability to repay any loans. Small wonder.

By the end of this year, the Greek government will owe over 150% of the country's annual output, reckons the International Monetary Fund (IMF). By 2016, even with huge state spending cuts, that figure will only have fallen to 146%.

History shows that once a country's debt/GDP ratio rises above 150%, a default is just a matter of time. Greece is going to be no different.

What will it really mean for investors if Greece goes bust? 

In other words, Greece is about as bust as can be. Trouble is, Europe's finest can't agree on what to do about it. The EU authorities want to buy time, first to allow European banks to rebuild their capital bases, second to give Greece the opportunity to enact structural reforms that could boost the country’s productive potential, and third, to allow the other peripheral countries to strengthen their finances so that they have some protection in the event of the crisis escalating. As time passes, official creditors will hold a higher share of Greek debt and so will remain reluctant to trigger a debt default.

But Germany isn't keen. It wants private investors in Greek debt to take some of the pain as well. And the Germans are trying to delay a second bail-out package until September, according to Reuters yesterday.   And the French are preparing to extend the maturing debt into new 30 year term facility.

Unfortunately, time is running out fast. Protests against cuts on the streets of Athens are getting nasty, and could pull the government down. That increases the risk of a 'disorderly' default, where Greece just turns around and tells its creditors and the rest of the Eurozone where to stick their austerity. 

Could Greece become Europe's Lehman Brothers? 

What happens then? Let's look at who's got what on the line. 

At the end of 2010, according to data from the Bank of International Settlements (BIS), Italian banks held $2.3bn of Greek debt, and UK lenders were in for $3.4bn. They should be able to cope with those losses. 

But then the numbers get much scarier. French lenders held $15bn of Greek sovereign bonds, while German banks were exposed to more than $23bn. The total for European banks was $52bn.  This does not include the ECB debt, which itself has bought €47bn-worth of Greek bonds in a failed attempt to boost confidence in the country. It's become an enormous dumping ground for bad loans. No expert can say how it can jettison these without dealing a fatal blow to the European banking system.

On top of this, exposure to Greek banks in emerging Europe "is rife". Greece's banking sector is largely Romania's and Bulgaria's banking sector. Subsidiaries of Greek banks in these countries have accounted for a large slice of domestic lending. As these subsidiaries are forced to send more money back home, the least bad outcome, is that lending will collapse in Romania and Bulgaria. That would be damaging for growth. 

But if those Greek bank subsidiaries run out of money, they in turn could be forced to default. And in a mad scramble for cash, that could lead to the worst-case scenario: "a fire sale of emerging European assets". 

And then there's the question of what happens to all the credit default swaps (CDS) written as insurance against Greece going bust. If Greece defaults, would the banks who wrote this insurance be able to pay out? 

This may all sound familiar. That's because we've seen it before. The probability of a Euro Zone “Lehman Brothers” moment is increasing. Markets are looking at a scenario of a Greek debt default becoming disorderly. 

The big worry is that, as happened with the Lehman collapse in 2008, banks will stop trusting one another as fears over exposure to the country's debt contaminate the Euro Zone.  'Counterparty risk' will become an issue once again, as banks that once looked credit worthy will have their capital eaten up by Greece-related debts going bad. So banks will stop dealing with each other - which is key to a functioning economy.

Finally, the combination of defaulted bonds and a likely acceleration of withdrawal of deposits from Greek banks would place the Greek banking system under particular strain.

The pressure to abandon the euro would doubtlessly increase from some Greek politicians and public – an apparent “quick fix‟.

You are beginning to see a - very, very messy - picture by now. Eventually a disorderly exit of Greece from Euro. And it's likely to prove to be bad news for the Euro. 

So where are the safe havens?

Clearly, GOLD is one. If ever there's a time to stick with it, now is that time. 

The other is less obvious. America is hardly trouble-free, as reflected by the weak dollar. But compared with Europe's looming woes, US's problems are small. The Euro land outlook has to be dollar-positive for the balance of 2011. 

In summary, tighten your seat belts for a bumpy ride!!! And REMEMBER...CASH IS KING!!!