“Lord make me chaste, but not yet” St. Augustine …..
Robert Farago di Schroders
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It is clear to all that Greece will eventually default on its government debt in some way or another. Indeed, Standard & Poor’s rate the country’s bonds at CCC, ranking it 131st of the 131 countries that it covers. Yet last week saw the markets swoon as unrest on the streets of Athens triggered a no confidence vote in the government, increasing the odds of an imminent default.
Our baseline economic view is that the recent stream of poor economic data is due to a mid-cycle slowdown, exacerbated by supply-chain disruptions due to the devastation in Japan. If we are right, the economy should rebound in the second half. This would be positive for equity markets and negative for government bonds. However, this week’s political crisis in Greece adds a new risk into the equation.
Up until now, the drama in Europe has been acted out by members of the ECB, the IMF, the European governments and their central bankers. Each has a different agenda, but they all speak the same language and understand the risks of their collective actions.
This week’s announcement of a vote of no confidence in the Greek government has brought a new player into the act: the crowd gathered in Syntagma Square, Athens. The people gathered in the square come from different backgrounds and their motives are diverse. However, they are unified in their distrust of the politicians and bureaucrats who are deciding their fate. For now, the politicians across the spectrum in Europe’s periphery are broadly pursuing an austerity agenda according to the IMF script. But this is not what the crowd want to hear. The risks of an unexpected outcome have increased and this is unsettling the markets.
It is clear to all that Greece will eventually default on its debt. It is only the timing and method that remains uncertain. An orderly restructuring is in everyone’s best interest and is our central scenario. The worst case scenario of a disorderly default that triggers contagion across the European banking and sovereign debt markets appears unlikely. We believe that the amount of Greek debt still held in private institutions is too small to trigger a systemic problem. The hit to these institutions from a default is already discounted in markets. This, and other factors, should prevent disruptive contagion in the event of default. Still, this assumes that the authorities make the right choices in the event that this crisis worsens. In addition, we know we will see turmoil in financial markets next week if the Greek government does fall.
Three problems with delaying a resolution
1 – A delayed recovery
It is somewhat counter-intuitive that financial markets are hoping for a delayed resolution to the peripheral debt crisis since the delay increases the problem in a number of ways. First, the history of sovereign debt crises tells us that those countries that are quickest to recognise the problem and recapitalise their banking system are also the quickest to recover. This was the experience of Sweden, Finland and Canada in recent decades. In contrast, Japan took more than a decade to deal with its banking crisis and continues to suffer the deflationary consequences. This delay means that Europe is likely to face a prolonged period of sluggish growth. In turn, this will make it more difficult for indebted countries to grow their way out of their debt burdens.
2 – A growing debt burden
“Instead of restructuring the manifestly unsustainable debt burdens of Portugal, Ireland, and Greece, politicians and policymakers are pushing for ever-larger bailout packages with ever-less realistic austerity conditions. Unfortunately, they are not just “kicking the can down the road,” but pushing a snowball down a mountain.” Ken Rogoff, 3 June
Second, the current approach is to provide additional loans to the indebted countries. This solves their immediate liquidity needs but increases their debt burden. As Ken Rogoff has pointed out, this is not kicking the can down the road but rolling a snowball down the hill. It risks a bigger crisis down the road.
3 – An increasingly hostile political backdrop
“The chances of reaching a positive resolution are getting worse with the passage of time rather than better… Instead of
integration you actually have political disintegration, differences of opinion, and that’s why I think the time is against you. I think there is a resolution; and probably under the pressure of a crisis a resolution will be found. But the sooner it is done, the better it would be, and the solution would be better and less expensive.” George Soros, 14 June
Third, the longer the delay in tackling the problem, the greater the risk that the political backdrop becomes more challenging. This is what we are witnessing in Greece this week.
Two reasons behind the delay
1 – Fear of contagion across the financial system
So why is a Greek default being delayed? This conundrum is explained by two factors. First, the complexity of the inter-connected European financial system remains a threat despite our belief that any damage can be contained. The delay will provide time for the banks and governments in the rest of the euro area to be restructured and recapitalised. A period of economic growth will help this process. The hope is that we will get to the point where we can be very confident that a default in Greece has limited impact on other country’s financial systems. The fear is that the euro zone is a complex, tightly coupled system and these are always prone to failure*.
2 – A gradual move to political integration
Second, we remain some way off a sustainable long-term framework for the euro. Greater fiscal and political integration is required. This is politically challenging and will take time. Voters on both sides of the current crisis – the tax-payers of the wealthy core and the suffering periphery – are questioning the benefits of deeper integration. Over the last two years, a series of crises has allowed the authorities to push through changes in this direction. As pointed out above, the political backdrop is changing and this gradualist approach is under threat.
The next two weeks sees a meeting of the European heads of state and a Greek government vote on their fiscal strategy.
We expect that, once again, the period of market stress will provide the stimulus for compromise to be reached. This will allow Greece to meet its next treasury bill payment on 15th July. We have already seen German Chancellor Angela Merkel signalling a willingness to take a softer line on bank bondholders in order to resolve the crisis. Still, they say a week is a long time in politics. The next fortnight will see many twists and turns.
The views and opinions contained herein are those of Azad Zangana, European economist, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored.
Source: IFAWorld – Schroders