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Interim Report - Why Greece Mattters 5/03/10

"We are basically trying to change the course of the Titanic. People think we are in a terrible mess and we are."
Greece Finance Minister, George Papaconstantinou

Greece and a few other highly leveraged European economies have risen to the top of our worry list as the potentially most disruptive influence in an otherwise increasingly attractive overall global economic recovery. How can this be the case when Greece’s total annual value of all goods and services produced (GDP) represents approximately 2% of the GDP of all Euro based economies? If we make an analogy in terms of the U.S, Greece’s GDP is approximately equal to the economy of the state of Maryland as it relates to the GDP of the U.S. So why should we, as U.S. investors, be concerned about Greece’s current deficit problems? Two primary reasons come to mind.

First, watching the Greek financial crisis unfold, we have a perfect view of the startling rapidity with which financial contagion spreads like a wild fire through a parched pine forest on a windy day. Greece has been the most profligate spender among the 16 countries comprising the Euro region and is the highest leveraged. Its financial behavior is grossly in violation of European Union (EU) rules regarding acceptable levels of sovereign leverage.

The country suffers from many political and financial ills. Included in this partial list of woes are the following:

Tax evasion is a national pastime among the population and there is endemic corruption among its public officials
The country suffers from some of the lowest productivity in the Euro Zone while its politicians continue to promise its citizens increasing wage, health and retirement benefits without having the money to honor these promises
Greece must borrow more money each year just to pay the interest on its growing amount of public debt. Since the country is still in an economic recession and experiencing negative GDP growth, its debt burden will continue to grow despite the severity of whatever economic restraints are imposed upon it by the EU and the International Monetary Fund (IMF) in return for their bailout funds. In other words, no matter how severely the politicians clamp down on government spending, Greece’s financial picture will become increasingly dire every year for at least the next three or four years.
The politicians have hidden from EU authorities, (until very recently) billions of euros of off-balance-sheet financial liabilities in high risk derivative securities. Some of these “investments” offer the potential for unlimited losses over as many as the next ten to twenty years, making it impossible to ever derive an accurate reckoning of total unfunded government liabilities.
Liquidity in Greek bonds dried up prior to the agreed-upon bailout. Trading volume declined to approximately 200 million euros per day from 2 billion euros per day before the crisis blew up to current proportions. This means that those who wanted to sell government bonds couldn’t, and the government lost its ability to raise new funds from additional bond offerings
Greek banks own significant amounts of Greek debt, estimated at 45 billion euros. Concerned depositors are rapidly withdrawing their money from these banks out of fear that they will eventually collapse. Since a guarantee of deposits from a bankrupt government is less than reassuring, investor fears and concerns are becoming self-fulfilling prophecies.
The amount of money needed to pull Greece out of its downward financial spiral continues to escalate at a dizzying rate. Original concerns were focused on a formula through which EU member countries would help Greece meet its cash needs for the month of May, estimated at 15 billion euros. That discussion quickly moved on to cover the amount needed for the balance of 2010, including assistance from the IMF amounting to approximately 54 billion euros. Once Standard & Poors downgraded Greek debt to junk bond status, the view regarding the amount needed to stabilize Greece and restore its financial credibility, quickly changed such that funds now required would be approximately 145 billion euros over the next three years. This figure is sure to rise further in the coming weeks and months.
The economic reforms required by the country to bring its spending under control include multi-year wage and benefit reductions in the public sector; tax increases, sale of state-owned assets and the ability to fire more employees on the public work force. Unions are violently resisting the government’s efforts for additional reforms though strikes and threats of increasing civil disobedience. Tourist industry revenues, upon which Greece is heavily dependent, are being decimated. Unfortunately for Greeks, and people across the entire EU, the current crisis is just a few weeks into its genesis. As mentioned above, Greece’s severe austerity measures will need to continue for the next few years. Portugal, Ireland and Spain all face a similarly grim 3-years of austerity

S&P’s recent downgrade of Greek debt to junk status was followed by downgrades for Spanish and Portuguese debt as well. Borrowing costs for each of these countries has, as a result, risen sharply and with each downgrade European banks take an additional hit to their net worth. The natural reaction for banks caught in this situation is to hunker down, lend less to worthy borrowers, etc, etc. This crisis is following so closely on the heels of the last recession that people haven’t yet had time to forget how quickly events can spin out of control. The difference between this and the 2008 crisis is that today, the crisis is caused by the regulators and politicians. Nobody regulates the regulators and eventually the citizens have to pay the price of their misfeasance.

One of the promises that countries make when they join the EU is to keep their annual deficits at not more than 3% of their GDP. One year ago, Greece estimated its 2009 deficit at 3.7% of GDP. More recently the figure was revised upward to 12.7%. Then EU officials discovered omissions in Greece’s calculations which when taken into consideration have brought the deficit up to approximately 14% of GDP or perhaps even higher.

The current Greek crisis has illuminated a fundamental flaw of the EU and its common currency which stems from the disparate economic strength of its members and the lack of control by EU officials over their fiscal policies. For example, Greece’s low productivity and bloated public sector normally could be counterbalanced by currency devaluations were it not an EU member. Without the currency devaluation option, the country’s debt burden continues to grow as expenses mount and government revenues languish until bond markets rebel by refusing to lend more money regardless of interest rates offered. Every borrower eventually reaches a limit in borrowing capability. Greece has just discovered theirs. Portugal and Spain and Ireland are not far behind. There is a clear lesson here for the U.S. as well.

Our second reason why we at home here in the U.S. should be greatly interested in this unfolding calamity is because the financial problems of Greece mirror those of many other overleveraged, developed countries – including the U.S. We are simply a few years behind Greece in facing the market consequences of reckless use of leverage. Greece represents a very clear window to what the future holds for us if we don’t stop spending money we don’t have on new and expanded entitlement programs.

Should we encounter unexpected bad economic news, such as spreading contagion from the euro crisis, for example, U.S. tax revenues could plummet once again and we could experience debt to GDP ratios similar to that of Greece in a much shorter period of time.

These are some of the reasons why Greece matters.