Greece is a small country, representing only 2.5% of Europe’s GDP – about the size of Delaware when compared to the US economy. Though relatively small, Greece’s troubles make the nightly news and influence world markets. Rioting in the streets, confidence votes, and parliamentary austerity negotiations are all part of the drama.
Its large debt to GDP is mostly held by Greek banks, other euro-governments, the European Central Bank (ECB), and the International Monetary Fund (IMF). Additionally, German banks have over $20 billion in direct debt to the Greek government. French banks have $15 billion out to the Greek government. French banks also have loans to companies and individuals of $42 billion. While not insignificant, it is less than 2% of the combined GDP of Germany and France.
The concern is that a Greek default would be a European equivalent of Lehman Brothers, being the first of many other defaults with world-wide implications. While the direct debt is manageable, it is challenging to measure the potential ripple effects. That uncertainty unnerves financial markets. The ECB has been reluctant to openly discuss a restructuring, which Greece clearly needs, for fear of triggering credit default insurance. Five year Credit Default Swaps for Greece at 22% are currently the most expensive in the world (twice those for Pakistan and nearly three times for Ireland and Portugal). A "voluntary" restructuring proposal by French banks, and being considered by German banks, would try to avoid triggering credit default insurance. The rating agency Fitch, however, recently indicated that it would consider any voluntary debt rollover as a default. Nevertheless, a Greek default would not surprise the financial system as did Lehman’s collapse. Counterparty risks would be easier to identify, and costs would not be large. Interbank lending would suffer, though, at least temporarily.
Although Chinese leaders have expressed some support, it would be a mistake to think that China will come to the rescue. It is in China’s interest to have a stable Europe. However, if some of the participants decide to go their own way, China will not interfere. China is clearly diversifying its investments. It is estimated that China has purchased $57 billion of euro denominated assets this year, some of which are in peripheral economies. It is unlikely they will invest much more, particularly if it is perceived to be a lost cause.
We have heard the expression "kicking the can down the road." The serial rescue packages for the troubled European peripheral countries (Greece, Portugal, Ireland) have allowed the banks to unwind some of their exposure (and put it onto the ECB and IMF). Although the Greek rescue is being conducted in tranches and is being dragged out, the fundamental debt problem is not being resolved. Interestingly, high interest rates, currently 20%, are not pricing in an immediate default. But, Greek yields are pricing in the near-certainty of a default by mid 2013. By any measure, the outlook for the Greek economy is grim. The country has years of austerity and, if not recession, at least very slow growth to look forward to, with no hope of growing its way out of its problems. They will need debt relief and painful restructuring to make their economy competitive.
The euro still looks vulnerable to ongoing uncertainty, not only because of Greece’s immediate problems, but from the ongoing search for solutions to the debt burdens of the European peripheral countries, as well. We see more upside for a safe haven like gold.