Some areas of the media have been trying to outdo each other with hype over the financial mess which is modern day Greece, with melancholy scenarios for the global economy.
This paper provides an antidote to manic behaviour and focuses on the current state of global financial affairs and what a default by Greece on its debt a scenario that the market has already priced in – would mean for you.We have always espoused that markets are forward-looking and prices today reflect expected outcomes. That is certainly the case with Greece.
What is happening in Greece today?
In October 2010, we wrote a paper discussing the situation in Greece:
After the International Monetary Fund (IMF) and European Union (EU) bailed out Greece last year, the Greek Government has failed to follow through on many of the pledges it made and there are grave doubts about its capacity or willingness to deliver.
Standard & Poor’s, the international ratings agency, has subsequently cut its rating of Greek debt to CCC, only two notches above default. Markets expect Greece to default and this has been reflected in recent prices – two-year Greek Government bonds by late June were yielding around 26%.
There is much debate between the IMF, EU and European Central Bank (ECB) on how to structure future bail outs of Greece. However, fundamentally, nothing has changed since late 2010 about Greece being effectively bankrupt.
Would a Greek default act as a contagion across Europe?
The ECB has warned that a Greek default could spark “contagion” across Europe, causing Greek banks to implode and inflicting major damage on the big banks in France and Germany. Countries such as Spain, Ireland and Portugal, which also have high levels of government debt, could be adversely impacted.
Willem Buiter, the chief economist at Citibank, is regarded as an expert on financial crises. He has rejected dire economic forecasts for Europe, but notes several courses of action that would be calamitous for Greece.
Mr Buiter warned against suggestions that Greece should split from the EU, default on its debts and recover by devaluing its new, standalone currency (which would make its exports more competitive). This action would likely cause a run on its banks, followed by the collapse of its banks and corporate sector. Greece’s future still lies in Europe.
We need to remember that the EU single currency experiment is just over a decade old, and this is the first real financial test of the blueprint. EU nations effectively are being forced to make decisions on the run on how country-specific issues should be dealt with by other members. Mr Buiter predicts that a default by Greece in the next few months will result in a cosmetic restructuring of its debts, followed by similar restructuring of debts in other struggling EU countries. This would buy the EU a year to more effectively structure the debts of troubled countries.
He also predicted that the European Central Bank has sufficient reserves to get Portugal, Ireland and Spain out of trouble. He further labelled as ‘scaremongering’ comparisons by the ECB of Greece to Lehman Brothers.
While the collapse of Lehman had not been widely predicted by the market, a Greek default has been and is reflected in current prices. Lehman also had a larger balance sheet than Greece and one that was also far more complex due to its exposure to derivatives.
We do not suggest that Willem Buiter’s predictions will necessarily come true, but it is a considered response amongst the sea of media headlines today.
What are the risks of a default in the U.S?
The IMF has quite rightly warned that the U.S and Europe must urgently get their debt issues under control. Despite this, the outlook for the global economy remains strong.
The world averaged annual growth of 3.2% from 1980 to 2010, but the IMF is forecasting growth of 4.3% in 2011 and 4.5% in 2012. China and India are significant contributors to this growth, but we must also remember that the G7 leading industrial nations now account for around only 30% of the world’s growth. This is an example of how quickly we can lose perspective.
US federal debt will reach roughly 70% of Gross Domestic Product (GDP) by the end of the year, the highest percentage since just after World War II. That figure compares with a debt level of 40% of GDP at the end of 2008, which compares favourably with the 40-year average of 37%. In contrast, Greece’s debt is around 150% of GDP at present.
In the U.S, a two tiered approach is underway, with a down payment of debt initially, followed by a longer-term agreement. The focus in the U.S is on a corporate tax overhaul, a weak US Dollar accelerating exports and other measures to encourage new investment.
We must always be mindful that the U.S and many European countries have large populations that enable them to increase taxes to manipulate their budget in a way simply not available in Greece, where widespread ingrained tax avoidance and an undeveloped tax collection infrastructure hamper efforts.
Looking at the current pricing of Australian and U.S Government debt, the market actually believes that Australia is more likely to default on its debt than the U.S. Also, the S&P 500 index (500 largest listed stocks in the U.S) returned just over 16% in the last 12 months, compared to the Australian market which returned around 2% (returns measured in local currency terms).
What happens if a country defaults on its debt obligations?
While this is a rare event, it can and does happen. There are two recent examples we can learn from.
How many people can recall August 1998 when the Russian stock, bond and currency markets collapsed and inflation was at 84%? This is a country of 140 million people, compared to just 11 million in Greece. The IMF provided loans to Russia at the time, similar to what they’re doing in Greece today.
Most of the decline in the Russian stockmarket occurred leading up to the default, as shown in the graph below:
Source: Dimensional Fund Advisers
Shortly after the default, markets started to gradually recover. But are the longer term outcomes dire? Not in the experience of Argentina, home to 40 million people.
Again, many probably don’t recall Argentina’s Government defaulting on its debt obligations in 2002. So how has the Argentinian stock exchange performed over the past decade? In U.S dollars, its stockmarket has returned 10.9% pa. This compares to around 7.8% pa in Australia over the same period.
It is important to remember that economic growth is not directly linked to bond or stock market performance, as our paper from October 2010 discusses:
The Russian and Argentinian examples demonstrate that markets are continually adjusting prices to reflect expectations, and a Government defaulting on its debts is not necessarily destructive to investment opportunities.
Is reading the daily business pages doing me any good?
Ian Macfarlane, the former Governor of the Reserve Bank (RBA), thinks Australians get too much news about the economy, and this surfeit actually worsens the decisions we make about investments. Over the past couple of decades the public has been inundated with economic statistics, he says.
”The newspapers and magazines are full of economic news, television reporting is saturated with it, there are special radio and television programs devoted to it.”
And there is a strong bias towards sensationalism and hype. Greece is in “chaos” and could endure a “financial catastrophe”. Interest rates don’t merely rise, they ”soar”, the exchange rate ”dives” or ”plunges” and budgets ”blow out”. It’s the nature of the news cycle and sectors of the media industry.
Macfarlane says a broad range of information is better than a narrower one, but more frequent information about a particular thing may stop us seeing the forest for the trees.As evidenced by the Russian and Argentinian examples above, none of the problems in the world today are new – they are just variations on a theme.
If your broker or financial adviser reads the Australian Financial Review (AFR) religiously each day cover to cover it may sound impressive, but does it really provide them with any additional knowledge or insight to help you achieve your goals? After all, most of the information in the AFR is at least 24 hours old.
The judgement and decisions of billions of people influence market prices. Taking an alternate view really begs the question, why? If your view is formed simply on what you’ve heard in the media, question their motives and ask yourself whether you are better off ignoring the business section and just focus on sport.
In summary, the events in Greece and Europe today are dire, but the world has seen similar and worse before. The expectation is that Greece will default on its debts. The known risks of today are already priced into fixed interest, property and equity securities, so reacting to media articles and making short term financial decisions inconsistent with your long term goals is unlikely to be in your best interest.
 Former adviser to Goldman Sachs, sat as an external member on the Bank of England’s monetary policy committee, and is a former professor at the London School of Economics.
 Citi Chief Upbeat Over Greece, SMH, Stuart Washington, 22 June 2011
 SMH, 23 June 2011
Other articles for this quarter:
- Are the Big 4 Banks a Guaranteed Great Investment?
- How the Icelandic People have Boldly Tackled the Legacy of the GFC
- Why China is so Important to Australia & Our Stockmarket
Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.