Greece will default--when it's in the country's self interest sometime in 2012
09/23/2011 8:30 am EST
Certainly not before next week. (How’s that for optimism?) And almost certainly not before December.
But the financial markets are still pricing in a default by Greece on its government debt—with all the chaos that would produce in the Greek economy and banking system and rippling outward to the rest of Europe and then the world—sometime within the next five years.
Want to know when? I think you can get a pretty good idea by looking at the self-interest of the major parties involved—Greece and Germany. Greece will default when the self-interest of Greece is clearly weighted toward default or when the self-interest of Germany is clearly weighted toward allowing a default.
The self-interest of Germany argues for a relatively early default. Not December but in the first half of 2012. The self-interest of Greece argues for a somewhat later default. Say, half way through 2012 or a bit later. But both point me toward 2012.
Here’s how I get to this time line.
Everybody—myself included--looks at the pain and disruption that would be caused by a Greek default and says, Nobody wants that to happen. A Greek default would be much larger than other recent defaults in Argentina in 2001 or Russia in 1998. Greek public debt now comes to about $500 billion. Argentina’s debt when it defaulted was $82 billion and Russia’s $79 billion.
The size of Greece’s public debt assures that the consequences of a Greek default would ravage the Greek economy. Inside Greece, banks would face huge losses on bonds in their portfolios, and would have to close their doors until somebody—but who?—recapitalized them. The economy would grind to a halt with some projections putting the contraction in GDP at upwards of 25%. ATMs would stop working. Business credit would dry up and businesses would shut their doors. . The government would be unable to pay its bills.
But the damage wouldn’t stop at Greece’s borders. Bond buyers would flee Italian and Spanish government bonds, requiring the European Central Bank and the European Financial Stability Facility—if it’s set up by then—to pour billions into buying those bonds to support the markets. European banks would take a huge hit as the value of Greek government and corporate debt in their portfolios plunged. Big banks and insurance companies in Germany had a total exposure of $33 billion to Greek government and corporate debt as of the end of March, according to the Bank for International Settlements. French banks had exposure to Greek public and private debt of almost $80 billion. That exposure is not spread evenly. In France much of it is concentrated at three big banks, Credit Agricole, Societe Generale, and BNP Paribas. In Germany the government set up bad banks as part of its bailout of Hypo Real Estate Holding and WestLB. Those bad banks hold more than half of all the Greek debt held by German banks and would undoubtedly need another infusion of taxpayer cash.
Exactly how far the damage would spread depends on the degree that bond markets would punish the bonds of Ireland, Portugal, Spain, and Italy. The exposure of U.S. banks to Greek debt alone is relatively small but U.S. banks have $670 billion in exposure to all five of the PIIGS group.
And it depends on whether a default would force Greece out of the euro. That’s not an inevitable result. Greece could default on its huge debt to banks but pay its relatively smaller debt to international creditors such as the International Monetary Fund, the European Union, and the European Central Bank. Those institutions might even see a capital infusion into Greek banks—along with a process that rolled up bad banks under new, perhaps overseas ownership—as a better alternative than the end of the European Monetary Union. The consequences of a collapse of the euro would be huge on even a strong economy such as Germany. UBS estimates that a collapse of the euro that found Germany on its own could produce a drop of as much as 20% to 25% of German GDP in the first year after a breakup.
Those scenarios seem so grim that it’s hard to imagine any rational politician steering his or her country into that storm. And that’s been the strongest argument—one that I’ve made on more than one occasion—for saying that Greece won’t default and Europe will figure out a way to rescue the country from its debt spiral.
But there is another way to look at the “Why would Greece default? question. International Monetary Fund economists studying past sovereign defaults came to a conclusion that turns any approach to answering this question on its head. Turns out that in past defaults, and the economists looked at defaults by Argentina, Ecuador, and Indonesia, countries defaulted when the country saw that a default was in its best interest.
There are lots of ways of defining “best interest.” Greek politicians could decide that default is in the best interests of the ruling Socialist party of Prime Minister George Papandreou or of the opposition New Democracy party if it would help them win the election that looms on the horizon. The government might decide that it’s in Greece’s best interests to default if the demands of the Troika—the International Monetary Union, the European Union, and the European Central Bank—have become so onerous that Greece can’t meet them. Greek leaders in and out of government might decide that the level of violence in the streets had reached a height that made a default the least worse alternative.
But the economists discovered a less subjective measure that had a high predictive value in indicating when a country would default. It relies on something called the primary budget surplus. A country shows a primary budget surplus when it’s budget, without the interest that it is paying on its debt, is in the black. At that point, a deeply indebted country that has cut spending, raised taxes, and instituted other austerity measures often decides that the best way out of its hole is to eliminate those interest payments by defaulting on its debt. After all it’s the payments to creditors that are the problem, right? (Please note, I’m not talking about the accuracy or even the rationality of this view. If a country was deeply economically uncompetitive going into the crisis, it almost certainly still is at this point and writing off its debt isn’t a permanent fix.)
And guess what? On current projections Greece is likely to be running a primary budget surplus by sometime in 2012. Of course, it will still be struggling to pay the interest on its debt—with just about no chance of significantly reducing that debt. At that point defaulting on its debt starts to seem in Greek self-interest even against the backdrop of that scenario of dire consequences.
That timing gets even more convincing when you add in the self-interest of the European countries that are footing the bill to rescue Greece month in and month out. There doesn’t seem to be any end to this demand on their taxpayers. The costs of the rescue are deeply unpopular in most of the countries—notably the Netherlands, Finland, and Germany—that are paying the bills. The Greek rescue looks like it could bring down Angela Merkel’s government in Germany.
And did I mention there seems to be no end to the money taxpayers are being asked to pay out?
At some point the self-interest seesaw in one or more of these countries will tip toward a Greek default—even against the scenario that I painted above. It doesn’t have to tip in every country in the EuroZone; in fact if it tips in Germany alone it would be decisive because the EuroZone doesn’t have the financial muscle to rescue Greece and control the threat to Italy without Germany.
So it’s very important to investors trying to understand how the Greek debt crisis plays out that Germany is far along with its plan to deal with the consequences of a Greek default. It created bad banks to handle the worst portfolio problems of its shakiest banks as part of its solution to the global financial crisis of 2008. Its biggest banks, Deutsche Bank (DB) and Commerzbank (CRZBY) hold a comparatively small $4.7 billion in Greek debt. And the country sees an open-ended commitment by the European Central Bank to prop up the bonds of Greece, Italy, and Spain as a one-way ticket to financial hell.
At the same time I think Germany understands that it is in its own self-interest not to destroy the euro. The economic consequences of giving up a weak currency for a strong Deutsch Mark on Germany exports would be immensely negative. And it would be extremely hard to prevent the current crisis from engulfing not just Italy but France without the EuroZone.
But once the European Financial Stability Facility is in operation and once Germany’s Plan B to stabilize its banks is in place, then I’d expect to see Germany begin discussions with Greece, the European Central Bank, and other EuroZone members on how to let Greece default and yet preserve the euro.
Those discussions would be in Germany’s self interest. And in the self-interest of Greece too.
Look for them sometime in early 2012. Look to see if the steps to control the spread of the consequences of any Greek default to Italy, etc. are credible—that’s the key to the reaction of global financial markets.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/