Tuesday, 13 September 2011

The Greek Debt Crisis


Greek.Debt.Crisis.

Those words have been repeated a lot over the past 2 years, and more so in the last few weeks signifying Greek debt is still not in order. One may wonder why a Greek debt crisis can cause a financial tidal wave of problems that could result in a global pandemic - that could affect an individual . Maybe even Zeus will have trouble paying the bills on his expensive thunderbolts he likes to throw.

Let's start with the basics. A government issues debt notes to be able to pay off their expenses. Expenses include the roads you drive on from maintenance or construction to payment of union wages. Notice I did not include an adjective behind "wages" to show my disgust at how high they are - I am trying to be objective. From the European Commission, government debt can be broken up into four sectors - Central Government, State Government, Local Government and Social Security Funds. Most European countries have the central government holding the largest portion of debt.  Debt holders can be broken up into non financial corporations, financial corporations, average households or non profits serving these households, and the rest of the world. Types of debt include currency/deposits, securities (usually being bonds), and loans.  The most common instrument used in Greece for financing is bonds.

So, let's apply all this knowledge into a micro example. We will use the American dollar as the exemplified currency, the fictitious city of Bocock, and the financial corporation of Eugene and Jungle. Bob and Suzy decide to place money into a mutual fund for their retirement.  So, they go to the offices of Eugene and Jungle where they consult with an advisor named Sophia. Sophia advises them that they can invest in a fund that has a 5% return each year, and is very low risk. Suzy and Bob love the idea of no risk, so place their entire life savings of $50 000 in, which results in a $2500 return each year. Sophia then decides to loan the $50 000 to Bocock through bonds, at a rate of 20% return each yeah.  However, Bocock develops social problems and over spends on them, resulting in a default and are unable to not only pay their interest obligation, but also the original $50 000. Since Bob and Suzy were the only clients of Eugene and Jungle, Sophia cannot use other capital to repay their money - and Eugene and Jungle goes bankrupt. Bob and Suzy lose their nest egg, and now must resort to rioting at G20 conventions to express their anger, and food stamps which costs the central government extra money.

The example is overtly simplified, but it's easy to see the chain reaction. Now, let us consider the nation of Greece. The financial crisis and fear of Greek default have spiked Greek Bond Interest rates to nearly 40% in extreme cases, meaning for every annual dollar borrowed, the Greeks pay 40 cents in interest. This kind of interest rate is completely ridiculous, and even if the interest rate dropped to 25%, the nation would have a hard time paying the returns. Lets looks at some statistics. In 2009 Greek budget deficit was 12.7% of GDP and overall debt 113% of GDP.  For 2010, Greece GDP was EUR 230 Billion, with inflation around 4.7% climbing past 5% as most models indicated. Unemployment rates have soared to around 17%, while the OECD announced a more conservative estimate of 14.3%. Currently, the Greek debt to GDP is an astonishing 145% or so, which shows a rather large increase from 2009.

How did these numbers come about? Ridiculous spending caused by an antiquated government showing no fiscal restraint, cheap lending brought about by the Euro, and fancy accounting by Goldman Sachs. Wait, did I say Goldman Sachs helped cause this? Yes, I did. Basically Greek debt managers created cross currency swaps which the government in which the government debt in yen and dollars was swapped for euro debt, and was exchanged later.  Basically, Greece would issue a bond for a million dollars, and the swap allowed Greece to get 1.1 million worth of Euros right away, but had to pay as many euros back plus interest. Noticed I said dollars before in the bond issue.  Officially, Greece borrowed only a million, but actually they borrowed 1.1m. Italy has been doing the same thing, and Germany did something similar and most other nations probably have done it as well. Financial schemes such as this have skewed statistics. This is why regulators and policy makers were unaware of the reality of the debt crisis, and why headlines read constantly "Crisis worse than thought".

So now what? Well Greece has passed austerity packages. What are they? Cuts in spending and tax increases. Cuts in spending mean large union cuts, no union pensions, no union benefits, and in some cases no union jobs. Are people happy about this? Not exactly, that's why we have nice pictures of police throwing tear gas at angry mobs. Will it work? Probably not. With the fear around the market and rising Greek interest rates, it is probably impossible for Greece to pay back their loans with interest payments being the largest portion of government expenditures. Also, with additional taxation and an underdeveloped private sector - it is doubtful Greece has the resources to improve their GDP to pay off their debts.

So Greece, like Bocock,  defaults.

Now what?

Well like the example, the investors of Greece now lose their investment. Countries like Germany who have heavily invested in Greece to keep it from falling, institutions like the ECB which is rumoured to be using leveraged funds to lend Greece money, and financial corporations like many banks in France who have taken the risk of investing in Greece due to the reward of high interest rates - all stand to lose a lot of money. What happens when they lose a lot of money? Well, Germany hikes taxes to make up for the loss causing Adolf to get angry because he has less money to spend on hobbies such as spreading Nazi paraphernalia (it was a joke ok?). The ECB which collects money from member Euro states has to collect more money, so all Euro nations raise taxes to pay for the Central Bank's loss.  Jacques can't buy as wine and cheese anymore because Societie Generale lost a ton of his money from investing it in Greek bonds. 

That's it? Nope. Something called contagion, or fear beings to spread globally. Fear in the high debt to GDP ratios of other G20 countries especially the United States which freezes up credit supplies. Basically, lending by banks contributes to a phenomena known as the money multiplier effect - artificially inflating spending power. With less credit, businesses are less flexible and have to cut down. Market interest rates increase due to credit being difficult to find (less supply  = higher price) and consumers are less inclined to buy houses with higher payments on mortgages or cars with higher interest rates.

And that my friends is what this crisis is about.

The question you should be asking is how to make money on this. Well, find a broker that allows you to short. I recommend shorting any French bank specifically Societie Generale (on the Pink Sheets would be tough to find a contract there). Find financial institutions that are exposed to Greek debt - I believe Goldman Sachs, and Citi would be decent shorts. Remember, this is all short term - they'll be a bottom eventually. Forex traders should take comfort in selling Euros and buying the American dollar, as the dollar should increase simply because the American's state is less terrible then Europe's - at least temporarily.
Macro Advice? Ask David Cameron and the Brits. They know how to cut partisanship and make cuts. That's the model that must be followed.  

24 comments:

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