Investors should prepare for Lehman-type moment

SERIOUS MONEY:FINANCIAL MARKETS have stabilised following the provision of co-ordinated support by the world's major central banks for the euro zone banking system. The decision helped to ease funding strains within the financial system that became evident through late summer and early autumn.

However, tension remains elevated and concerns that the Greek sovereign is on the verge of default refuse to go away. Indeed, current market prices imply that the probability of a Greek default in the coming months is virtually certain. As a consequence, investors should not dismiss the possibility of a Lehman-type moment in the euro zone.

The Greek story has been an accident in the making for several years. Careless lenders, in a desperate hunt for yield in a low-return world, flooded the country with cheap capital following the country’s euro entry in 2001.

The seemingly endless supply of foreign credit saw the premium on Greek public debt versus German bunds drop from 11 percentage points in the early-1990s to less than 40 basis points (0.4 of a percentage point) at the height of the lending frenzy.

The foreign lenders, primarily French and German banks, operated on the misconstrued premise that sovereign risk in the euro zone was negligible and, mistakenly, believed that external imbalances within the monetary union were irrelevant.

The Greeks lapped up the low-priced credit and used the funds to finance current consumption rather than productive investment, which precipitated a build-up of dangerous macroeconomic imbalances that made the country highly vulnerable to a sudden loss of confidence and an accompanying cessation in lending.

Low gross national savings that fell well short of domestic investment saw the current account deficit expand from less than 4 per cent of GDP in 1997 to 14.5 per cent a decade later. The dependence on foreign capital saw net external debt, both public and private, jump from less than 50 per cent of GDP early in the new millennium to 85 per cent by 2009, while net interest payments doubled from 2 to 4 per cent of GDP over the same period.

The external debt indicators surpassed levels that were witnessed in the lead up to previous crises including Argentina in 2001 and Hungary in 2008. As a result, Greece required only a small nudge to push it over the edge. That moment duly arrived in autumn 2009, when the newly elected government revised the projected fiscal deficit for that year from less than 4 per cent of GDP to almost 13 per cent. Further revisions followed in the spring of 2010 and the subsequent loss of confidence left the government with no option but to request assistance.

The European Union and the International Monetary Fund put together a €110 billion rescue package with strict conditionality that required a gargantuan turnaround in the primary budgetary position – ie before interest costs – from a deficit of almost 10 per cent in 2009 to a surplus of 6 per cent by 2012.

However, the required fiscal consolidation has proved to be too demanding and Greece has begun to miss its targets, even though the cyclically adjusted tightening last year – at about 8 per cent of GDP – was the largest one- year consolidation achieved by a developed country in at least the last three decades.

The primary budget deficit was reduced by five percentage points in the face of a deepening recession, but much more is needed if the outstanding public debt ratio – at more than 140 per cent of GDP – is even to stabilise, let alone fall to a more sustainable level.

The dynamics of the Greek economy suggest that the remaining adjustment required is simply not feasible without considerable economic pain. The impact of fiscal consolidation is magnified whenever the marginal propensity to consume is high and the marginal propensity to import is low, conditions that are present in the Greek case.

Furthermore, external demand is unlikely to soften the blow, given that the export share of GDP is relatively low, while loss of global market share in recent years suggests the export sector is uncompetitive.

The Greek economy is likely to have registered a near-10 per cent decline in output from the peak in 2008, by the end of this year, and further contraction in 2012 cannot be ruled out in the face of further austerity. The unemployment rate is 16 per cent and the accompanying discontent suggests that the stomach for further job losses is minimal.

Indeed, recent polls reveal that almost nine out of 10 are opposed to additional austerity measures, while roughly four out of five anticipate significant social unrest in the months ahead.

The facts suggest that a hard restructuring of Greek debt is absolutely necessary if the country is to have any chance of introducing structural reforms that lead to sustainable long-term growth.

The reckless lenders from France, Germany and elsewhere must recognise that they are partially responsible for the current predicament in Greece and shoulder the burden appropriately. Unfortunately for them, sovereign defaults rarely occur in isolation and Portugal could well be next.

www.charliefell.com