The Economist magazine says “Greece looks bust”. No argument there…
Given that we here in the US are essentially the pot calling the kettle black, we need to pay attention because the stakes are very high. How high?: several estimates for eventual losses on bonds from:Portugal, Greece & Spain total $800B. This is more than sufficient to bring down the large European Banks. As we now know from watching banks implode in 2008, they are all interlinked via the nearly $300T international derivatives market. So if banks fail in Europe, some very large US banks will fail too.
It has been my assertion for some time now that the federal government has purposefully created the perfect environment for banks to make large profits so that they may have the money to write off the bad debt on their balance sheet (mortgage loans), and to sustain a body-blow from a large bank failure either here, Europe, or in Japan. US Banks have quietly increased their purchases in US Treasury bonds over the past year. These bonds are paying interest at rates far lower than the bank’s typical return on equity, so there has to be a good reason for bank managers to accept a rate of return lower than what their business can generate. With that said, here is an update on Greece, Portugal, and Spain.
Greece:
Greece’s sovereign bond rating was dropped to junk status a week ago. This was anticipated by yours truly. The country is now a basket case.
The latest iteration of a ”rescue package” for Greece was announced a week ago. Roughly $150B will be loaned to Greece by the IMF & the EU over a 3-year period beginning in a few days. In exchange for this sum, the Greek federal parliament is committing to deep cuts:
- Public wages and pensions frozen for 3 years.
The value-added tax on fuel, tobacco and alcohol will rise by 10 percent.
Increase in the value-added tax from 21 percent to 23 percent for all goods.
New taxes on illegal construction.
These efforts are estimated to save $40B over the next 4 years. Provided the economy does not contract more than 3-4% end to end, Greece would emerge with a 3% budget deficit in 2013. Therein lies the problem: you can’t do wholesale budget cutting and tax raising without forcing an economy into a recession. Because these measures will force Greece into a depression -not just a recession - Greece will not achieve the mandated 3% budget deficit target because its economy will shrink considerably (say 10-15%). Bear in mind that the current plan aims to cut social benefits + increase tax collection rates + raise consumption taxes. Greece has never been able to do even one of these three painful actions during stable economic times, much less all three during a depression. Greece will default because the IMF & EU will eventually stop throwing good money after bad once it is obvious Greece cannot make the level of changes required without anarchy.
Portugal:
Portugal’s debt rating was dropped 2 notches, but remains Investment Grade — albeit with a negative /weakening outlook. Here are some datapoints to describe Portugal:
- At $180B — it is one of the smaller Eurozone economies – 10th out of 16 economies. This makes it 80% as large as Greece.
- A large portion of its annual budget deficits are financed by foreign investors -just like Greece. This year’s budget deficit will be approx 9%. That’s very high and unsustainable, but considerably lower than Greece’s, Spain’s, and Ireland’s. For relative purposes – Portugal’s deficit is also lower than the US’s deficit.
- The ratio of public debt to GDP is troublingly high at 85% — higher than most European countries, but again lower than the US, I point out. Add to this Portugal’s household and company debt and you see that Portugal is buried in debt — proportionately better off than the US — but bond markets are starting to treat it as risky.
- Other than the obvious budget deficits, public debtload, and reliance on foreign investors, Portugal has these structural issues:
- Large annual trade deficits -hence the need for foreign borrowing.
- Near zero GDP growth for the past decade, and no hope of economic growth for years to come. We know most of Europe will have a hard time making any economic gains for years to come, so Portugal is not alone in that weak prognosis, but Portugal didn’t see a boom during the 2003-2007 credit-fueled growth period that others saw. This is a concern because if you can’t see growth in the best of times, you’re sure not going to see any during the worst of times.
- Too much of Portugal’s export industry is filled with low-skilled labor. This makes it vulnerable to competition from emerging markets with rapid productivity growth and with currencies that have devalued vs the Euro in the past 10 years.
- With very little opportunity for prosperity at home, the best & brightest have been leaving Portugal for years. This contributes to Portugal’s chronic low productivity growth.
- With all that bad news, there is some somewhat good news. Portugal demonstrated in 2005-2007 that it can cut its budget deficit in half. It currently has a plan to cut spending to 2.8% by 2013. That should avert a default. But the fun’s not over yet. Because of stagnant growth and high debt loads, Portugal will need balanced budgets for a decade or more in order to get its debt load to manageable levels.
Spain:
Spain’s debt rating was also dropped. It remains Investment Grade, but has a negative outlook meaning S&P foresees future lowered debt ratings. Let’s take a look at Spain’s economic issues:
- Spain is a sizeable economy – at roughly $1.4T it is the 4th largest of the 16 Eurozone economies.
- At the top of the list is the 20% unemployment rate. It has been near this level for a year and shows no sign of improving.
- More than any other Euro economy, Spain had the largest property bubble – though Ireland gave it competition. I wrote a year ago that Spain built as many residential units as most of the rest of Europe combined during the property bubble. As a result of this over-building, Spain has the same issues as the US economy, but in a larger way.
- Far too many homes were built and remain vacant. These empty units remain on bank balance sheets and will take many years to unload and will generate bank losses for years to come.
- Just as Japan did with their property bubble explosion, Spain is not recognizing the extent of bank losses and is choosing instead to disregard reality and stretch out the pain.
- It’s debt to GDP ratio was only around 55% last year — one of the lower debt loads in the Eurozone. But with budget deficits over 11%, it will quickly see its debt load reach the point where it will have to default to climb out from under its debt.
- Unlike Portugal’s government, Spain’s socialist federal government continues to spend wildly to support programs it cannot afford. That’s why even with 20% unemployment we don’t see civil unrest –yet.
But Spain is unlikely to see any economic growth for years as it begins to cut back on social programs to reduce it’s out of control deficits and sees unemployment rise further. The challenge will be to keep civil unrest under control.
This is what it has come to: can several european governments maintain control of their populations while they implement the most onerous but responsible economic policies since the end of the second world war. In the 20th century, conditions such as these would have sparked a war. Mercifully, the europeans have no stomach for it now.
If you remove Ireland from the PIIGS group of countries, you’re left with Club Med: Italy, Spain, Greece, Portugal. This article provides information on why Portugal + Greece + Spain are the biggest concern. When I say concern, I mean the impact of bond markets loosing faith in those country’s ability to repay their debt will be a larger melt-down than the Lehman Brother’s collapse in September 2008.
NAPFA
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