The Absolute Return Letter
July 2011
What Happens Next?
by Niels Jensen, Absolute Return Partners
âAnyone who isnât confused really doesnât understand the situation.â
Edward R. Murrow, Broadcaster
I can already hear the collective sigh - oh no, not another letter on Greece! The battle fatigue is evident. We are all exhausted from years of fighting the crisis but, at the same time, we are fast approaching the end of the road, at least as far as Greece is concerned, for one simple reason. Policy makers are running out of options, verified by their increasingly desperate reactions to undesirable news.
One recent example: Earlier this week Moodyâs downgraded Portugal (in my opinion deservedly so). Governments across Europe, who in the past have been highly critical of the rating agencies for being behind the curve, suddenly criticised Moodyâs for undermining their work. Long live hypocrisy.
No, this letter is about what is likely to happen after Greece has defaulted, which is where I am increasingly focused. The can may be kicked further down the road in order to buy additional time, and every trick in the book may be used to portray the default as a benign event (note, for example, the use of the word ârolloverâ rather than the somewhat less pleasant ârestructuringâ in the latest proposal), but default it will.
Greece is now a side show
The reality is that Greece is increasingly becoming a sideshow. Much of the media may not have realised this yet (with a few honourable exceptions, they are still obsessed with Greece), but most investors certainly have. Following the downgrade of Portugal earlier this week, Portuguese, Irish, Spanish and Italian credit default swaps (CDS) all widened substantially. And out there, in the real economy, it is not only
Greek savers who have come to realise that this is going to end in tears. Irish retail bank deposits have dropped approximately 15% since early 2010 (see chart 1).
In fact, the situation is now so bad that the ECB is financing about âŹ400 billion of banksâ balance sheets in the crisis countries (see Gavin Daviesâ blog in the FT here). Given that the combined capital and reserves of the European System of Central Banks is only about âŹ81 billion, the ECB is increasingly at risk of being bankrupted.
This raises a myriad of questions. What defines a default? Will the proposed rollover of Greek debt trigger a CDS payout? Does the rollover provide a sustainable solution for Greece? What happens if the ECB is bankrupted? How will a default, whether explicit or implicit, affect Portugal, Ireland and possibly also Spain, not to mention Italy?
How much is too much debt?
Before I go any further, allow me to provide some theoretical background which will come in handy as my thinking progresses. To begin with, letâs take a look at what constitutes unsustainable debt levels. It is a mathematical fact that as long as nominal GDP growth remains below the average cost of debt (when measured as a percentage of GDP), a countryâs debt-to-GDP ratio will rise even if the primary budget deficit1 has been eliminated through austerity.
