The biggest threat for 2010 – countries going bust
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Associate Editor
David Stevenson Dec 09, 2009
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The sovereign debt disease is spreading, and looks set to be the big bad news story of 2010. This time it's Greece that's in trouble – and that's official.
Just as the 'don't panic' brigade were telling us not to fret about Dubai World defaulting – not big enough to matter, it's an isolated case, surprised it didn't happen before, etc, etc – a much bigger problem has cropped up. Greece has had its credit score chopped by one major rating agency, and more of the same could be on the way.
Over the last year or two the rating agencies have copped a lot of flak for reacting much too slowly to the first round of credit crunch damage. This time they've got the red pencils out a bit more sharply, as they sensed trouble building up. On Monday Standard & Poor's put Greece's A-rating 'on watch' for a possible downgrade. And yesterday, Fitch Ratings cut the country's score to BBB+, the third-lowest investment grade available.
Greece is hardly the dodgiest sovereign debtor on the block - far from it. There are some real basket cases around - Ukraine, Venezuela and Argentina to name but three. But it's certainly now the riskiest in the eurozone.
And this isn't just accounting arcana. It's potentially very serious indeed. The ratings agencies are saying that there's a rising risk of Greece defaulting on its public debt – i.e. that it won't be able to pay the interest the country owes to its creditors.
Why? Mainly because the Greek government's finances are in a right mess. The budget deficit is running at almost 13% of annual output (GDP), which is extremely high (in the old days before the credit crunch, an economist would have seen 6% as getting on for 'banana republic' levels).
And overall national debt could reach 125% of GDP next year – the highest in the eurozone - warns S&P. Look further out, and the figure might rise even higher. "The downgrade further underlined Greece's dreadful fiscal position and the correspondingly weak outlook for the economy", says John Higgins at Capital Economics. In other words, the higher the state deficit goes, the more the Greek economy will suffer as it's forced to fund it.
To reflect the rising dangers involved in holding Greek bonds, investors have demanded that they receive a much higher return. They've forced up the yield on Greece's long-term debt to almost 5.6% - nearly 2.5% more than German bunds. Two years ago, the difference was just 0.35%. As yields rise, prices fall. So the value of Greek bonds has been slashed.
Of course, there's a risk that this could create another vicious debt spiral. The higher the yield on Greek debt is pushed, the more Greece will have to pay when it tries to raise more money to fund future deficits. And that increasing cost will simply make the country's future budget deficits even worse.
What's more, there's another, more technical, aspect here. This one affects the country's whole banking system. Greek banks use their government's bonds as collateral to borrow funds from the European Central Bank. That steady source of funding has been rather handy amid some of the carnage of the last two years.
But this latest scare has made bond investors ever more fearful that this scheme won't continue for much longer. At the end of next year, the ECB is set to return to its pre-financial crisis rules, which state that assets need to be 'A' rated to be used as collateral. If Greek government bonds are scored BBB+ as they are now – or even lower – such collateral deals will be off the agenda for the country's lenders.
And that would mean Greek banks would be in very big trouble, too.
And as Greece is a euro member, unlike Britain, it doesn't have the luxury of being able to devalue its currency or inflate its way out of its growing fiscal hole via such strategies as printing new money. It could default on its debts, but that would rather undermine the whole idea of the European Union.
The optimists will tell you that there's no chance that Greece will be allowed to go bust, and that if push comes to shove, the French and the Germans will bail it out. So they might. We just don't know. But we wouldn't take it for granted.
As Tracy Corrigan says in The Telegraph, "the prospect of help from other eurozone members – themselves hardly prospering – seems, at the very best, less than a dead cert". After all, no eurozone country has ever got this deep into the mire before.
And even if Europe's big boys do rally round to support the Greeks, this will only come at a massive price. Greece will be forced into a long period of economic stagnation. Taxes will have to be hiked. Prices across the economy will have to be cut, while wages and living standards will have to be slashed. All very, very painful indeed.
Meanwhile, the markets are now scouring round to see who's next. The Baltic states – where several countries carry foreign debt that exceeds 100% of GDP - look like prime candidates.
But it's a long list. Economist Willem Buiter sums it up: "From Dubai to Iceland, Ireland, Greece, Hungary, Italy, Portugal, Spain, Japan, France, the UK and the USA, sovereign debt burdens have been at current levels during peacetime only on the way down from even higher public debt burdens incurred during wars. Watching public debt/GDP ratios rise to levels likely to reach or exceed 100% of GDP by 2014 is deeply worrying".
So worldwide, we could see some nasty sovereign debt shocks in 2010 – in fact, it'll be quite a surprise if we don't. This is likely to be bad news for both bond and equity markets alike. Stick with defensives – and be ready to buy gold when the current correction is over.
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David Stevenson
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