State of the Union – Better Investors

Article by BT Financial

The spotlight fell first on Greece but reluctance to address the problem when it was in its infancy has resulted in contagion effects. Many commentators believe these problems have the potential to jeopardise the future of the European experiment, and this has led to a sell-off in risk assets around the globe. While only 2.5% of Eurozone GDP, the situation in Greece has prompted serious questions about the long-term solvency of other peripheral EU countries such as Portugal, Spain and Ireland. This has caused a spiral of widening fiscal deficits and ever increasing debt loads. It also makes some form of restructuring of debt increasingly likely at some point – the German Chancellor Angela Merkel has talked about ‘orderly restructuring’. In fact it is surprising that the International Monetary Fund has not already insisted on this ‘burden sharing’, as it is part of its normal conditions for involvement. Delaying the inevitable?Greece is the epicentre of the crisis because it was the first country to own up to misleading economic statistics and hidden debt, which when restated have pushed its fiscal situation, mathematically, likely beyond the point of no return. Tough fiscal austerity measures that need to be implemented in Greece have already led to widespread civil unrest and worse may still be to come.Near-term default by Greece was a possibility, before the bailout, as the short-term funding requirement and long-term solvency issue were clear. This would have likely led to a second round of bank losses as banks would have been required to take haircuts on their holdings of Greek debt.These problems prompted a near 750 billion Euro emergency package provided by the IMF and EU members to help resolve the liquidity issue for the peripheral countries. The market welcomed this initially however doubts on the viability and execution of the package caused further market volatility. Despite the package, the market still believes that eventual default of Greece is still likely as it doesn’t address solvency but rather, more immediate liquidity concerns analogous to ‘kicking the can down the alley’. The term of the facility is limited to 3 years which suggests that it is designed to delay restructuring debt of the troubled countries instead of fixing their problems. It instead allows the bonds to move off European bank balance sheets over this period to effectively nationalise the eventual losses. Questions remain over the stability of the European banking system even after the much publicised stress tests. More recent developments in Ireland involving the nationalized Anglo Irish bank reflect this.Sharing the loadThe mere fact that the EU is a monetary and not a fiscal union makes these developments unsurprising. Weaker countries could fund at lower rates subsidised by the stronger members while not having to exercise fiscal discipline. The rescue package sets the stage for a large scale fiscal transfer from the core EU countries (especially Germany and France) to the periphery, which will demonstrate the willingness of the core countries to keep the EU together.Without this help a break-up could be a possibility and even if the core countries are willing to lay their balance-sheets on the line in an attempt to support the union, there is still a likelihood that the fiscal deficit reduction targets will not be met without pushing some countries into severe economic contractions – how willing the electorate will be to suffer this remains to be seen.For the peripheral countries the membership to the monetary union is now working against them. A relief valve in this situation would be a currency devaluation spurring exports and tourism. However, since this is not available a much more difficult downward adjustment of wages is necessary, increasing political stability in these nations.The views expressed in this article are the author’s alone. They should not otherwise be attributed. The information in this publication does not take into account your personal objectives, financial situation or needs and you should consider its appropriateness having regard to these factors before acting on it. Visit for more financial market insights.

About the Author

Vimal Gor joined BT Investment Management in November 2009 and is the Head of Income and Fixed Interest. He is responsible for leading the process and strategy of the Sovereign and Credit funds and heading up the Income and Fixed Interest team.