You can check out, but can never leave

If there was a game with a name like, say, Tragic Greek Default, would you play? It could be a version of the classic Monopoly, but souped up with credit default swaps, bonds, yields, deficits, politics and treaties, to reflect the language of our times. At the core of the game would be the Greek crisis in which credit run up in good times has fallen due. It is not a good time to be settling these accounts. Growth has slowed and is slowing further, decreasing the tax intake, while borrowing costs have spiralled upwards as investors have taken the view that they are unlikely to get back their money.

The cost of insuring against default on sovereign Greek bonds has continued to rise and calculations now predict a 98% chance of default — and the question is when, rather than if. Sovereign defaults are not new but should the inevitable happen and Greece defaults it will be the first developed country to do so. Defaults in the past have been by standalone countries and the fallout has largely been limited to the defaulter. Default triggers the collapse of the currency, raising the cost of imports and boosting exports. The country has to cut its cloth in line with new, austere times and a period of painful adjustment follows. But Greece is part of the eurozone and cannot unilaterally devalue its currency, the euro. And this is where analogies with board games end. Unlike Monopoly, there are neither rules to guide what will happen next nor are there pre­cedents from which to plan likely outcomes.

Many possibilities are being thrown about. One is that Greece will do a runner, leave the eurozone and default. But a counter argument is that it is too tied to the eurozone and its institutions for this to be a serious possibility. Another scenario is that Germany will do a runner, taking its powerful, rich economy out of the eurozone and leaving the other countries to fend for themselves. The counter argument to this is that Germany is too wedded to the euro project to want this outcome, even if a lobby in Germany is strongly opposed to bailing out profligate ­fellow members.

But a stand-alone Germany would have practical outcomes too. One would be a currency that would double in value, according to market commentator John Mauldin, creating the same problem for German exports as experienced by the Swiss, when agitated investors rushed to the Swiss franc for safety. The Swiss currency has appreciated to such an extent that the authorities have said they will buy unlimited quantities of foreign currency to ensure the Swiss franc trades at no more than 1.2 to the euro. The German economy is doing well from the weaker euro brought on by the Greek and associated debt crises.

As noted by some analysts, joining the euro is the easy part. But lyrics from The Eagles’ famous song, Hotel California, explain the exit process: You can check out any time you like / but you can never leave. The Italians apparently see the Chinese as their financial saviours: they are reportedly in talks to convince the Chinese to buy up some of their debt. Ideas are flowing fast and loose. Some appear so whacky that you do not give them credence, only to find later that they are based on truth. One suggestion is for the Brics — Brazil, Russia, India, China and South Africa — to come to the rescue. The developing world will bail out the developed world. The poor will fund the rich. As a member of the Brics group, South Africa will be asked to contribute. A meeting has been scheduled for next week to discuss how to help the eurozone, including through buying bonds. Will we step up to the plate? We were, after all, prepared to bail out Swaziland, so why not the eurozone too?

But Finance Minister Pravin Gordhan threw cold water on the idea. ‘I’m just aware of contact between, at the moment, one country in Europe and one country in Asia, where there are some exchanges about buying bonds. And that is something that has happened before,” Reuters reported Gordhan as saying. ‘South Africa is not part of that market at the moment — it’s the big countries, who have $3.2-trillion in reserves. We are Mickey Mouse compared to that and they can afford to look at some of those issues.” James Mackintosh of the Financial Times believes that Europe should ask the Brics for advice, rather than money.

‘Better, perhaps, might be their advice. Russia defaulted only 13 years ago, while Brazil’s 1983 default, in the wake of Mexico’s, is seared into policymakers’ memories.” He could have added that South Africa had a default, called a partial debt standstill, in 1984. German Chancellor Angela Merkel, who has been trying to steer a middle road through the crisis, insisted recently that no default was ­imminent and that it could not happen before 2013, at the very least.

Deep Recession
Stanlib economist Kevin Lings said the Greek economy had suffered extreme hardship and remained in deep recession. ‘From its peak in the third quarter of 2008, the Greek economy has declined by a total of more than 10% real. The latest gross domestic product data for quarter two of 2011 shows a decline of 7.3% year on year, and the economy is on track to fall by a total of 5% in 2011. The unemployment rate is above 16% and rising. Clearly the situation is dire.” Some observers believe the best way forward is for Greece to default and to do so as soon as possible. Others liken the crisis to the collapse of Lehman Brothers in 2008. It is clear who Lehman Brothers is — Greece — but who is AIG, the insurer that collapsed, requiring a $182-million ­government bailout because it could not pay insurances it had written on mortgage-related securities?

Based on the analysis of Markit, a London-based financial data firm, the New York Times reported that credit default swaps valued at $5-billion on a net basis and $78.7-billion on a gross basis would fall due in the event of a Greek default. News website Business Insider has listed the banks exposed to Greek sovereign debt, including from Germany ($22.6-billion), France ($14.96-billion), the United Kingdom ($3.4-billion), Italy ($2.3-billion), the United States ($1.5-billion), Spain ($540-million), Japan ($432-million) and Greece ($62.8-million). The 2008 crisis is different from the present one. Notwithstanding the scale of that meltdown, bankruptcies of private companies precipitated the crisis.

In this case it is a sovereign nation, embedded in a wider economic union, that is set to default, putting pressure on banks in the eurozone and beyond and exposing other euro economies to further stress. The contagion could spread from the smaller, peripheral economies to significant economies such as Italy, the third-largest in the eurozone. The 2008 crisis gave us the phrase ‘too big too fail”; 2011 is set to enlarge this to ‘too big to fail, too large to save”. The song says you can check out any time you like but you can never leave. But whether you checked in or not, you have at least a bit part in this giant unfolding tragedy.

Who’s afraid of Greek bonds?
Yields on two-year Greek bonds have risen to record levels of about 70% in the past week, which means if you buy a Greek bond, you will earn yourself 70% interest income in euros. Sounds like a good plan, so why is everyone not racing to load up on some seriously good interest income in hard currency? It is simply a matter of risk. The risk-free cash yield in euro at the moment is about 2%, which means that for every percentage point above that, you are taking on risk. At a 70% yield, you are taking a huge risk. Assume there is a default and Greece agrees to pay out 40c in the euro. If a Greek bond was issued at 10%, for example, and an investor is now selling at a yield of 70%, they would get back only 40% of their capital, effectively writing off 60% of the investment.
So the seller (the market in general) expects Greek bonds to devalue by 60%. In other words, traders believe that Greece will default on its loans and that the government will pay back only 40c per euro it has borrowed via that bond issue. So, while you may be getting a great interest rate, there is a good chance that your capital will more than halve. Is a Greek bond still worth buying? Andrew Canter, the chief investment officer at Futuregrowth, says that it is a calculated risk and at a certain yield, the risk may be worth taking, but only for that portion of an investor’s portfolio that they are prepared to write off.

While it is most likely that Greece will default to a degree either by extending the loan, lowering the interest rate paid, or reducing the capital repayment, the likelihood of creditors being paid only 40c in the euro is relatively small. This is simply because the Greeks owe money to large banks that would be very unhappy to take that much of a haircut, which is why the rest of Europe is bailing out the Greek government and why German taxpayers are disgruntled. Canter says that currently Greek sovereign debt is equal to 120% of the country’s gross domestic product (compare that to South Africa’s 40%). The aim would be to lower the debt level to about 90% of GDP. This would require a write-off of about 30% of its debt. ‘Greece will either have to pay back a fraction of the amount due, or extend the term of the debt at some new interest rate, or both,” says Canter. ‘In any case, there will be some sort of restructuring and bond holders will probably not be made whole.”

In addition to the likelihood of default and restructure, a reason the bond yields are trading at such a high level is because many large institutions, such as pension funds and asset managers of prudential funds, are not allowed to hold on to any bond that is not investment grade and with the downgrading of Greek debt, funds are selling them at whatever price they can get. It is creating an opportunity for hedge funds to buy the bonds at a discount which should result in a tidy profit if the write-off is limited to 70c per Euro. However the write-off may be larger than that if large European Banks are prepared to stomach the losses or if European taxpayers start to apply serious pressure on their governments. South Africans wanting to take a Greek gamble would have to have sizeable funds offshore, an account with one of the larger stockbrokers in London and an even larger capacity for risk. — Maya Fisher-French

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Kevin Davie

Kevin Davie is M&G's business editor. A journalist for more than 30 years, he has worked in senior positions at most major titles in the country. Davie is a Nieman Fellow (1995-1996) and cyberspace innovator, having co-founded SA's first online-only news portal, Woza, and the first online stockbroking operation. He is a lecturer at Wits Journalism. In his spare time he can be found riding a bicycle, usually somewhere remote.

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