August 2011
And the cradle will rock...

A Greek sovereign debt tragedy

The Greek government's austerity budget will secure its near-term financing needs, but challenges remain. This €12 billion interim payment is just one instalment in a total funding package from the European Central Bank (ECB) and the International Monetary Fund (IMF) forecast to total €150–160 billion. Moody's has cut Greece's credit rating to CAA, a level that implies a 50% probability of default within five years. Two-year Greek government notes, yielding over 28%, are being priced as though default is inevitable; investors are projecting a recovery of 65 cents on the dollar, a level consistent with past sovereign debt defaults.

If Greece were not part of the euro zone, the government could address its fiscal crisis by devaluing its currency, stimulating growth through the resulting improvement in export competitiveness. This is why pundits speculate about Greece abandoning the euro. Greek citizens are certainly acting to safeguard their wealth from such an eventuality – they are withdrawing deposits from Greek banks and moving them to more fiscally secure jurisdictions like Germany or France, and they are buying gold. Greek banks thus face a funding crisis, and are so heavily exposed to Greek sovereign debt that any event of default could wipe out their capital and see them nationalized, as happened in Ireland.

Recovery value in past sovereign debt defaults

Source: IMG; Datastream; Moodys; Bank of England. * Ratio of the present value of cash flows received as a result of the distressed debt exchange versus those initially promised, discounted by yield-to-maturity immediately prior to default. **Pre-distressed exchange trading price.

Ripples from Greece hit Irish and Portuguese bonds

The ripples from Greece's sovereign debt crisis have driven the yields of Irish and Portuguese bonds to double their March levels. These financing costs are clearly unsustainable, especially in the present low-growth environment. Herein rests the fundamental dilemma faced

European banks have strengthened their capital positions over the past year and could absorb a Greek debt restructuring with limited discomfort. However, if Portugal and Ireland were to follow suit, the impact would be devastating and governments might again need to recapitalize their banks in order to prevent financial chaos. Hence, the ECB and European politicians have opted to provide funding to Greece until such time (2013?) as their banks are strong enough, and confidence in Ireland and Portugal has been sufficiently restored, so that a Greek default has minimal fallout for Europe.

... and let's not forget China

China's economy continues to expand rapidly, with growth forecast at 8.5%–9.0% this year. However, with continued growth has come upward pressure on prices, with inflation at 5.5% in May, and rising. China's Central Bank has endeavoured to cool activity by steadily increasing bank reserve requirements in order to slow credit and money supply growth. The sharp jump in the Shanghai Interbank Offered Rate ("SHIBOR") in recent weeks suggests that credit conditions are tightening.

China: Tighter monetary policy starting to bite

China may also need to inject US$450 billion into its banking system to offset losses on bad loans to municipal authorities. The Chinese banking system thus appears fragile, adding to investor fears that the recent easing of China's Purchasing Managers Index may presage a more abrupt slowing of China's economy, undermining demand for a range of key industrial commodities.

The economy: A pause rather than a downturn

Capital markets might have dismissed the events in Greece and China were it not for growing concerns about growth elsewhere. Japan, which remains the third largest economy in the world, is expected to record two consecutive quarters of negative growth, a recession, as a result of the plant closures caused by its devastating earthquake and tsunami. US unemployment has drifted back above 9%, and the housing sector remains weak. However, the US Midwest was battered by floods and tornadoes during April and May that also caused plant closures and disrupted traffic on the Mississippi river. The Japanese plant closures have also disrupted the supply of key components to factories in other countries, such as auto plants in the US and Canada. It is likely that the recent slowing of industrial activity is a temporary result of the disruptive impact of these natural disasters. The ISM (Purchasing Managers) index has softened over the past two months in the US, Europe and China, but remains above 50, confirming that the manufacturing sector continues to grow in all three key regions.