From the beginning of the European crisis two years ago, it has been our conviction that Greece would be unable to pay its huge debts and would ultimately have to default. That is still our belief. Greece’s debts were so large relative to GDP (approaching 160% of GDP) that repayment was always unlikely. But the country’s ability to repay was sharply reduced by swingeing fiscal tightening imposed by the European Community as a condition for its aid package, and by a bizarre tightening in monetary policy by the European Central Bank “ECB” (since reversed). Fiscal tightening reduces demand: taxes are increased, government spending is reduced. In Greece, old age pensions, unemployment benefit, government salaries and subsidies were sharply cut. But this reduced overall
spending in the economy, which in turn caused tax revenues to fall, so the deficit didn’t decline. Yet more austerity was imposed, which caused the economy to contract further, which meant again that the deficit didn’t fall… You get the picture.
The economic decline in Greece over the last four years has been extraordinarily severe, matching the depth of the Great Depression in the United States between 1930 and 1933. Just two statistics: the volume of industrial production has fallen 30% since the peak and is still falling; unemployment
is 21% and rising fast. As a result, despite great austerity and hardship, Greece still can’t pay its debts. The populace has refused to countenance any further austerity, voting in a majority of anti-austerity parties to the Greek Parliament in the recent election.
Meanwhile in the rest of Europe, electorates have also turned against austerity- imposing governments, even in the relatively better off northern economies. In Holland, the government has fallen; in Germany Angela Merkel’s ruling CDU party lost two provincial elections by large margins, one in the key province of North Rhine-Westphalia; and France has a new socialist president. But Greece is a special case. Its government lied about how much debt it had before the crisis; its benefits (such as old age and disability pensions) were absurdly generous; its state owned sector was extremely inefficient; its debt to GDP ratio was the highest in Europe; and it’s been running huge government deficits for years. It’s also relatively small.
The other high debt economies in Europe haven’t been as profligate (Spain, for example, ran government surpluses before the crisis) and are also – crucially – too big to be allowed to fail.
The Greek government will be unable to pay its bills by mid June. There is a run on Greek banks, with depositors withdrawing funds in cash or transferring them into non-Greek bank accounts. It looks as if the radical left Syriza party will win the new elections in Greece (likely to take place in June). Syriza wants to tear up the bailout and austerity agreement. Time is running out.
So what will the consequences of a Greek default be?
First, unlike the situation three years ago, most European banks have already written down the Greek debt on their books. There isn’t much left to impact them. A Greek default will not cause a widespread bank crisis in Europe. Second, the ECB itself has been talking about the possibility of Greece leaving the Euro currency zone, which was previously taboo, but which implies that they surely already have plans in place to cope with the aftermath of a default. These plans would certainly involve unlimited liquidity for Spanish, Italian and Portuguese bond markets and banks as well as other confidence-boosting measures. The ECB has learnt a lot during this prolonged crisis, and seems to have finally accepted its central role in preventing a Europe-wide meltdown.
Third, outside Europe, economic growth is OK. In the US, recent data have been a little soggy, but this is “payback” for robust numbers earlier when unseasonably mild weather boosted employment and demand. The “Fed” (the Federal Reserve Bank) remains strongly committed to exceptionally easy monetary policy, and though there will be fiscal tightening, there is unlikely to be any until after the election later this year, if then. In China, though the government is absorbed in internal political infighting, the People’s Bank of China again reduced liquid asset requirements last week. The Banco Central do Brasil has cut its discount rate 6 times since August and there are early signs that the Brazilian economy has bottomed. Eastern Europe is growing strongly.
The effect on sentiment of a Greek default is negative, but its practical effect will be less than it would have been even a few months ago, and much less than it would have been two or three years ago. Markets are more or less resigned to default. Some even see this as beneficial because it will force a change in policy in the rest of Europe and at the ECB away from deep austerity and insufficient monetary support. This is our view, too. This doesn’t mean that market volatility won’t be high. It will be. Markets dislike uncertainty and until the situation is resolved share markets will remain fragile. However, when it is resolved, the underlying fundamentals will reassert themselves.
And these fundamentals are broadly positive. Though the Australian economy will slow a little over the next twelve months, real GDP growth will still be positive—somewhere between two or three percent. The Reserve Bank can still cut the cash rate further to stimulate the economy, and we believe it will. The Australian dollar is falling and this has in the past supported our economy and our share market just as a strong dollar has in the past held them both back.
The share market is good value, on a six month or twelve month outlook—the dividend yield on the Australian All Ordinaries share index is, adding back franking credits, around 6.5%. This compares with a cash rate of 3.75% and a 5-year Commonwealth bond yield of 2.74%. Even without any capital gains, shares will outperform all other asset classes.
Nevertheless there are risks. The biggest is that the authorities in Europe fumble their response to the Greek default. This is a small but not negligible risk. However, they have been through a lot of pain over the last two years and have learnt a lot, and we believe their response will be appropriate and positive for share markets globally. The other risk is political instability in China. Yet the two greatest fears of the senior cadres of the Communist Party
are growth being too slow and inflation too high. Inflation has halved over the last year, and the authorities in China have switched to emphasising growth.
Our view is that the extreme political need to keep the economy growing willconcentrate their minds, and further stimulus measures will be introduced. China runs a fiscal surplus, and has over two trillion dollars of gold and foreign exchange reserves, so it doesn’t lack the firepower to get things moving again.
We will of course continue to keep a close eye on developments, and will adjust portfolios accordingly. If you have any queries we would be pleased to discuss them.
