Markets remain extremely skittish and worried about the outlook for Europe, Greece and the West in general. Despite the best intentions of European policy-makers, markets are not willing to settle down and take at face value the various austerity programmes being rolled out across Europe. Markets have been spooked by the unilateral measures on the part of Germany to ban naked short-selling on sovereign bonds, CDS (credit default swap) and 10 major financial institutions’ equity shares. The measures have caused concern as they have exposed the lack of policy coordination in Europe (once again) and made investors into the bad guys causing irrational pain for the real economy. Politicians, instead of trying to address the credibility gap they face with markets, are trying to effectively badger investors into falling in line. Comments of a war between markets and politicians do not help matters, and investors continue to fear that the German move could be duplicated by other European Union (EU) states.
The crux of the problem continues to be the markets’ unwillingness to accept the sustainability of the Greek rescue plan. While it is true that Greece has effectively been backstopped for two-and-half years, and has no need to approach investors for any funding whatsoever over the next 30 months, markets are still not convinced. Bears point out that Greece will come out of the bailout period with a public debt-GDP ratio of 150 per cent, so even after 30 months of credit support, how will the economy be any more viable? Why will the markets support its borrowing programme then, if not willing to do so today at lower levels of indebtedness? The bears continue to question the solvency of Greece, the bailout has solved the liquidity risks and bought some time but does nothing to address the longer term solvency issues. The only way for the country to regain solvency is to correct the fiscal and improve competitiveness as an economy, both of which require huge political will and local populace buy-in, neither of which is yet obvious in Greece. The question of how can you force a massive austerity on the local population and pay out creditors in full is a matter of current debate. Will local politics permit the entire pain to be borne domestically with no cost to international creditors?
The bears continue to expect a debt restructuring in Greece, with creditors forced to take haircuts on their debt holdings. If Greece restructures, then inevitably the expectation will be that the other PIIGS will follow, sooner or later. Just for context, the Royal Bank of Scotland estimates that ¤2 trillion is the amount of debt issued by public and private institutions in Greece, Spain and Portugal and held by financial institutions outside these three countries.
The fear around restructuring, contagion and its implications brings about the inevitable comparisons with the Lehman collapse.
Though Greece is a small economy (only about 2 per cent of EU GDP), European banks own billions of dollars of its debt (largely French and German banks). Any restructuring will involve these banks having to take a significant haircut on their Greek bond holdings, which will blow a big hole in their balance sheets. To fill this hole, the respective EU governments will have to recapitalise the banks.
This is where the contagion, fear and comparisons with Lehman become more relevant. If the banks have huge losses on Greek bond holdings, everyone will start trying to figure out who is holding these bonds, exposures etc. Interbank funding markets will start to tighten as nobody will want to deal with banks perceived to be sitting on huge sovereign bond losses. As counterparty issues resurface, liquidity tightens, banks and their clients are forced to de-leverage, we enter the whole Lehman death spiral once again. The markets will then go after the other PIIGS. Thus, irrespective of how small Greece may be, this is obviously a huge problem with systemic implications. Initial signs of rising Libor rates, elevated swap spreads and unease in funding markets are obviously spooking the markets and forcing everyone to pare back on risk and de-leverage. Having just gone through a near-death experience 18 months ago, no institution wants to be caught napping this time. The strong correlation in price movements between gold, crude oil, stocks, commodities and spreads indicates that risk of all types is being taken off the table.
The only way out seems to be for Greece to accept and implement austerity measures, combined with an orderly and assisted debt restructuring plan. Once they accept the need for debt restructuring, EU authorities can then firewall the affected banks through disclosures and capital support, so that interbank funding markets do not seize up. This has to be accompanied by Spain, Portugal and the other targets moving quickly to implement their own austerity programmes and thus convince the markets of their solvency.
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While one can be tempted to buy today, it may make sense to wait till Greece finally accepts the need to restructure and we go through the inevitable fallout from such an announcement, before taking on more risk in your portfolio. Such an announcement, if handled sensibly by EU policy-makers, will be a buying opportunity and not the beginning of another Lehman-like meltdown.
While India is relatively unaffected by what is happening on the real economy side, the linkages are obviously more through fund flows and risk aversion. Once again, at the first signs of global risk appetite being reduced, our markets have taken it right on the chin, with Indian equities down over 13 per cent in dollars terms this month alone.
Hopefully, our policy-makers will also understand from the Greek problem that the markets’ patience for tolerating irresponsible fiscal policy is not endless. Already over the past 10 days, in three global emerging market (EM) presentations, I have seen strategists highlighting India as the only large EM country with fiscal and current account issues and vulnerability. Investors do not seem worried yet, but focus on fiscal sustainability has never been higher. We fund our deficits internally, and thus cannot be attacked by global markets, but we do need to get our fiscal deficit under control. We will not be able to attract the FDI and FII flows we need, unless investors are more comfortable with our macro framework. The finance minister has outlined a road map to bring the fiscal deficit and public debt/GDP under control. Now we will need to move ahead aggressively in implementing the direct taxes code and goods and services tax reforms which underpin these targets.
The author is the fund manager and chief executive officer of Amansa Capital