Small Country, Big Problems

After the conservative, pro-bailout New Democracy (ND) party won the June 17 parliamentary elections in Greece, investors heaved a collective sigh of relief. But it was short-lived.

Greece will soon have a new coalition government, but the problems are far from over for this deeply troubled country. Meanwhile, the investment world is now looking more intensively at the extreme debt woes that plague the remainder of Southern Europe. Spain and Italy, each with an economy far larger than Greece’s, are raising alarms anew.

The “pro-Europe” forces have won the right for a coalition government in Athens, undeniably a positive for investors. At the same time, the work required to get the country’s economy back onto a growth path is enormous. It remains to be seen whether Greece’s squabbling politicians are up to the challenge.

Our view is that the probability of Greece exiting the euro zone remains low, at about 10 percent. The reasoning behind this assessment: Europe simply couldn’t withstand the outcome. According to the most recent assessment, the direct cost of a Greek exit from the euro zone would exceed 100 percent of Greece’s gross domestic product (GDP). The entire euro zone—indeed, most of the world’s economies—would get caught in the downdraft.

The new Greek government won’t renege on the austerity package, but it’s likely to renegotiate at least some of the terms. The plan calls for €11 bllion of spending cuts over two years; ND’s leaders are proposing an extension to four years. They also vow to push for lower interest rates and help with growth-enhancing measures such as greater infrastructure spending.

The pressing issues for Greece right now are the €23.9 billion needed for bank recapitalization, as well as the €3.9 billion due to the European Central Bank in August.

Daunting Debt

Social unrest in Greece remains a possibility. A large segment of the Greek population argues that the country can dispense with economic austerity altogether. Despite the fervor of the anti-austerity crowd, this is not a realistic option.

Greece sports a current account deficit of 8.6 percent of GDP (five percent of which is interest payments), a primary budget deficit of 2 percent of GDP, government debt-to-GDP of 156 percent, and net foreign debt of around 90 percent of GDP.

Our view is that increasing numbers of Greeks, even those on the angry left, will understand that abandoning the euro—or getting tossed out of the currency—would wreak a ruinous cost on the entire country. Always a fractious bunch even under the best of circumstances, Greek’s politicians are grappling with the inevitable and it appears likely that some sort of workable deal will be reached. Now the spotlight turns to other countries with daunting debt problems.

Spain is the new source of worry, as bank deposits there continue their flight. With Spain, the stakes are much higher. Greece is the 15th largest economy in the 27-member EU; Spain is the fourth largest.

The Spanish economy will require substantial government cutbacks to even attempt a stabilization of its government debt in terms of GDP. The second half of this year promises to be very painful for Spaniards, as fiscal tightening gets under way, wages continue to fall, and banks deleverage by reducing access to loans.

For the euro zone experiment to succeed it will, at very least, require fiscal union. This goal eventually will be forced on politicians by the markets. In the meantime, European societies will be stuck in limbo and investors will rightfully remain wary.

For investors looking for a play on these trends, the recommendation here is to short the euro. The currency has bounced to around 1.27 USDs to 1 Euro. Our target is closer to 1.20, while longer-term investors could look at 1.10. This issue, we also spotlight the stock of UK-based bank Standard Chartered (London: STAN, OTC: SCBFF).

 

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