Europe’s Four Little PIGS: A Greek Tragedy

Europe’s Four Little PIGS: A Greek Tragedy

Pacifica Partners’ Financial Post Weekly Column – February 12th 2010

This and other articles also available online at: Financial Post & Investment Waves Blog

Just as the world seemed to be unshackling itself from the bonds of the Great Financial Crisis, the markets are now confronted with the potential for yet another one – this time Europe is ground zero. Specifically, it is a group of countries known as the PIGS (Portugal, Ireland, Greece and Spain).

The magnitude of the crisis of has left the Euro damaged. Recall, only a few months ago investors were seemingly unanimous in expressing their disdain for the US dollar.

It is not to say that the US does not have problems of its own, but compared to the economic problems of the US, Europe has its hands full at a whole other level. Spain is confronted with unemployment of over 20% and young males are experiencing unemployment of over 45%; Portugal and Ireland have banking systems that are in tatters and Greece has set the bar as far as going into and out of bankruptcy.

Usually, when countries run into problems the common response is to devalue the currency and lower interest rates in order to start exporting their way back to economic stability. The problem for Greece, however, is that they do not have that luxury since they share a common currency with the rest of the European Union. Therefore, they do not have the ability to set an interest rate course that is best for them – monetary policy has to be set in accordance with what is best for all of Europe. Given the size of Germany and France, it comes down to what is best for Germany and France.

One might say then “Why doesn’t Greece just decide to opt out and bring back its old currency – the Drachma?” The reason is that because Greece is a member of the European Union it receives some of the advantages that come with EU membership – which is mainly the ability to borrow at an interest rate lower than it would be able to on its own and also access to European markets for trade. In addition, the market assumes that in a worst case scenario, Germany and France would step up to save the day with some sort of loan guarantee framework.

Official Net Debt as a Percentage of GDP

(Click on chart to enlarge)
Source: Newedge Canada Inc.

Part of this assumption comes from the fact that many large European banks have made loans to Greece. If Greece defaults, will the shockwaves reverberate across the world? For example, it is estimated that French banks are on the hook for over $75 billion of loans. No wonder the French government is keen to try to put together a rescue plan.

At this point, investors have chosen to shoot first and ask questions later. Capital has been racing out of Greece to the tune of over €8-10 billion since November of last year. For a country the size of Greece, this is not an inconsequential amount. The only realistic way for Greece to stabilize its situation is to be able to cut spending, raise taxes and reform its economy. This is never an easy task at the best of times. Governments would rather focus on stimulating an economic recovery – not tightening fiscal policy.

Tax evasion is rampant, government spending is out of control and the public sector unions are driving a hard bargain before committing to any cost cutting efforts by the government. In addition, the announced plans for economic stabilization by the Greek government are being met with skepticism. To give some perspective on the level of tax evasion, Greece’s finance minister has stated that only 15000 people have declared income of over €100,000 a year and 90% of its citizens declare less than €30000 of annual income. This is hard to believe in a country of over 11 million people.

The difficulty facing the European Union is that the situation of the PIGS has left many to question the raison d’être of the European Union and by extension the Euro. Thus, this helps to explain the rush of international capital flows towards the US dollar. It is not a question of whether or not Greece is a pivotal member of the EU – it is only about 3% of the European economy. Rather the real question is: If Greece gets rescued, who’s next? Portugal is not far behind Greece when it comes to solvency.

Even if this crisis is resolved under the most optimistic of scenarios, the Euro has been dealt a serious blow. Other governments that had sought to diversify their foreign exchange reserves into Euros and away from US dollars might have to rethink their options. Perhaps gold will come to the forefront again. At the very least, this should give the US dollar some reprieve from its long line of naysayers.

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This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice. Past performance is not indicative of future performance. Please note that, as at the date of this report, our firm may hold positions in some of the companies mentioned.

Copyright (C) 2010 Pacifica Partners Inc. All rights reserved.

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