Greek Calamity

Greece's big fat debt
by Joel Schlesinger

Failure to solve country's problem could bring woe to whole world

What goes on in Greece doesn't necessarily stay in Greece. The small Mediterranean country has become the focus of financial watchers recently, but not because it's an economic powerhouse.

For a developed economy, Greece is a lightweight, but its debt and yearly public overspending (its deficit) are indeed heavy weights for the country and the European Union (EU), of which it is a member. Greece is running a deficit close to 13 per cent of its gross domestic product. By comparison Canada's expected deficit for 2010 -- one of its largest ever -- will be about three per cent of its GDP.

Greece's public finances are in such a bad state it may not be able to pay its upcoming debt obligations, meaning it might default, unless other EU members step in to help out.

But that's Europe's problem, not ours, right?

"Greece is a long way away, but because we live in such an interconnected world, if Greece were to default, it could be much the same as the subprime crisis," says Robert Ironside, professor of finance at Kwantlen Polytechnic University in Langley, B.C.

"When that started off, people said it's contained -- only affecting a small area -- but of course, that's not what happened."

Most observers say the chances are small that Greece's economic woes will lead to another financial meltdown, but a firm understanding of the mechanisms involved in bailing out an industrialized nation and the associated risks are not only important for investors, but also anyone who pays taxes in a modern democracy.

No easy solution exists, even though EU members will likely guarantee Greece's debts somehow. Like most nations, Greece normally finances public-spending debt by selling bonds, but it faces a problem when the market is uncertain it can cover its current debt payments, let alone issue new bonds.

"If no one was willing to finance debt externally or internally, even at very high interest rates, then you have a situation where a country defaults," says Sacha Tihanyi, currency analyst with Scotia Capital in Toronto.

"It'd be more of a political decision than anything else, because it's tough to think of a scenario where you can't adjust a yield on a bond so it's high enough to be attractive to foreign investors."

But higher yields might only prolong the inevitable and, in fact, make the situation worse because more revenue goes toward making higher debt payments as a result of the incentive to attract those buyers.

As a result, many EU members have discussed other measures, such as an EU bond with a lower yield, but providing aid is a slippery slope.

"Whatever they do with Greece is going to set a precedent for Spain and Portugal," says Ironside, adding that bailing out those two nations would be even more costly.

To make economic aid palatable to voters in other EU countries, who are questioning why they should foot the bill, the bailout will be conditional on economic reforms.

"(Greece) is going to be forced to do what's responsible," Tihanyi says. "It will have to impose austerity measures."

In this respect, the government has two unpalatable political choices: raise taxes or cut spending.

Normally, a government has a third option to tackle overspending, which is to devalue its currency relative to other currencies. Inflation ensues, making the currency worth less, which in turn makes the debt worth less. One way to inflate currency is print more of it, but oftentimes, the foreign exchange market will step in and do the job already if the economy backing the currency is weak, says Tihanyi.

"The market would just sell off the currency because of its outlook," he says. "That kind of depreciation is almost an automatic offset that will help boost exports, or make tourism more attractive because it's cheap to travel there."

But Greece doesn't have its own currency. It has the euro, and devaluing the euro has negative effects on other EU members.

Even without deliberate devaluation, the euro has dropped relative to safe-haven currencies like the U.S. dollar over the last few weeks, says Rob Hall, former hedge fund manager now writing a market watch newsletter based in Winnipeg.

"In the case of Greece, which is dominating the headlines, the U.S. dollar and the (Japanese) yen tend to come under pressure when the economic news for Greece is good," he says. "Good news that equates to calm and an improved outlook tends to see a switch from safe-haven holdings to both commodities and stocks."

Strangely enough, the Canadian dollar tends to do well in either scenario. EU uncertainty raises its value relative to the euro and calm makes it attractive to buyers because Canada is rich in commodities.

But the longer-term big picture is much less clear and potentially problematic.

"It's kind of overblown to one degree if you look at the size of the Greek economy relative to the size of the euro zone," Tihanyi says. "But on the other side of things, people worry about contagion risk and the viability of the euro zone as a currency union should one of its countries default on its debt without the support of other members."

Even if the Greek crisis remains contained, its troubles serve as a bellwether for larger economies.

Its government spending may be more out of control than most, but practically every major free-market democracy in the world is running record-sized deficits and pushing sovereign debt to new heights.

"What Greece, other nations in the euro zone and countries around the world, for that matter, are dealing with are budget imbalances exacerbated by the recent economic and financial crisis and the injection of massive amounts of liquidity," Hall says.

The developed world has had to spend its way out the so-called "Great Recession," leading to a new era of risk concerning sovereign debt, Ironside says.

"Over the long term, the worst country may be Japan because it is the second-largest economy in the world and currently has a debt-to-GDP ratio that is something just over 200 per cent," he says.

Still, Japan's public spending problem has gone on for two decades.

"Japan shows us that these things can go quite far," Tihanyi says, adding it has the benefit of market confidence.

"If one believes that an economy can still continue to grow in order to pay off its debt burden of today and even grow out of it, and demonstrate a commitment to fiscal responsibility, the market will give that economy a pass."

Greece doesn't enjoy that confidence right now, and its government has to make politically unpopular choices to cut its deficit to three per cent by 2012 to comply with EU rules. (Many observers question whether that is even possible.)

Still, it may take years for debt issues to become problematic for countries like the United States, Japan or even Canada -- or they may never materialize at all.

In the short term, the fallout from Greece could derail the global economic recovery. And if not Greece, then it could be some other nation to push markets back down, Ironside says.

"I think right now we've just been in a bear rally; I don't think we've been in a bull market at all," he says, adding a market shakeup would be another chance for investors to buy bargain-cost equities similar to last March and October of 2008.

"I certainly wouldn't be suggesting market timing, but if you have got extra cash, I might hold onto that, and be ready to step into the market."

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Page from the past

What happens when a country defaults on its debts?

Greece has a long history of defaulting on its debt, but it has never done so as a modern, industrialized nation. The last developed nations to do that were Russia in 1999 and Argentina in 2002, says currency analyst Sacha Tihanyi.

"Typically, governments don't actually pay down their debt," he says. "They roll it over. As their economy grows, they will devalue their debt." But developing economies or economies that have difficulty financing a large part of their borrowing needs in their own domestic currency issue debt in foreign currency. "That's because countries with loose monetary controls have a propensity to run high inflation because of seigniorage -- printing money -- to finance deficits." Because their domestic currency has been devalued, their ability to pay back foreign currency debt is also decreased. The longer the situation continues, the worse it gets and the market stops buying the debt.

Left with no other funding sources, the government prints more money, leading to hyperinflation. Public services are slashed, and the nation must undergo years of painful reforms before investment returns, states a Times Online article from 2008. Defaults also cause problems for global markets because debt-holders -- those who bought bonds -- often don't get repaid. According to the Bank of International Settlements, France, Germany and Switzerland hold more than $100 billion in Greek bonds.

Inflation -- backdoor taxation

Governments can tackle overspending by raising taxes or cutting public services. These are often good ways not to get re-elected. As a result, they often turn to more deficit spending, which leads to inflation.

"I always like to say that inflation is just another form of taxation," says finance professor Robert Ironside. If you buy a government 10-year bond today, you'll get your money back in 10 years. "However, if we have a bout of unexpected inflation over that period, the goods and services that my $1,000 will purchase have shrunk dramatically," he says. "There has been an effective confiscation of my wealth that is every bit as real as it is with income tax, but it is so insidious that even the weakest of governments can impose it."

While politically it is expedient in the short term, currency devaluation is not always in the best interest of the electorate in the long term. "If you look at who is the most affected, it's the middle class. Periods of high inflation tend to wipe out the middle class."