What happens when Greece finally goes bust? - Outside View by MoneyWeek

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What happens when Greece finally goes bust?
Jun 23, 2011

Greece is bust and on the verge of default.

So tell us something new, you say. The headlines have been full of Greece's troubles for ages.

The question is: why is Greece panicking markets now?

It's because markets had assumed that Europe's bosses would do all they could to avert disaster.

With Germany and the European Central Bank at loggerheads, that now looks increasingly doubtful.

So what will it really mean for investors if Greece goes bust?

A Greek default is just a matter of how and when

A quick recap: Greece was bailed out a year ago to the tune of €110bn. The government promised to slash the budget deficit - the annual shortfall of state spending minus the tax take.

Yet lenders still didn't believe the country could service its existing borrowings. The debt pile Greece had already built up was just too great.

So they slashed the value of Greek government bonds, driving up the yield. If Greece tried to borrow today, it would have to pay up to 30% a year. That indicates just how little faith investors have in the country's ability to repay any loans.

And small wonder. By the end of this year, the Greek government will owe over 150% of the country's annual output, reckons the International Monetary Fund (IMF). By 2016, even with huge state spending cuts, that figure will only have fallen to 146%. History shows that once a country's debt/GDP ratio rises above 150%, a default is just a matter of time.

In other words, Greece is about as bust as can be. Trouble is, Europe's finest can't agree on what to do about it. The European Central Bank (ECB) wants to keep 'extending and pretending', ie give Greece more eurozone taxpayers' money to buy it time while it knocks its finances into shape.

But Germany isn't keen. It wants private investors in Greek debt to take some of the pain as well. And the Germans are trying to delay a second bail-out package until September, according to Reuters yesterday.

Unfortunately, time is fast running out. Protests against cuts on the streets of Athens are getting nasty, and could pull the government down. That increases the risk of a 'disorderly' default, where Greece just turns around and tells its creditors and the rest of the eurozone where to stick their austerity.

Could Greece become Europe's Lehman Brothers?

What happens then? Let's look at who's got what on the line.

At the end of 2010, according to data from the Bank of International Settlements (BIS), Italian banks held $2.3bn of Greek debt, and UK lenders were in for $3.4bn. They should be able to cope with those losses.

But then the numbers get much scarier. French lenders held $15bn of Greek sovereign bonds, while German banks were exposed to more than $23bn. The total for European banks was $52bn.

This doesn't include the ECB, which itself has bought €47bn-worth of Greek bonds in a failed attempt to boost confidence in the country. "It's become an enormous… dumping ground for bad loans", notes Matthias Brendel of Spiegel Online. "No expert can say how it can jettison these without dealing a fatal blow to the European banking system."

On top of this, exposure to Greek banks in emerging Europe "is rife", says Joseph Cottrell on FT Alphaville. "Greece's banking sector is largely Romania's and Bulgaria's banking sector."

What does this mean? Subsidiaries of Greek banks in these countries have accounted for a large slice of domestic lending. As these subsidiaries are forced to send more money back home, the "least bad outcome", says Nomura, is that lending will collapse in Romania and Bulgaria. That would be damaging for growth.

But if those Greek bank subsidiaries run out of money, they in turn could be forced to default. And in a mad scramble for cash, that could lead to the worst-case scenario: "a fire sale of emerging European assets".

And then there's the question of what happens to all the credit default swaps (CDS) written as insurance against Greece going bust. If Greece defaults, would the banks who wrote this insurance be able to pay out?

This may all sound familiar. That's because you've seen it before. "The probability of a eurozone Lehman [Brothers] moment is increasing", says Neil Mackinnon at VTB Capital. "Markets are looking at a scenario of a Greek debt default becoming disorderly".

The big worry is that, as happened with the Lehman collapse in 2008, banks will stop trusting one another as fears over exposure to the country's debt contaminate the eurozone.

'Counterparty risk' will become an issue once again, as banks that once looked OK have their capital eaten up by Greece-related debts going bad. So banks will stop dealing with each other - which is key to a functioning economy - in case they don't get their money back.

It's like finally picking a winner at Royal Ascot but finding the bookie can't pay out. In turn, that would undermine your own finances.

How the dollar could benefit from Europe's woes

You're getting the - very, very messy - picture by now. And it's likely to prove bad news for the euro, as John Stepek noted last week: The battle for Greece looks set to slam the euro.

So where are the safe havens? Clearly, gold is one. If ever there's a time to stick with it, now is that time, as Dominic Frisby was saying yesterday: What the '70s bull run can teach us about today's gold market.

The other is less obvious. America is hardly trouble-free, as reflected by the weak dollar. But compared with Europe's looming woes, US problems are "small beer", reckons Charles Dumas at Lombard Street Research. "The euroland outlook has to be dollar-positive for the balance of 2011."

We'll be looking in depth at ways to take advantage of a stronger dollar in a future issue of MoneyWeek magazine. Meanwhile, if you're looking to trade currencies direct, spread betting is one way to do it. It's certainly not without risk.

This article is authored by MoneyWeek, the UKs best selling financial magazine. MoneyWeek offers intelligent, easy-to-read analysis of the financial news, with practical investment advice.


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