Greece, in an economic sense, is finished. A 50% writedown on debt is just a roundabout way of defaulting without using that particular word. Nobody voluntarily agrees to halve the value of their investment overnight - as is the case with banks which have exposure to Greek public debt. An unemployment rate of greater than 17% is not conducive to consumer spending, and thus in no way helpful for economic growth. Similarly, austerity and fiscal restraint send economic growth in the wrong direction.
If Greece were a case study it would be heaped in the "economic failure" basket.
The icing on the cake? Political failure, resignations, confidence votes, and referendum talks. All in all, desperate measures by those in power - not wanting to relinquish the reins or step down and risk being named "a failure" in the history books.
Greece - goodnight and goodbye.
Next Up: Italy
Italy, welcome to the arena. Challenger (investors) ... ready! Gladiator (Italy) ... not yet!
Next on the draw card is the market versus Italy. I'm placing my bets well and truly on the market for this match up.
Firstly, take a look at current Italian bond yields:
- 1 year: 5.0%
- 2 year: 5.5%
- 5 year: 6.1%
- 10 year: 6.4%
For the 10 year bond, the generally accepted "point of no return" is 7.0%. That's to say, if the 10 year bond yield exceeds 7.0%, the country will begin to spiral out of control.
But why 7.0 percent? After all, emerging economies such as Brazil have bond yields in excess of 10% and they seem to be doing alright?
The answer lies in the projection of economic growth. Let's take an analogy of running a business. Your business is a start up and currently in the "high growth" phase (a la Brazil). Borrowing money at 7% is a good economic decision, because that money could be reasonably put to work to generate a 10%+ return in the form of growth. Thus, at the end of the financial year, you could pay back the loan + 7% interest and be in a better position than you would have been had you not taken out the loan.
The same applies to an economy. As long as the pay off in economic growth and quality of life is greater than the cost of financing - taking on further debt is an attractive option, even at a relatively high yield.
Italy is not in the above position. Economic growth for Italy is less than 1% annualized. How could one possibly expect a 1% growth rate to finance a 7% long term loan? Regardless of how you look at it the answer will always be: you can't.
Essentially it's the ultimate ponzi scheme - on a sovereign level. New debt is used to pay the financing costs of the old debt, deferring the economic problems until a later date and making the debt load even higher.
Here is the predictable flow of events as a result:
- Accounting Imbalance (cost of debt = higher than return on debt)
- Rescue Package (i.e. EFSF)
- Reform (often promised in return for a rescue package)
- Default or Stabilization
Default OR stabilization? The final destination for an economy in the above situation is almost entirely dependent on step 3 - reform. Minor reforms are easier on consumers and businesses and might create moderate / manageable citizen discontent and protest. Examples include welfare cuts, labor market reform, new laws regulating debt, etc. Such reforms are so pathetic in the scheme of things that they will only buy time.
Major reforms, including complete overhauls of government, public finance, and the financial / banking sector are deeply unpopular and controversial and will almost certainly lead to political suicide. Yet they are exactly what is needed for any hope of stabilization.
It's a double-edged sword.
Italy is currently on step 3. They have chosen the typical array of lame reforms which might buy 4 - 8 months worth of investor content, if that. Following this, the situation will likely follow exactly the same path as Greece - only on a much larger scale.
At some point, a "writedown" or "haircut" will occur which as we all know is a more palatable term than "default". It's the same thing, just sugar-coated.
So keep an eye on things folks. Watch that benchmark 10 year bond yield - and when you see it hit 7% (which is only a matter of time), check back here and i'll provide you with the next iteration of commentary.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
