Greece is a beautiful country with incredible historic sites and hundreds of islands that are a once in a lifetime experience for travelers. Unfortunately, the country has dominated financial press lately as it teeters on the brink of bankruptcy and is largely responsible for the recent pullback in the equity markets. I was lucky enough to spend my honeymoon in the Greek Isles, but it appears the honeymoon may be over for the country, and possibly even for the European Union (EU).
Why is a country that accounts for only 2.6% of Europe’s GDP and roughly 0.5% of global GDP so important? The answer lies in the level of interconnectedness in the world economy, amplified by a recurring problem in the developed world: mountains of debt.
The cycle continues….Mike has written extensively on the Great Deleveraging Cycle and how this process must eventually shift from individuals to governments. Greece is providing a first look into the inherent difficulties of this progression. In simple terms, Greece cannot pay back its debts. Using an analogy from the recent housing meltdown, Greece is a subprime borrower that cannot afford its mortgage and owes more than the house is worth. It may seem appealing to discount Greece due to its relatively small size, but subprime mortgages only represented about 12% of the mortgage market at the peak in real estate. And we all know how that turned out…..
Other countries in the EU and the International Monetary Fund jointly announced a $143 billion relief package to Greece earlier this week, but even that appears to be insufficient. Rates on 2-year Greek bonds recently spiked to almost 20%, as few entities believe Greece will repay their debts in full. In order to qualify for this aid package, Greece must agree to severely cut its deficit over time, and has announced increases in taxes, cuts to public sector wages, and cuts to both private and public sector pensions. The reaction in Greece has been troubling. Protesters are throwing bottles, firebombs, and anything else they can get their hands on at government buildings and banks. Police are fighting back with tear gas and fire hoses. In short, it’s a mess over there. Adding fuel to the fire, the government must deal with a culture in which tax collection is laughable: only about 5,000 people in a country of more than 11 million declare more than 100,000 Euros ($130,000) in annual income. How can the government close the deficit if it can’t collect taxes? Serious structural reform is a necessity.
Beyond its borders…Greece’s troubles are reverberating in other European countries as EU taxpayers, predominantly Germans, wonder why they should work hard and save so that their money can be used to bail out their neighbors that live beyond their means. 
The German taxpayers offer a very good question, but unfortunately for them, all EU countries are linked by one currency, and therefore dependent upon each other. Additionally, the vast majority of Greek debt is held by banks in France, Germany, and other European countries. According to the Bank of International Settlements, French banks own $75 billion in Greek debt and German banks own $45 billion. Combined, this represents more than half of Greece’s outstanding debt. Needless to say, a Greek default would have serious repercussions for these two countries’ financial systems.
Not surprisingly, the financial markets are focusing on who is next. Spain, Portugal, Italy, and to a lesser extent Ireland, are all candidates. The Greek crisis would not be as important for global financial markets if these other countries did not also have troubling fiscal situations. Much as the financial markets focused on the next weakest investment bank after Lehman Brothers imploded, all eyes are on the next weakest country in the Euro zone. Investors learned from the subprime crisis that fear spreads quickly and that no one wants financial exposure to the next worst country.
We’re all in this together….Europe represents roughly 20% of global GDP, so why can’t the other 80% just hum along without them? Because the world has changed dramatically over the last few decades. Yes, China, India, and other emerging markets will continue to dominate global growth, and yes, the emerging Asian consumer is much more economically important than the European consumer. But the EU is China’s largest trading partner. A huge slowdown in European growth will work its way through the connected system and depress global growth. No one was counting on Europe to lead the recovery, but it would be helpful if they didn’t inhibit it.
From an investment strategy perspective, this is a reminder that the global economic recovery will be bumpy and painful. We are likely to learn Friday that the US economy created more jobs in April, which may provide a diversion to the unsettling situation in Europe. Economic recoveries are rarely smooth, and positive and negative events will continue to pull against each other as we emerge from the recent recession.
The daily drama in Greece reinforces our investment process of focusing on high quality companies with manageable levels of debt and strong cash flow. Excessive debt can suffocate entities and impede future growth potential. Worse over, burdensome debt levels can lead to devastating spirals from which escape is very difficult.
In the coming weeks and months, the fate of Greece and the Euro currency are in the hands of a few European countries and the European Central Bank. The world survived before the EU was created and could survive without it again, but the current problems add to the volatility of the recovery and may potentially dampen global growth.
Tom Searson, CFA
