In the last few weeks there have been a lot of headlines about Greece, full of sensational statements like “FTSE 100 drops as Greek debt crisis triggers global rout”.  So what exactly is going on in that corner of the world and why do riots in Greece matter to Canadian markets and investors?

How We Got Here

There have been a lot of events that one can point to as the start of the crisis but most would agree the origins lie with the start of European monetary union in 1999.  From the start there was a lot of skepticism that countries could share a currency without also sharing control of fiscal policy.  There was an attempt to address this issue by placing restrictions around how much debt and deficit spending each of the countries in the Euro could have (no more than 60% debt to GDP (‘Gross Domestic Product’) no more than 3% of GDP budget deficit per year) but with no real enforcement mechanism, these restrictions have been largely ignored.   What the Euro allowed countries like Greece to do was borrow at artificially low rates made possible due to their new ties with strong partners like Germany and to put off economic reforms necessary to keep their economy competitive.  When the credit crisis and accompanying deep recession hit, not only did the Greek budget deficit balloon to over 15% of GDP, but it was revealed that the Greek government had been misstating their debt numbers for years.  These realizations caused bond investors to refuse to rollover maturing Greek debt, which in turn forced the other members in the Euro together with the IMF to come up with a €110 billion bailout in May of 2010.  Unfortunately, by the first quarter of this year, it became obvious that the original bailout wasn’t sufficient and that Greece needed another €60-70 billion.   This time around,  the bailout is not a given.  Serious rioting has dominated recent headlines.   Greeks are protesting the package of tax increases  and spending cuts that are a prerequisite of accessing the money from the second bailout package, which itself has not been ratified by the donor countries, who themselves seem to be increasingly reluctant to supply more cash.

Why Does It Matter?

Normally, it would seem odd that a crisis in a country that makes up a mere 2% of Euro zone GDP would command so much attention, so why is Greece so important? One reason is that European banks, especially French and German ones, hold a lot of Greek debt and a default would cause significant damage to balance sheets that still have not fully recovered from the deep recession of 2008-09.  The other, far more important reason, is that Greece was not the only member of the Euro that was able to use its membership of the Euro zone to borrow at artificially low rates.  If you look carefully at much larger and more important members like Italy (7x the size of Greece) or Spain (4x) there are a disturbing amount of similarities to Greece’s finances.  Bond investors are already demanding higher interest rates from these countries and a disorderly default by Greece could easily cause rates to climb to unsustainable levels, and the turmoil this would cause could easily tip the fragile recovery into another recession in Europe.

What Do We Need to Watch?

The recent passage of the austerity package removed a lot of the near term danger of a default by Greece and has resulted in a rally in most of the markets around the world.  However, this doesn’t mean the situation is  resolved.   In the near term, the details of the second bailout package are still to be worked out and ratified, with meetings of all the finance ministers in the Euro scheduled for early July.  Even if the money is raised, it is becoming evident that simply lending Greece more money on an ongoing basis is not sustainable, and some sort of debt restructuring will be necessary.  While we anticipate that a solution will be found, how this is going to be accomplished is going to be source of a lot of tricky negotiations over the coming months.  And although a successful resolution of the problem of Greek debt will help defuse some of the immediate risks facing the Euro zone, we would caution against complacency as it does very little to address the underlying imbalances facing the rest of the members.  We will continue to monitor the evolution of Eurozone policy and the systemic and counterparty risk to your portfolio.

The article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.