Greece's Agony

Mar 15 2010

Ranga Chand’s Notes on the Global Economy & World Financial Markets – March 2010
 
 
Greece’s Agony
 
An Economy on the Brink of Disaster
Greece’s economy is rapidly spiraling out of control. Saddled with a budget deficit of close to 13% of GDP – the largest in the European Union – a debt-to-GDP ratio of over 110% and a current account deficit of around 10%, the chickens are now coming home to roost with a vengeance. After a decade of profligate spending, the country now faces a prolonged period of economic austerity, rising unemployment and falling living standards.
 
What precipitated the current crisis was the revelation last October by the new socialist government that the budget deficit was virtually double the previous estimate. Evidently, the preceding conservative government had been fudging the numbers. Predictably, market reaction to the news was swift. Investors started dumping Greek bonds on the market which sent yields surging, significantly raising the borrowing costs for the government. For example, prior to the crisis, the average yield on the 10-year Greek government bond was around 4.5%, compared to today’s yield of about 6.25%.

In the immediate future, the government needs to borrow 20 billion euros to refinance its bond holdings that are maturing in April and May. With investors continuing to be concerned that the government might default on its huge debt and coupled with the downgrades by the major rating agencies, it is a given that it will be considerably more expensive for the Government to borrow the funds it needs to keep going.
Government Hamstrung on the Economic Policy Front

To extricate the economy from its deep hole is going to be both challenging and extremely difficult. The problem is that in dealing with the economic crisis, the Greek government’s hands are effectively tied. Being part of the European Union and sharing the common currency of the Euro, it cannot pursue an independent monetary policy; it cannot devalue the currency nor can it simply opt out of the Euro. At a minimum, pulling out of the euro would trigger another Lehman Brothers fiasco and send world financial markets reeling. It would also be ‘lights out’ for the fledgling global economic recovery.

On the fiscal policy front, with the Greek economy still firmly stuck in recession – GDP contracted for a fifth consecutive quarter in the fourth quarter of 2009 – the government cannot use its fiscal levers to pump-prime the economy. On the contrary, instead of being able to use fiscal policy to stimulate aggregate demand, the government is being forced to implement draconian fiscal measures to slash the deficit and reduce its national debt of close to 300 billion euros. To this end, public sector salaries have been cut, various taxes are being increased, pensions have been frozen and the retirement age is being pushed-up from 61 to 63.
Austerity Measures to Further Depress the Economy

The trouble is that the impact of all these austerity measures, while necessary and unavoidable, will not only further depress the economy but it will also prolong and deepen the recession. Nevertheless, despite these deflationary measures, the government is banking on the private sector to pull the economy out of its slump and return it to positive growth. That, however, will be a tall order. Sideswiped by the global recession, both consumer spending and business investment have been contracting for several months now and the latest spending cuts and tax hikes will only exacerbate the situation. Moreover, with borrowing costs rising, loan demand is likely to be moribund.

In addition, given the size of its current account deficit, the Greek economy is not competitive and thus it cannot rely on the export sector to bail it out. Not having the option to restore its competitiveness through currency devaluation, some analysts have suggested that the only way for

Greece to boost its competitiveness is for the economy to lower its costs relative to its competitors. While in theory this makes sense, in practice it is a non-starter as it would require across the board wage cuts and a more flexible labour market and is something that the unions would fiercely resist.

But, despite the powerful headwinds facing the economy, the government nevertheless heroically expects GDP to contract by a negligible 0.3% this year, before returning to positive growth next year. Moreover, the forecast is for growth to accelerate in the ensuing three years rising from 1.5% in 2011 to 1.9% in 2012 to 2.5% in 2013. Given the severity of the underlying cyclical and structural issues that the country faces, these projections are overly optimistic and lack credibility. 
Deficit Reduction Targets Unlikely To Be Met

With the Greek economy still stuck in recession, it is highly unlikely that the government will be able to hit its deficit-reduction targets of 8.7% of GDP this year, let alone meet the EU benchmark of 3% in 2012. The austerity measures announced so far have only temporarily eased the financial crisis, but there is still a long way to go before the economy stabilizes.

Indeed, as noted above, the recession is likely to deepen under the weight of painful cuts and this will inevitably push back hopes of a much needed rebound. The problem is that, should the economy’s performance worsen over the next few quarters, the deficit could well start to climb again. While the odds of such an outcome occurring may appear to be small, it would be foolish to dismiss it out of hand.
Given all the uncertainty about the near-term direction of the economy, investors and speculators betting against Athens achieving its budget targets will likely remain on the forefront for the foreseeable future. It may well take a lot more fiscal tightening to appease the bond market, but that would put the Greek government in an untenable situation forcing it either to seek a bail-out or default on its debt.
Bottom Line

As Greeks stare into the economic abyss, it is little wonder that at a recent press conference the country’s Prime Minister, Mr. Papandreou, said that ‘…the financial crisis threatens the (very) sovereignty of the country’. It is a melodramatic statement for sure, and one that was squarely aimed at preparing his fellow countrymen of the painful times that lie ahead. But, let us hope that it doesn’t turn out to be prescient as well.

© Copyright 2010 Chand Carmichael & Company Limited

 
 
About Ranga Chand
Ranga ChandRanga Chand is recognized both domestically and internationally as one of Canada's leading economists and mutual fund analysts. Professionally, he held senior positions with Canada's Department of Finance, then served as a director of the Conference Board of Canada, before joining a major stock brokerage firm. He has also taught economics at the University of Waterloo, published extensively in the field of economics, and represented Canada at numerous economic forums, including the OECD in Paris, the United Nations, and the World Institute of Economics in Germany.
 
A media personality with a huge following, his popular television show "Talking Mutual Funds with Ranga Chand" aired weekly on Canada’s Report on Business Television (ROBTV) for three years from 2000 to 2003 and reached over 4.3 million viewers nationwide. Much in demand by organizations, industries, and associations throughout North America, Ranga is well known for his down-to-earth, clear, and informative presentations on the subjects of the global economy and investing.

He is the author of a number of best-selling books including:
  • Ranga Chand's Top 50 Mutual Funds
  • Ranga Chand's Getting Started with Mutual Funds
  • Best of the Best Mutual Funds, Featuring America's top 50 Heavy Hitter funds
  • Is Your Retirement at Risk? Winning Strategies for a Financially Secure Future.
Highly respected in the investment community, Ranga Chand is founder and President of the research and consulting firm Chand Carmichael & Company Limited, located in Ottawa, Ontario.
 

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