Earlier this month, the world watched as the Greek economy teetered on the brink of default. Having benefited from a decade of unprecedentedly cheap capital, Greece borrowed heavily. Lenders knew that the currency was stable and assumed that fellow members of the European Union would not let one of their “sister” countries fail. Investors priced Greek debt with a presumed “backstop,” assuming stronger countries would save the weaker ones. This would be especially true of a relatively tiny member like Greece, which represents a mere 2.5% of the Eurozone economy.
Ten years ago, Greece went through a major transformation before being allowed to join the European Monetary Union and trade in its drachmas for euros. As a condition for admission, it appeared to have controlled runaway inflation and, most impressively, reduced its national debt to below the required 60% of GDP and its annual deficit to GDP ratio close to the suggested 3%.
Along with Portugal, Italy and Spain, which deployed comparable remedial measures, Greece went from being a failed economy with spiraling inflation and burgeoning deficits to a darling of the international investment community. These four countries were collectively hailed as Club Med. Investors were eager to bask in these sunny markets which seemed so tranquil, transparent and trust-worthy.
From Club Med to PIGS sty
Portugal, Italy, Greece and Spain are no longer referred to as Club Med. Instead, they are now known by the pejorative acronym: PIGS. Just as the American financial crisis was triggered by homeowners becoming intoxicated on cheap credit and using their homes as ATM machines, these countries were able to access global capital markets at interest rates that were essentially similar to those being paid by Germany or France. Just as mortgage companies didn’t differentiate among borrowers and extended financing to any and all applicants, international investors were allowing our “PIGS” to borrow and spend well beyond their means.
Widespread application of financial derivatives further bolsters the analogy. Mortgages generated during the real estate bubble were sliced, diced, stripped and repackaged by the most creative minds on Wall Street. The financial community convinced itself that it was able to take the risk out of the system by creating expanding tranches of debt. It became nearly impossible to decipher who owed what to whom. Throw in the credit default swaps that enabled all this mischief to take place “off balance sheet,” and you begin to understand how the global financial system would have imploded but for government intervention.
Purim in Europe - removing the mask
Derivatives were similarly used aggressively by PIGS to hide loans, dressing them up to look like something entirely different. In 2001, just before adopting the euro, Greece entered into a currency swap with Goldman Sachs that helped mask $10 billion in outstanding debt. Goldman collected a whopping $300 million fee that was similarly concealed within the transaction. In several other trades, Greece was able to borrow billions immediately in exchange for all its rights to airport fees and lottery proceeds for decades.
Portugal, Italy and Spain also applied financial “make-up” generously to make their balance sheets look prettier. Banks were eager to provide cash upfront secured against streams of income anticipated by those governments, in some cases for over 30 years. More egregiously, by using credit default swaps and other creative instruments, those liabilities were kept off the books of both the borrowing governments and the lending banks. They were never disclosed as loans. Investors were completely misled about the piles of liabilities accumulating at “Club Med.” The whole process violated every principle of financial kashrut.
In November 2009, our caring friends at Goldman Sachs came back to Athens with a new costume and offered to drop additional “pearls” before our desperate debtor. The specific proposal was to defer Greece’s health care liabilities into the distant future, essentially turning a sow’s ear into a silk purse. However, by this point, the finance ministry was under increasing scrutiny. Practically and politically, it would have been impossible to masquerade the transaction as something other than prohibitively expensive long-term debt.
Preventing sovereign debt swine flu
Earlier this week, George Soros warned that troubles in Portugal, Italy, Greece and Spain could threaten the euro itself. While I’m not a fan of his interminable political pronouncements, I’ll be the first to admit that Soros does know something about currencies. His most famous and successful trade was “short-selling” the British pound sterling in 1992, knocking it out of its prescribed band. Soros recognized that macro-economic factors in England were too weak to support the artificial floor established by the British government and his insight earned him $2 billion.
Ironically, that event was a catalyst for the birth to the euro itself, though Great Britain, while an EU member, chose not adopt the currency. Instead, Germany, the strongest economy in Europe, led the way towards continental monetary union and has the keenest interest in a stable euro. Despite bailout prohibitions within the euro agreement, Germany may still find a way to save Greece. However, its pockets aren’t nearly deep enough to rescue all the other failing nations.
Since becoming EU members, each of the PIGS has violated all the major Maastricht admission criteria. For example, Greece’s debt to GDP ratio is fast approaching 120%, double the prescribed ceiling, and its deficit to GDP ratio is over 12%, more than 4 times the suggested level. Whatever method is ultimately chosen to deal with the current crisis, the hard lesson already learned is that when Greece or any other EU member -- sneezes, the rest of the Eurozone catches a cold.
Will that cold become contagious, giving rise to the equivalent of a swine flu in the sovereign debt markets? We may discover the answer in the next few days. A week ago, Greece announced a 5 billion euro (nearly $7 billion) 10-year bond offering. If it actually happens - and succeeds - it will prove that countries can, at least in the short run, borrow their way out of a crisis. If the offering fails, the rest of the Eurozone will have to come up with a concrete rescue strategy - and fast.
America the beautiful
At 13%, America’s deficit to GDP ratio is even higher than Greece’s and as high as it has been since the country financed its military expenditures during World War II. Moreover, while America’s national debt is only about 85% of GDP, that’s still over $12 trillion - and rising every day. At current interest rates, the debt service is about $200 billion annually, an amount that the US economy can absorb easily. Yet that number is expected to double within the next couple of years, a burden that will be much more difficult to shoulder, especially if economic recovery remains elusive.
Nevertheless, whenever global markets get ugly, investors seek the safety of the United States. February has seen an impressive purchasing trend in many US securities, particularly treasury bonds. As expected, the dollar strengthened meaningfully and interest rates have remained low. America can still raise unlimited amounts of cheap capital which, in my view, has all the appeal of a Greek tragedy.
My advice is “don’t do it.” America should take note of how other countries got into trouble and resist the seduction of easy money. Borrowing your way out of a debt crisis makes as much sense as digging yourself out of a hole. Or, if you prefer, like putting lipstick on a pig.
Lyon (Lenny) Roth is a senior executive at an international wealth management firm and a member of Ben Gurion University's Board of Governors.
Published by Globes [online], Israel business news - www.globes-online.com - on February 25, 2010
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