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The Globe and Mail

Brian Milner explains the Greek debt crisis

We've been reading a lot about Greece's debt crisis, which has now spread to other countries. How did it begin?

The problem started long before the current situation. Greece has been living beyond its means for a long, long time. In fact, from the time it joined the euro zone, its deficits have been higher than 7 per cent, which is more than double what they're supposed to be to belong to the euro. Greece has structural problems within its economy that it never really resolved. It's a very small economy with a very large public sector which accounts for about 40 per cent of its GDP. It was deficit spending all along and the 2004 Olympics made things even worse.

Then along came the global financial crisis which meant that suddenly Greece was faced with even more severe economic problems and had to come up with more money for social spending, unemployment was rising, and the economy was getting even weaker, which meant it had to borrow more money to keep things afloat. As long as rates were relatively low, they could keep that thing going.

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Warren Buffett once said that in a financial crisis you see who's swimming naked. Well, the Greek's have no clothes, and that's been going on for a while. What precipitated this actual crisis is that when the Greeks looked at their treasury, they realized that they didn't have enough money to keep financing their deficit, which is growing alarmingly. Their interest costs are now so high that they account for more than 22 per cent of all government revenues, which means that merely one in four dollars the Greeks collect has to go just to pay the interest on their debt. That's about €1.5-billion a month.

Who are Greece's creditors? Who's going to suffer if it defaults on its loans?

Anybody who's stuck with Greek bonds, that includes foreign institutions, foreign governments, foreign banks, a lot of pension funds, which in fact were attracted to Greek bonds in the first place because they were getting higher yields than they could on other euro bonds. So if you believe the euro's pretty safe, why buy German bonds when you can get much more yield from Greek or Portuguese or Spanish bonds, and that's what attracted people to it, in the belief that there would be no danger of default, and Greece had an investment grade credit rating from the ratings agencies, which made it eligible for a lot of pension fund investments. These pension funds are not allowed to hold any bonds that do not carry investment grade ratings.

What do the high yields of Greek bonds tell us about the credit worthiness of the country?

They tell us that it's not very credit worthy. When you have to pay 24 per cent to get people to buy your bonds, they don't think that your word backing those bonds is worth very much. The real risk of default causes investors to demand those kinds of yields, and only people who play in that sort of market, which is high, high risk bonds, are going to invest in them. Most institutions won't touch them -- they're not allowed to under their own covenants because of the risk attached. Of course, they're now fearing they will get much less than the face value of their investments when they have to cash them in.

The Greeks are not able to issue new bonds with those rates -- they can't do it because they can't afford it, so we're not seeing any new issues. The Greeks are basically being frozen out of the bond market for now. There is going to be, if not a default in actuality, it will be what's known as a soft default, whereby the Greek government negotiates new terms with these creditors and basically says, we can't give you cash for your bonds, but we can give you new bonds for your old bonds. These new bonds will carry higher interest rates in some cases and lower principal payments, in other words, they're going to have to accept less than thought, and there are estimates ranging anywhere from a 30-to-70-per-cent reduction on the actual value of the bonds they hold, and that doesn't mean they get the cash right away. They get new bonds that mature at a later date than the bonds they currently hold.

How is the current crisis connected to the financial crisis of the past two years?

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It's intimately connected with it because as the markets closed up and the global economy started coming to a halt, that hit the very small Greek economy directly. Its key sources of revenues are things like tourism and of course that was way down because of the global economic problems. At the same time, borrowing costs rose, lenders became much edgier about giving money to questionable borrowers and in the case of Greece, the Greek banks are heavily exposed in the Balkans -- they've been lending a lot of money to places like Albania, Macedonia and Serbia, and to do that, they'd been borrowing from bigger banks and Germany, France and elsewhere, and securing those loans with Greek government bonds as collateral. It's the same at the European Central Bank. If a bank needs overnight financing from the ECB, it puts up Greek government bonds as collateral. But the ECB is not allowed to accept any bonds that aren't investment grade, so if Greece's bonds are suddenly turned to junk by the rating agencies, the ECB is not allowed to accept that collateral, which means it can't give money to the Greek banks. So that's a major problem and a lot of that was precipitated by the initial financial crisis because once credit markets froze up, they just lost access to all kinds of potential funding that was available before at relatively low rates.

Remember that interest rates were very low, you could borrow really cheaply, and that enabled them to finance incredibly profligate spending. Some of it was required by Greek law, because they have a huge social safety net, bizarre contracts with public sector unions that enable them to get 14 months salary for 12 months work, huge pensions, as the economy slowed down they were faced with much higher unemployment costs and all the things that go with it. We've seen it in North America, the U.S. and Canada had to take on huge deficits to cover amazing problems in the financial system but also in their economies. The Greeks did the same thing on a smaller scale, but they had no money to do it.

What are junk bonds?

It's a wonderful term that came out of the late 1980s when Michael Milken created what's known as the junk bond market. These are just bonds rated below investment grade, which means they have a higher risk than bonds where you're more confident of the future of the issuer. Once that happens, and in fact it happens before they get downgraded to junk, when they're on the edge of it, a lot of institutions aren't allowed to own them. Major pension funds cannot own high risk bonds for the most part. The big pension funds we know have to have investment grade bonds to balance out their riskier equity investments and other things like that. So as long as Greece had an investment grade bond with a nice yield, the Scottish widows and orphans fund, for example, could buy it. When it's junk, they can't touch it and they're required to sell it, which makes the problems even worse because you have to have more of this stuff on the market, you have yields rising to exorbitant levels because investors need to be rewarded for the high risk, the market shrinks, in this case the Greek government can't issue new bonds because it's impossible, the market won't accept them and the Greeks desperately need a handout from the IMF and their colleagues in the euro zone.

We've heard recently about ratings agencies like S&P and Moody's downgrading other countries such as Spain. What does that mean when a country gets downgraded?

It means they're no longer as comfortable with the country's debt ratio. The things they measure are the ability of a borrower to repay the bond. That means that they look at things like revenue sources, economic prospects, debt-to-GDP levels, which are an important indicator, budget deficits, future costs and future prospects for increasing revenue, i.e. can they raise taxes if they have to, is there an opportunity to make cuts in fiscal spending. Those are the things they're supposed to evaluate on a regular basis and the ratings are supposed to reflect their view of the prospects of a borrower to repay, so when they make a cut of any serious amount, (i.e. a cut from triple-a to triple-a-minus is not a major cut -- that just means they're a little more leery than they were before), but if they go down a whole letter, from A to B, which happened in the Greek case, that's a serious cut, that means they're convinced the borrower is no longer as capable of repaying the debt as they thought. It doesn't mean they won't pay, or that they're about to default, but it means there's a higher risk of default and you as a lender need to be aware of these things.

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The problem with ratings agencies is they often come in after the horse has left the barn to try to close the door. In the case of Greece, the market was already saying their debt was junk, so coming out with a rating now and saying we're downgrading it to junk doesn't mean much to the market -- they were already regarding it that way -- they're just matching reality right now.

In the case of Spain, which was downgraded, it's still rated as an investment grade bond. That means institutions can still own it. They may want a better mix of higher grade bonds in their portfolio, but they don't have to dump the Spanish bonds yet because there's no danger Spain is in danger of defaulting the way Greece is.

Greece and Spain aren't the only countries with massive debts. Why are a few European countries being treated so differently? what is unique about their situations?

Every country during this current economic crisis has taken on much larger deficits to cover rising social costs and to try to stimulate their economies. But other countries with very high debt levels like Italy, for instance, don't have the same exposure in the credit markets. Because they have larger economies, the French, the Italians and others with high debt levels can mostly finance them on their own. They have taxing capacity, capacity for economic growth and creditors aren't as exposed in these countries as they are to the smaller ones, where the countries really can't make the changes they need to quickly enough to turn things around.

Britain has a very high debt level, but it has its own currency, and it can devalue that currency -- it already has. Once you devalue a currency, your domestic economy improves because people tend to buy more domestic products and import less. Your export market improves because your costs of production and exporting go down. Greece and Portugal, which are very small economies, don't have that flexibility because they're tied to the euro, and they can't devalue their currencies to fix any of this. So they're stuck with a relatively strong currency, which means that they have these imbalances continuing. Ireland is in the same boat, although it has taken much tougher measures to get its fiscal house in order.

What does all this mean for the strength of the euro currency and its future?

The euro has been coming down in value as investors lose confidence in the region, there's no question about that. But for Greece and the other smaller southern European countries to benefit, the euro would have to basically plunge to 80 cents (U.S.) and right now its still around $1.30, so you can see the difference. If Greece still had its own currency, the drachma, it probably wouldn't have got into this pickle in the first place, because the markets would have told them, you have too much debt, but because it was issuing debt in euros, it never got that signal, the market was perfectly happy with the euro for a long time as an alternative to the American dollar, because they were worried about American economic prospects, and they needed to balance their portfolios so they were buying Greek bonds, even as the Greek economy was collapsing.

That wouldn't' have happened with the drachma so they lose an important signal in the market place that's there if they have their own currency. A slightly falling euro benefits the strongest economy in the region quite a lot. That's Germany, because it's a huge exporter. But the fall won't be enough to benefit these smaller countries, and there would be no stomach for a drastically reduced euro because then the Germans and the French could say, well, if we're only going to have an 80 cent euro, we might be better off going back to our own currencies. A lot of risks are going forward for the euro. It's been overvalued for a long time, and most analysts say it probably should never have been above $1.20, based on Europe's economic prospects on its demographic issues and structural problems.

But the problem is when you have a single currency and 16 separate fiscal policies, you're going to have these issues. They were very lucky for nearly the first decade of this currency that they didn't have this crisis and that's because they had this booming global market. That's not there now, aand they're going to have to readjust and that's going to mean further stresses on this particular currency.

Why are investors flocking back to the U.S. dollar?

Because the U.S. dollar for all the problems that the Americans have, remains the safety net of choice. And the first thing investors do when they're worried about another market or currency is rush to U.S. bonds. The U.S. has never defaulted on a bond in its history, it still has the world's largest economy, it's recovery is actually stronger than a lot of people thought and when push comes to shove, people still feel safe with those greenbacks. and the fact is that the Americans have severe fiscal problems, but as long as other people are willing to own their debt, they'll always be able to finance their way out of this mess and that's something not available to a lot of these sad European countries.

How and why is this crisis spreading to other countries? People are referring to it as a contagion.

They're even calling it an Ebola virus. It spread because once investors begin to lose confidence, it quickly mushrooms, so for instance, say you're buying bonds denominated in euros issued by Greece, and you don't want those bonds any more. Then you say, well, if Greece is having this problem, who might be next?

And clearly the next weakest country in the euro zone is Portugal, so suddenly there's a run against Portugal, and nobody wants Portuguese bonds -- they don't want to be the last person holding a dicey euro bond, so what do they do? They abandon the weaker bond issuers, and if they still want to hold euro bonds, they'll go to Germany which is the strongest economy in the region, and they'll buy German bonds. That gives them the euro exposure they might want in their portfolios without the risk that they perceive. In fact, what has happened is they've even been abandoning those. They've been rushing back to U.S. bonds and moving into Swiss bonds.

These are the traditional safety nets, they've been buying gold again -- that tends to happen, and it's really a crisis of confidence and it's hard to arrest that crisis without dramatic action and the problem in Europe is that they're been dithering.

It was described by one Greek commentator as the European union pushing the button but knowing it wasn't connected to anything. And what they did was say to the world, we will make sure Greece is okay, and you don't have to worry -- we'll put up the money necessary to keep the Greek government afloat, and by implication pay all its debts to bond holders. Well, if that had worked, the market was saying, great, the money's going to be there, I'm going to keep buying European bonds... But it didn't work, which means they weren't able to arrest the crisis of confidence by doing nothing, which is what they wanted to do.

Now they actually have to do something and the bond market looks at this and says, well, they're really not moving very quickly, considering that now I'm facing junk bonds on one side and devalued bonds from other countries, what is going on? Well, as that process drags on, investors in those bonds say, I have to get out of this because this is only going to get worse, and if they're dithering this much about helping Greece, what happens if Spain implodes? Spain has very high unemployment right now -- they've got a youth unemployment rate that rivals south Africa. What happens if Spain suddenly needs billions more to keep its social safety net from unravelling? Those bonds are going to end up junk too, so they say, I better sell them now and get into something safer and that's the contagion, and unless they treat the virus at the source dramatically with really strong medicine, this is what happens.

Is this a rational response by investors?

Well, markets are not rational, and neither are many investors. But it depends. There are people who profit in markets like this. Truly rational people who weigh the risks very carefully and say, I can get a yield on Spanish bonds, that is just terrific, and my risk might be limited by a hedge I might be doing somewhere else and that makes for a good investment, but if you have no stomach for that risk, then rationally you should be out of those markets, and right now, rational investors should not be pouring money into Europe, because the situation is in flux. We don't know what the solution's going to be and we don't even know if the solution will be enough to fix the problem. We know the problems are going to get worse, not just for Greece, but for Portugal, for Italy, for all of the really debt-laden countries and Britain too. Britain has its down currency, so they can do a little more on the monetary side, but their problems are really severe and you don't see any of the people who are running for office saying we've really got to bring in tough, tough austerity measures to fix this problem and that should worry bond holders, because governments that won't impose austerity are going to be back borrowing more and more money and that devalues existing debt.

How far could this contagion spread? Could it affect Canada and the U.S.?

We know from our experience with the Asian debt crisis of 1998 that a little problem with the Thai currency set off a massive crisis which spread to Russia and triggered a major debt default, and that led to the collapse of a huge hedge fund in the United states. That could happen again if there are investors heavily exposed in these markets, but in terms of the effect on the Canadian economy, the Canadians should be winners from all of this because as investors look around for safer places to go, and if they're worried at all the soaring U.S. deficit, they'll say well, what gives me the same kind of safety in an economy that's sort of tied to the Americans who are recovering without the risk of those big budget deficits, well Canada, Australia, New Zealand, they're big commodity producers, they're tied to growth buyers of those assets, mainly Brazil and China, they might be the places I want to put my money, so in fact, Canada could benefit by having cheaper financing as more money pours into the country.

What about the high loonie? Is that better or worse when it comes to this crisis?

The strong loonie is what's attracting all of this capital, but it's terrible for Canadian manufacturers. The government has tried to pretend that we should be able to live with a strong currency now and it enables companies to make productivity improvements and to buy technology cheaper which is all true, but it definitely hurts our export markets and we are still heavy exporters. We rely enormously on the U.S. market and the strong dollar doesn't help central Canada at all. And it doesn't do a whole lot more for our resource producers because they've already been benefiting from the earlier strength in the dollar. The problem is that as the euro weakens, we'll see the Canadian dollar and the Australian dollar get even stronger.

You just did some travelling in Europe. Did you get a sense people knew they were in a crisis?

You certainly don't see that crisis mentality in the big capitals, and I was in Paris, London, and Scotland. There's still consumer spending and it's actually holding up quite well.

Housing markets in the big cities are still booming, the cost of living in these places is ridiculous... I was looking at apartment prices in London, and they're still ridiculous. But when you talk to individuals, there's no question there's deep concern. Unemployment rates are rising, entrepreneurial opportunities are getting smaller, there's concerns about heavy new taxes that will be needed to bring these deficits under control, because remember it's not just the Greeks that are required to reduce their deficits. Any country that's over the 3 per cent target set by the European monetary union really has to bring its deficit down and even Germany is at 3.2 per cent now. That's manageable, obviously, but they're worried about trade within Europe and we have to remember that Europe itself is the world's second biggest exporter, it's a huge market, and as it slows, it will affect the entire global economy, so those are the risks and people are aware of that.

And they're certainly worried about it. It's shown up in the election campaign in Britain, and the politicians are talking about spending more money, not less, which is really worrisome. There's nobody talking about reining in deficits, about bringing government costs down and that's an issue they're going to have to face, just as the Americans will down the road and that means trouble for future generations.

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