Is Greece just the first domino to fall?

MoneyWeek magazine no 750 cover illustration

If Greece tumbles out of the euro, no amount of printed money can save us, says John Stepek.

Greece has voted “no” to austerity, but doesn’t want to leave the euro. Puerto Rico, a US territory, has declared that it cannot repay its debts. China’s government is desperately trying to prop up a stockmarket that has plunged by more than 30% in a month.

What do these events have in common? They’re ultimately about debt, argue two Macquarie analysts, Viktor Shvets and Chetan Seth. In fact, we may be witnessing the “opening scenes of the last act in a global leveraging drama”, that they reckon began way back in 1990, with the bursting of Japan’s bubble “and continued during the global financial crisis of 2008”, notes Bloomberg.

The danger is that, with the dominoes starting to topple, “investors’ belief in the ability of monetary and public-sector policies to delay the day of reckoning until a less painful solution to inevitable deleveraging is found might be starting to unravel”, Shvets writes. So what’s happening – and what comes next?

Puerto Rico’s default

uerto Rico is an American territory in the Caribbean. It has outstanding debt of $72bn. Now the island’s governor has said that it can’t pay up. There are parallels with Greece, notes Matthew Yglesias on vox.com: “A poor government was tied up with a larger and richer one.” This enabled the poor government to borrow heavily from “short-sighted lenders”, but it didn’t spend the money very wisely.
The financial crisis hit and “now the bill is coming due”.

The tricky thing is that Puerto Rico can’t do what US states would do in this situation and declare bankruptcy, because it’s not a US state and so those laws don’t apply. So there is no formal process for defaulting, which means it could get messy. And, of course, it doesn’t have its own central bank to print money to bail it out.

However, notes Capital Economics, “we expect the wider impact of a Puerto Rico default to be muted”. Bank deposits are fully guaranteed by the American deposit protection scheme, “so there is no reason to anticipate any form of bank run”.

Unlike Greece, the region also benefits from fiscal transfers from America. And problems have been expected since at least mid-2013, so “most municipal bond funds… should already have reduced their exposure” and the region’s banks don’t hold the debt either. So while it’s miserable for  Puerto Ricans, it’s not likely to be the  end of the world.

The China crash

China’s recent stockmarket plunge has been precipitous and scary for those involved. One reason for the government’s recent focus on the stockmarket is to try to offset the deflating house bubble and, as John Plender notes in the Financial Times, to help recapitalise the banking sector. Shvets and Seth draw parallels with the Greek and Puerto Rican crises, arguing that, like those countries, China’s economy has serious structural problems.

However, the key difference is that China has complete control over its monetary policy. With interest rates still high, it has plenty of room to cut, and the Macquarie analysts expect the Chinese authorities to use this leeway – indeed, they’re still long Chinese stocks as a result.

So rather than panic, now might in fact be the time to get back into the market – 30% is the scale of correction that MoneyWeek contributor Rupert Foster predicted in our recent China cover story – he updates on his view here.

Greece – the end of the line

China and Puerto Rico have their problems – but they look containable. Greece, on the other hand, may well be different. If anything is going to rattle investors’ faith, it’s this. Here’s why. In democracies across the world, from the UK to the US to Japan, the job of “saving” national economies has been handed to central banks. Decisions on redistributing wealth – fiscal policy – are meant to be made by our elected politicians not unelected officials such as central bankers.

But central bankers’ policies since the crisis have been hugely re-distributional, and in a way that politicians would probably find hard to get past a voting public. Printing money favours those who own assets, those with huge debts, and those who can still access credit at a time when banks are cagey about lending – in other words, mainly the rich. That’s exacerbated the inequalities that people are up in arms about –soaring property prices, for example. As yet, electorates have gone along with it. They don’t see any other option, and many, of course, are beneficiaries – there can’t be all that many mortgage holders in the UK who are genuinely annoyed at the Bank of England for keeping interest rates at record lows for this long.

However, Greece’s big problem is that it doesn’t control its own monetary policy. And it has very explicitly been excluded from the largesse of central bankers because it refuses to make huge sacrifices in order to do what most developed countries have also failed to do – get its books in some sort of order. Within Europe, the European Central Bank (ECB) has printed money and bought the debt of other nations whose debt dynamics are not much better than those of Greece. This is a political decision, not an economic one.

The Greeks have now been given until Sunday to capitulate. At that point, European Union leaders will make their decision – if no resolution is found, the ECB will pull the plug on Greek banks. After that, Grexit is a matter of time (see page 6). That in turn will make it clear to markets – and more importantly, to voters – that eurozone membership is not irrevocable. In fact, you can only rely on ongoing membership for as long as your elected leaders agree to toe the eurozone line. So what happens when voters in France, or Spain, or Italy, decide to vote in a rebel party, one that doesn’t appreciate having economic policy and monetary policy dictated by an external body that doesn’t always act in the best interests of their nation?

This isn’t the fault of the Greeks or the Germans. It’s the inevitable result of tying entirely different economies and cultures together under one currency. As far back as 1997, German political adviser Arnulf Baring said: “The Monetary Union will boil down to a gigantic extortion scheme… One day [German taxpayers] will say ‘we have to bankroll the loafers who enjoy the easy life in cafés on southern beaches’… When we dare to call for more monetary discipline, the profligate countries will claim that such containment is responsible for their financial difficulties, and they will blame us for it… This way we risk again becoming the most hated people in Europe.”

The Greek crisis itself might not cause a systemic breakdown in the financial system alone. But the fracturing of the rest of the eurozone – and the demise of the euro – would. When that happens, central banks across the globe will be left wondering what to do. And money printing might no longer be sufficient to contain the panic. As William Hague put it in The Daily Telegraph, when future generations look back on this period, “their textbook is likely to say that the Greek debacle of 2015 was not the end of the euro crisis, but its real beginning”.

What it means for your money

The problem with all of these events, as always, is timing. The break-up of the euro would be traumatic for markets, but even if Greece leaves the eurozone, it will take time to play out. The market will watch the political situation in the peripheral economies, and the first signs of trouble will be bond yields diverging sharply from those of Germany – there have been signs, for example, of Portuguese and Italian “spreads” creeping slowly higher in recent months as a Greek exit has become more likely.

In the first instance, “safe-haven” bonds, such as UK gilts and US Treasuries, would be likely to do well, but if faith in central-bank omnipotence starts to falter, that could change. As we always say, hold on to gold (it’s been weak along with the rest of the commodity sector, but it’s still a good insurance against financial chaos).

If you’d like to take advantage of the plunge in Chinese stocks, one investment trust to consider is JP Morgan Chinese (LSE: JMC) on a discount of around 24%.