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Contagion has begun
Back in February 2010 when I wrote my first blog post about the Greek debt crisis, Australian financial advisers were assuring everyone that this crisis is self-contained and unlikely to spread through the global financial system. When the Greek crisis started, everyone assumed that Greece would get bailed out and that would be end of that “little problem”. Today, the picture is quite different. The Greek crisis has escalated quite significantly in the past week. While there were plenty of verbal assurances of a bailout for Greece by other members of the Eurozone, very little concrete action was actually taken. Bond investors started to lose confidence and bond yields skyrocketed. Two year bond yields went as high as 20%. Last Friday, the Greek Prime Minister had to asked the Eurozone and the IMF to activate their promised bailout facility. Rating agency Standard & Poor reacted to this by downgrading Greek sovereign debt to junk (non-investment grade) status on Tuesday. The scenarios that seemed unthinkable three months ago like debt default or Greece being forced out of the Eurozone are now real possibilities.
While Greece itself was never a big problem as it makes up only a mere 3% of the total Eurozone economy, the worry has always been the risk of contagion and events in the past week clearly shows that contagion has begun. Greece was not the only country to be downgraded by S&P this week. Portugal and Spain were also downgraded by the rating agency and naturally the bond yields and credit default swap (CDS) spreads for these countries have shot up. Spain’s economy which is four times the size of Greece, is considered by many as “too big to rescue”. The downgrade also triggered a sell-off in Italian government bonds. In case you think this is just a European problem, bond yields and CDS spreads for highly indebted countries outside of the Eurozone are rising rapidly as well.
If Greece’s sovereign debt is mainly held by its own citizens like Japan, perhaps their problems can be self-contained. However, most of Greece’s debt is held by foreigners, mainly other European banks in countries like France, Switzerland and Germany as shown in the diagram below from Reuters. If Greece does default, these banks will suffer big losses. These European banks also hold a lot of Portuguese and Spanish debt. Simon Johnson said this in his blog post (a must read) yesterday “Bankers are pounding tables all across Europe, demanding that governments buy out their position – or bring in the IMF to do the same. We again find ourselves approaching the point when the financial sector will scream: rescue us all or face global economic collapse”
The other option for resolving debt problems is to devalue currency. However, this is currently not an option for Greece as they have a shared currency given that they are part of the Eurozone. Now that the truth is known that Greece has obviously lied about their debt position to gain a place into the Eurozone, some of the member countries have suggested that Greece be removed from the Eurozone, leaving them to deal with their problem in isolation. Nouriel Roubini has even said “in a few days there might not be a Eurozone for us to discuss.” 61% of Greeks now also favour leaving the euro. Perhaps this is a less painful option than the austerity measures that they would be forced to take if they accept a bailout from the IMF/Eurozone.
It is already quite clear that the Greek crisis is spreading. When fear starts to spread, any country with a high public debt to GDP ratio is going to be subjected to close scrutiny. These countries are not only in Europe and some of them are not small (we are talking about the U.K, Japan and the U.S. here). I wonder if the same financial advisers who said that this Greek crisis is contained in February still believe that now, or have they already quietly started to sell their own banking stocks?
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