How to protect yourself from a Greek default

Imagine you’re running a business. It’s doing badly. You’re going to lose money this year and the outlook for next year is even worse.

On top of that, the firm is borrowed up to the hilt. And it’ll stay that way, even although you’re about to agree a deal to write off a large chunk of your long-term debts.

Meanwhile, the work force is getting very stroppy. No wonder – you’re cutting their pay packets. Some employees are already on strike. And the rest will soon be joining them.

Now the bank manager is talking tough. One massive bill simply must be paid next month. And your board of directors can’t agree what to do next.

How do you get out of such an awful mess? The ‘company’ of course is Greece. And its response to this question is very important to your portfolio.

Markets might be bored, but Greece could still shock them

The Greek bail-out farce continues. Yesterday its government missed yet another deadline for trying to sort out its shattered finances. And time is fast running out if Greece is to stay in the euro.

I’ll keep the details brief. Greece is broke. It needs another bail-out otherwise it shuts down.

There’s a €130bn deal from the European Union (EU) and the International Monetary Fund (IMF) on the table. Lenders have agreed to write off over 70% of the money they’re owed.

But to qualify, the so-called ‘Troika’ – the IMF, the European Commission and the European Central Bank (ECB) – has insisted that Greece make even more swingeing cuts in state spending.

Greek politicians were supposed to agree to these measures by 10am yesterday. But they failed to do so.

It’s just the latest in a long line of missed deadlines by Greece. In fact, the markets have heard it all so many times before, they’ve almost stopped worrying about the country’s woes. Share prices across Europe have surged in the last four months as investors have focused on other things.

 

That’s how markets often work. Unless there’s an ongoing stream of headline news, they can’t concentrate on one issue for very long.

But just because markets have got bored with Greece, doesn’t mean that the problem has gone away. Greece is still as much a threat to Europe’s financial stability as it’s always been.

There’s no way out for Greece

The first key issue is the country’s sorry economic state. The economy shrank by 6% last year, reckons the IMF. Unemployment has hit 18%. The country is “deeply uncompetitive”, notes Alen Mattich in the Wall Street Journal, and “the government is close to dysfunctional, certainly in terms of gathering taxes”.

And despite all the cuts so far, the budget deficit – the shortfall of tax revenues compared with spending – is close to 10% of GDP. That’s still very high.

Yes, the Troika is insisting on extra austerity measures. But these will only send the economy still further into recession. In turn that will make repaying the country’s debts even harder.

Further, Greek citizens may not stand for any more state cutbacks. Today we’re due to see nationwide strikes against austerity.

The second problem is time, or rather the lack of it. Greece will need the funds from its next bail-out very soon. On 20 March, the country is committed to making a €14.5bn bond repayment.

The way things stand, that’s not going to happen. In other words, Greece is moving closer to a ‘disorderly default’. This could get very nasty. “A really, really bad scenario for the euro area – a Greek default and departure from the euro area – simply cannot be excluded”, says Joachim Fells at Morgan Stanley.

 

But even if a deal is reached which will mean Greece getting its next slug of bail-out cash, this would be only a ‘sticking plaster’ solution.

Let’s assume that private creditors accept a 70% ‘haircut’ on their Greek bond holdings. The national debt – what the government owes in total – will still top 100% of GDP. And as we’ve said, with annual output set to drop much further, that ratio can only worsen.

Even taking the most bullish view, the economy won’t recover for years. Greece has almost no chance of making any real dent in its debts. It’s in such a mess that defaulting on its borrowings, and a return to the drachma, are the only realistic way out.

Meanwhile, it’s one thing for Europe’s politicians to talk about major haircuts for bond holders. But as we saw in the US subprime crisis, there can be much wider knock-on effects on the banking system than anyone expected – or that the markets have supposedly factored in. Don’t expect any difference this time.

Third, there’s the not-so-small matter of the ECB.

As John Stepek pointed out last month, “the ECB has been acting as an incredibly forgiving pawnbroker to the most troubled banks in the eurozone. It will accept troubled debt like Greek bonds and lend out hard cash in return”.

“If it turns out that those loans can’t be repaid and the collateral backing them is dud, then the ECB could end up having to be recapitalised. In other words, it’d be bust itself, and Europe’s taxpayers would have to cough up to raise funds for it”.

Insuring against a Greek default

Protecting your portfolio against a Greek default isn’t straightforward: we won’t know the extent of the fallout until it happens. But stock markets are always more vulnerable to bad news after they’ve enjoyed a strong rally – as they have recently. So don’t be fooled that investors have completely turned a blind eye to Greece. It still has the capacity to cause some major shocks.

On specifics, we’d avoid banks in general, as they’d be hit hardest by a collapse in Greece. We’d also hang on to gold, as insurance. The good news is that any Greek shock could create some buying opportunities.

Category: Economics