At some point the numbers have to add up
The problem in Greece is both simple and complex. The Greek government has spent years overspending and understating its budget deficit to the wider market. Recent events have shown this kind of situation can’t continue forever – at some point the numbers have to add up.
This is where the situation becomes more complex. Figure 1 shows the degree to which Greece’s expenditure has been out of control. The red line shows the escalating budget deficit.
The numbers are huge. Over the space of 10 years, Greece’s budget deficit has increased from just over €5 billion to almost €33 billion. If we look at the situation in relation to Greece’s economy, the budget deficit has almost quadrupled over the past 10 years to 13.6 per cent of GDP.
The problem is that Greece, on its own, can’t keep financing this amount of debt until its budget position improves. In an effort to stabilise financial markets and prevent another global financial crisis (GFC) occurring, Europe’s leaders surprised the markets by creating a €750 billion stabilisation package.
Figure 1: Greece expenditure out of control
Source: OECD, Bernstein analysis
Is €750 billion enough?
The €750 billion stabilisation package is a bigger rescue measure than many investors anticipated.
Importantly, it not only supports the €125 billion funding requirements for Greece between now and the end of 2012, but also those of Portugal, Ireland and Spain which require a further €560 billion.
But whether €750 billion is enough largely depends on whether Greece and other Euro area countries use the ‘time’ this stabilisation package has bought to get their financial houses in order.
Significant risks still remain
This is a key risk because of the pain it will inevitably entail. In agreeing to the rescue package, Greece needs to reduce its deficit to 3 per cent of GDP in the next four years.
It’s always easier to spend more than less. It will be very difficult for Greece to reverse the budget deficit in less than half the time it took to reach current levels of around 13.6 per cent.
Compounding this problem is that a large portion of Greece’s economy operates as a black market and the mechanisms are not in place for the government to easily cut expenses and collect revenue.
There are also some risks with the stabilisation package itself. First of all, only €60 billion of the €750 billion of funds provided by the European Commission is available at short notice.
The bulk of the funds, provided by the new Special Purpose Vehicle (SPV), need to be approved by national parliaments. This creates a degree of uncertainty for the markets in terms of decisions being made in a timely manner.
What this means for investors
The financial support package for the Euro-area periphery is positive for the countries involved and the broader market.
Whether Greece or other Euro-area periphery countries will default in the near term is no longer the prime issue for the markets.
Markets are now concerned about European recovery and that fiscal restraint at this time will stall economic recovery in the Euro area.
Current high levels of debt and deficits among European countries limit their ability to stimulate their economies.
For some countries, membership of the Euro also removes monetary policy leavers and doesn’t allow for currency to act as a shock absorber.
However, investors shouldn’t loose sight of the positive action taken by Europe’s leaders.
The impact on fixed-income markets is already being felt. Yields relative to standard Euro bond rates had risen to historic levels and the stabilisation package has brought them back in.
Recent events highlight that volatility is likely to be an ongoing feature of the recovery. Europe’s peripheral countries face difficult challenges in getting their financial houses in order – they need to make the most of the ‘time’ that the stabilisation package has brought them.
