"Beware of Greeks Bearing Defaults"
"We believe that Greece is a tragedy in four rather than two acts. In other words we don't believe that it will default in the near-term, but over the medium term it is a virtual certainty.
"The Greek government recently survived a vote of no confidence and the focus now moves to the austerity package. The package is the worst of its kind, focussing on tax hikes rather than spending cuts, and is likely to prolong the recession and lead to higher unemployment and deficits. In the less likely event that parliament fails to pass the package, there will be a knee jerk reaction in financial markets. We don't believe that the EU will cut off funding, instead the politicians will be given the opportunity to vote again under a government of national unity.
"This does not mean that the situation is sorted. Indeed, it is increasing difficult to kick the can down the road, because the can is becoming heavier, this weight driven by the silent run on the Greek banking system. The capital flight and the execution risks to the fiscal austerity and privatisation program suggest that there will be another crisis within the next twelve months. This will emphasise the fact that adding debt on top of already unsustainable debt levels will ultimately be self-defeating. We expect Greece to remain a problem until the inevitable default takes place, with the next IMF tranche in September a likely source of trouble.
"The key question remains whether this will be an orderly or disorderly default. An orderly default will occur when the Greek authorities have achieved primary budget surplus enabling it to fund itself on a day-to-day basis. This could take place within the Eurozone, ie a debt devaluation rather than a currency devaluation to the new drachma, but the authorities would still need funds to bailout the domestic banking system. There would also be contagion to the other smaller European periphery with investors expecting similar action from Ireland and then Portugal, but it would be easier to contain the damage to Spain and Italy. A disorderly default would result in immediate bankruptcy of the Greek state and most likely exit from the single currency. The resulting contagion would be worse for all of the other PIIGS.
"To paraphrase Donald Rumsfeld, there are known unknowns and unknown, unknowns in the current Greek crisis. We believe that Greek debt default is manageable, but the resulting contagion to other peripheral economies is not. We do not expect immediate default, but still believe that it is the most likely outcome over the next eighteen months.
"As Ben Bernanke noted in his post FOMC press conference the main source of contagion is US money market funds. These provide around half of European banks short-term wholesale funding and evidence over the past week suggests that investors are cautious of funds that have high exposure to European banks. A collapse in this source of funding could once again freeze money markets, compress global liquidity and produce a flight to safety.
"Milton Friedman predicted that the Euro would not survive the first recession. Political determination ensured that it did, but it will struggle to survive the next recession. The ECB interest rate policy is increasingly anti-growth and leading indicators point to a slowdown in core European growth by the end of the year."
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