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‘A Greek default seems ultimately inevitable,' says Newton's Iain Stewart
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The threat of contagion is very real, and time is of the essence
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Loose policy settings seem likely for as long as financial markets tolerate them
Iain Stewart, manager of the Newton Real Return Fund, looks at the likelihood of a Greek default as the Eurozone sovereign debt crisis intensifies, and gives an outlook for the coming quarter.
"We have little new to add to the debate on the specifics of Greek debt dynamics," says Stewart, "other than to agree with most commentators that some kind of default is ultimately inevitable, and probably desirable for Greece.
"The important point is that, although the detail of how, and in which sectors, debts have been allowed to build up may be subtly different in Greece, Portugal, Ireland, Iceland and even, for that matter, the UK and US, all are a result of the sort of monetary distortions - cheap money has led to a mispricing of risk for both borrowers and lenders," he adds.
"Clearly, the Greek sovereign bond market, much like the US sub-prime mortgage market and the Icelandic bond market, is an extreme case of this mispricing. One could argue, however, that the main difference between Greece and many other mature economies is that the bond market is now taking a more realistic view of Greek risk, whereas in the other markets the mispricing of risk is persisting." He explains, "We could ask, for example, if, at the end of June, 3.4% was the right price for the 10-year UK Gilt given the UK's undeniably inflationary history, its large budget deficit and its current inflation level as measured by the RPI, running at close to 5%?
"The turning point for Greece was, of course, the bond markets' rapid loss of confidence and the re-pricing of risk, via a spike in bond yields which followed, quickly making the unsupportable nature of Greek debt a self-fulfilling prophecy. Policymakers and politicians are acutely aware, therefore, that confidence is key. Even if they don't really know, or can't agree about what should be done (and there are genuinely few, if any, precedents) increasingly they need to have a plan. This of course answers, at least partly, the question posed above; UK bond investors for now, at any rate, seem prepared to give the UK coalition government's deficit-reduction plans the benefit of the doubt," Stewart adds.
"Under more ‘normal' circumstances, the debt of a relatively small economy like Greece could be restructured and written down, allowing us all to move on. The reason why we don't seem to be able to do that, and why equity markets around the globe are trading nervously on news from Athens, is the clear risk of contagion to other ‘debt dominoes' in the Eurozone and beyond," he explains.
Decision time for policymakers
"Clearly, the EU situation remains live and volatile. Ultimately, the pressures which have built up in the system will lead either to more political integration, or to a radical redrawing of the map of states which can function effectively with a single currency," says Stewart. "In the meantime, the EU authorities, rather than addressing these bigger issues, seem content to procrastinate with various plans that pile more debt on economies clearly unable to cope with the burdens they currently carry.
"If the sovereign debt crisis is, as seems plausible, the second phase of the global banking crisis, it is certainly showing some uncanny similarities with phase one, in that the official line tends to characterise the continuing malaise as a series of distinct and temporary liquidity problems, rather than something more structural which involves serious solvency risks," he adds.
"While the Greek example shows that both the recovery and financial system in the West remain extremely fragile, it also illustrates starkly that confidence about growth and the sustainability of debt are inextricably linked." Stewart continues, "With this lesson firmly in the front of policymakers' minds, current extremely loose policy settings - negative real interest rates and bond yields in most of the mature economies - are likely to be maintained for as long as financial markets will tolerate them, with the aim of back-stopping asset prices and consumption, encouraging investment and eroding the debt load in real terms. Moreover," he concludes, "maintenance of loose policy in the developed world is likely to lead to more divergence in policy globally as faster-growing developing world and resource-rich economies are forced to tighten and/or let their currencies appreciate to avoid inflation."
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