Greece, Sensex & Impact

Prior to joining the Eurozone, dif-ferent EU countries borrowed at a interest rate reflecting their sovereign fundamentals such as general interest rate, chances of default etc. However, after joining the Eurozone, everyone enjoyed the AAA rating, thus push-ing down their cost of borrowing. This is what happened with Greece after joining the Eurozone, its inter-est rates decreased and the economy became seemingly more stable due to the reduction of exchange rate risk and its unexpected devaluation. This made borrowing from domestic and interna-tional sources much easier and cheaper, leading to a huge credit boom and uncontrolled spending which guided it to a ballooning of its national debt to 115.1 per cent of their GDP. [PAGE BREAK] 

But the question that arises here is about how Greece managed to mask its huge debt without letting the out-side world know? This can be partially explained by the same thing that led to the fall of Lehman Brothers, which is politely described as financial engi-neering. One of the investment banks of Wall Street helped Greece mask the true extent of its deficit with the help of currency swaps. In one of the cases, in the year 2002 Goldman Sachs helped the Greece government to close a cross-currency swap deal which resulted into additional credit of USD 1 billion that was never reflected in the debt book. This helped Greece to delay solving its fiscal problem till the time it become unmanageable and threatened the entire Eurozone. Nevertheless, this does not mean that only Goldman Sachs are to be blamed for the crisis. It is the Government of Greece that is equally liable for this unfortunate situ-ation. They used the methods of cre-ative accounting to overcome the terms of the Treaty of Maastricht which limits the budget deficit to 3 per cent of GDP and the condition that the government debt should not exceed 60 per cent of GDP. Either they never accounted for the huge military expenditure or bil-lions of hospital debt was shown as an off-balance sheet item.

Recently it was discovered that Euro 40 billion in debts was not part of the measured public debt. In one of the extreme cases that took place in 2006, in order to bring down its deficit in the GDP ratio at a desired level, the Greece government decided to revise its GDP data by including some part of its black economy. All this helped Greece to hide its real debt position.

However, what separates Japan from Greece (and PIGS) is the financing of these debts. In Japan, most of the debt is financed internally by its private sec-tor and therefore does not pose much of a problem. This is because Japan’s savings surplus, mainly concentrated in the corporate sector and with capac-ity utilisation at a lower level, will contain Japanese companies for capital investment. This means that their cash flows will filter to other sectors of the economy either through dividends or purchase of financial assets. Compare it with a saving rate of negative 7 per cent as prevalent in Greece and things become clear why Greece is into such a mess. 

There are other barometers too which reflect the growing concern about the health of Greece economy and two of the most important are the sovereign credit default swap (CDS) spreads and the ten-year swap spreads. Sovereign CDS spreads are like any other CDS spreads (CDS are similar to buying insurance against default of a particular company or sovereign entity). The rate of payments made per year by the buyer is known as the CDS spread. Let us suppose that the CDS spread for a five-year contract on bonds issued by the Greece gov-ernment with a principal of Euro 10 million is 300 basis points. This means that the buyer pays Euro 3,00,000 per year and obtains the right to sell bonds with a face value of Euro 10 million issued by Greece for the face value in the event of a default by the Greece government.[PAGE BREAK]

That is supposed to compensate investors for default risk and in case of the sovereign CDS, it mirrors the default risk of sovereign bonds. For Greece, as on April 2010, the figure was 427 bps compared to 19 bps for Norway and 34 bps for Germany. The other important parameter is the ten-year swap spread which is the differ-ence between the negotiated and fixed rate of swap. For Greece, it is extremely high at 381 bps compared to minus 6 bps for Japan and minus 17 bps for Germany. These indicators clearly echo the fact that there’s something foul with these countries. And now, for the important question about how is all this going to impact the Indian markets?

This month, till now (May 27, 2010) FIIs have withdrawn over USD 1.2 billion from the stock market, the highest in the last 18 months. So what explains the fallout of the Indian market is that it is just a matter of sen-timents and investors are overreacting to the situation. Since India’s export to PIGS and the exposure of Indian banks to the Greek sovereign debt is negligi-ble, it is not going to affect much of the Indian growth story. Admitting this, Prof Tendulkar says, “If this crisis is contained, there will be no significant impact on India as our financial insti-tutions do not have large exposure to the EU financial institutions. Hence, the cost would be minimal for us.”

Even the high officials of the Indian government, including Montek Singh Ahluwalia, Chairman of the Planning Commission, has gone on record to say that this crisis will not have a dampen-ing effect on India and its policy rates. So it is more of sentiment which is now playing to the gallery. The other reason for such a fall may be the return of risk aversion among investors and their flight to safety. It’s a case of ‘once beaten twice shy’ for FIIs who are still coping with the shocks of the financial crisis of 2008, one of the worst since the Great Depression. This is clearly reflected in the rise of the USD Index in the last few months. The USD Index mea-sures the performance of the US dollar against a basket of currencies.

A rise in the USD Index indi-cates that money is flowing in USD denominated assets which investors consider safe haven. In the last six months, the USD Index moved up from 75 to 87, a change of 16 per cent (See Graph). Commenting on this scenario, Dr Narendra Jadhav, Member of the Planning Commission, says, “The sovereign debt crisis has gripped the Eurozone even as the world was slowly emerging from the throes of recession.  The Eurozone crisis is a serious development in recent times. All around the world, the stock and financial markets are tumbling, and the Indian stock market is no exception” But not everyone shares this sentiment and there are some smart investors like Mark Mobius, has stated that he has been buying stocks in BRIC countries as he believes that any slump in the emerging economy stock indexes is a correction in a bull market.[PAGE BREAK]

Leave alone what experts say, even if we talk about the valuations of the Indian market, though they are trad-ing at 19 times trailing earnings and almost at a 30 per cent premium to the emerging market, this is lower than the average premium at which the Indian equity market generally trades. Moreover, if we take into consideration the type of GDP growth (8.6 per cent for Q4FY10 and for a little more than 7.4 per cent for FY10) that is being exhibited, we feel that there is still room left before reaching a fair valua-tion of the Indian equity market.

Even if we consider the debt and fis-cal deficit of India, it is not at an alarm-ing stage and at the end of Q3FY10 the external debt to GDP of India was 19.4 per cent of its GDP.  Meanwhile, the fiscal deficit is likely to be brought down below six per cent at the end of March 2011. “I don’t think the impact on India is that much and hopefully we will remain in good shape,” opines Dr Devi Singh, Director, Indian Institute of Management, Lucknow.

This is because there are an equal number of cases when it took decades for countries to return to normal growth after the fall because instead of treating the disease they started treating the symptoms, thereby mak-ing the case worse. The famous case is the crisis of ABM i.e. Argentina, Brazil and Mexico in 1982. It took more than a decade for these countries to come out of their serious debt trap. And it could not have happened without many painful structural adjustments wherein they had to devalue their currency several times and witnessed their GDP contracting by 35 per cent. It was only in 2003 that Brazil was able to achieve the per capita income of 1981, which means that it took more than two decades to recover from the crisis and effectively losing two decades of growth due to the debt.

The reason for such delayed recov-ery was denial on the part of the creditors to admit the severity of the problem and it was only after five years that they agreed for debt restructuring under the Bardy Plan. According to this plan, they (creditors) took a cut of 40 per cent on the face value of deep discount bonds which were exchanged for syndicated commercial banks or the maturity period of the debt was increased to 25 years with a trimming down of the interest rate.

Last but not the least, Greece may opt out of EU and return back to Drachma, its erstwhile currency. However, it will require careful and calculated execution. This is because the first thing the Greek government will do after adopting the Drachma is to devalue it and nobody is going to accept a mode of currency whose value is going depreciate soon. As such, the long-term solution for Greece essen-tially lies in a combination of increasing the tax as a percentage of GDP, huge cut in public expenditure to bring the fiscal deficit within the prescribed level and at the same time increasing the net exports and domestic investments.

This is easier said than done since two of the most required arrows in the quiver of Greece are missing to target this. They can neither devalue their currency nor have independent interest rate adjustments options (if the Greece government does not opt out of the Eurozone). Therefore, the few options left with the government are to reduce the real wages and ask for devaluation Euro 40 billion of Greece’s debt was not part of measured public debt.of the Euro versus other currencies to make Greece products competitive.