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Greece finally does a deal but so what?
Greece has been the headline story on the news for a number of weeks and a new economic deal has finally been agreed but so what. Other than a fairly attractive tourist destination most people aren’t really affected by the Greek situation, or are they asks Mark Owen, Investment Analyst.
Well, the Greek debt crisis has been ongoing for years having started back in January 2001, when Greece first entered into the Eurozone and adopted the Euro. So why is it that it’s such a newsworthy issue now?
When Greece joined the Euro it created two major economic side effects in their economy that materialised over the subsequent year.
- Greece was able to borrow, what would prove to be an unsustainable amount of money at low rates of interest.
- The Greek workforce became less competitive relative to other Eurozone countries after adopting the Euro.
Both of these led to Greece accumulating the mountain of debt they have today, together with a diminished ability to pay it off.
Why were they able to borrow at low rates of interest?
Prior to the Euro, the international market would only lend to Greece at very high rates of interest (>10%) and therefore the Greek government were deterred from borrowing. However, once Greece became a member of the much wealthier Eurozone, the interest rate that the Greek government had to pay in order to borrow money declined dramatically. For much of the 2000s, the interest rate that Greece paid was almost the same as Germany, the European economic powerhouse (see chart 1 below).
Chart 1: Interest rate on Greek and German debt.
Source: Factsheet, Tradeweb, July 2015
By joining the Eurozone, Greece was effectively a small state of a larger, wealthier economy and therefore lenders looked at the credit worthiness of the whole Eurozone economy when determining the interest rate at which to lend to Greece. By offering low rates of interest the international market believed that Greece was just as capable at servicing its debts as say Germany and/or was effectively implying that if Greece couldn’t pay its debts, then other Eurozone countries would have to stump up on behalf of Greece’s.
This is what has eventually happened, following the financial crisis, with Greece receiving three bailout packages to avoid bankruptcy. The very low interest rates incentivised the Greek government to borrow unsustainable amounts of money to 1) fund a debt-fuelled spending spree on public services and 2) substitute the lost tax revenues from rampant tax avoidance. Greek government debt soared from 100% of GDP in 2000 to >180% of GDP by 2014 (see chart 2).
Chart 2: Greek debt compared to Eurozone average
Source: Eurostat July 2015
Spending on public services and infrastructure soared
The Greek government used the borrowings to fund a bloated public sector and invest in wasteful projects. Many cite the Athens Olympic Games in 2004 as the epitome of Greece’s structural problems. Hosting the event cost Greece almost €9 billion making the 2004 games the most expensive in history. Within days of the closing ceremony, Greece warned the Eurozone that its public debt figures would be worse than expected, reaching 111% of GDP, the highest in the European Union (EU). Greece became the first EU country to be placed under fiscal monitoring by the European Commission in 2005. The Olympics alone did not bring about the crisis; but was one of several areas where public spending was unchecked and funded by unsustainable borrowing.
Tax evasion was endemic
Tax evasion was also endemic across the whole of Greek society. The latest figures show that the Greek government collected less than 50% of the tax revenues due in 2012 and according to Transparency International's Corruption Perception Index, Greece, with a score of 36/100, was ranked as the most corrupt country in the EU. Tax evasion was widespread with undeclared income from self-employed Greeks, particularly doctors and lawyers, amounting to a staggering €28 billion in 2009.
Why did the Greek workforce become less competitive?
Although it was not obvious at the time, adopting the Euro would reduce the competitiveness of the Greek workforce in the international market place. Many of the northern European countries that used the Euro had higher rates of productivity than Greece. For example, the average German worker produced more of a type of goods per hour than the average Greek worker in the same industry. Historically, this problem was less important because a country could devalue its currency and compete by offering the same product at a much lower price. However, Greece could not use this strategy, as it no longer had its own independent currency and had no control over its new currency - the Euro. This loss in productivity meant that, over time, many Greek firms became less profitable and found it harder to compete with other European companies. German unit labour costs witnessed a 15% increase whereas Greek unit labour witnessed a 40% increase over the 14 year time period (see chart 3). Notably, from 2000 to 2010, Greek unit labour costs increased by 60% versus only 5% for Germany. These are staggering differences in workforce competitiveness and have resulted in weak economic growth, significantly reducing Greece’s ability to service its high debt levels.
Chart 3: Unit labour costs
Source: Darvas, Zsolt, Bruegel Policy Contribution July 2015
What finally exposed the Greek Debt Crisis?
The Greek Debt Crisis materialised during the Great Financial Crisis in 2008/9 when the world entered into a global recession due to excessive global debt levels and a banking crisis. In a recessionary environment it is harder for countries to service their debt and the financial market exposed a number of Eurozone countries as potential bankruptcy candidates due to their excessive debt levels, notably Portugal, Ireland, Greece and Spain or the so-called PIGS. There were also revelations that debt levels had been misreported by the Greek government or they “cooked the books” which destroyed trust with international lenders exacerbating the situation for Greece.
The borrowing costs of these exposed countries skyrocketed to unsustainable levels forcing these countries to access bailout funding from the EU to avoid bankruptcy. As part of the bailout package, these countries were required to implement economic reforms to improve their competitiveness and drive economic growth. Portugal, Spain and Ireland have since recovered to a more stable and growing economic environment following reform. However, Greece on the other hand did not implement economic reforms and was already lacking from a weaker labour market, lower productivity, and rapidly diminishing financial and political credibility, therefore economic recovery was very difficult without a complete overhaul of the economy.
Why have Greek governments been unable to implement reforms?
Successive Greek government have been unable to implement reforms due to a lack of political will and an inability to win the support of the people to enact the reforms. Since 2009, Greek voters have elected six parties of different political ideologies to reform and lead the country out of depression. This highly volatile political landscape makes it very difficult for any government to complete real reforms. However, why the high churn of government? The answer lies with Greek culture and a deeply embedded cynicism towards the role of the state and its morality. Since 2009, each newly elected government has attempted to implement economic reform such limiting tax evasion or reducing public spending however Greeks have demonstrated and over thrown the government. This has been driven by a long history of corrupt government reinforcing cynicism about public community obligations and the paying of tax. Greeks simply do not trust their Government with a portion of their hard earned cash and any changes to tax, spending and pensions is seen as the Government stealing from them.
Ironically, Syriza, the current Greek government, are an anti-austerity party; however Syriza have just accepted a proposal on behalf of the Greek people to adopt sweeping tax and pension reforms and further austerity to get Greece on the path to economic recovery. Syriza will probably suffer the same fate as previous governments.
What does the latest agreement mean for Greece, the Eurozone and the global economy?
Greece will receive a bailout package of €86bn to reopen the Greek banking system, fund pensions and public services and reboot the economy. In return the Greek government must introduce controversial economic reforms, including tax and pension reforms and spending cuts. The agreement ensures that Greece stays within the Eurozone; however Greece will go through a painful period of reform to readjust the economy. The country will witness a further fall in living standards, however over the long term, the country will return to sustainable economic growth and I believe creditors will pardon some of Greece’s debt in coming years. Perversely, the Greek Debt Crisis may have made the region stronger from a political perspective. The lack of support for Greece suggests all countries are happy with the Eurozone in its current form. However, the silence is partly driven out of fear of being the next “Greece”. If you disdain, the financial markets punish you.
The Crisis has been ongoing since 2009 and has been a constant worry for the financial markets and the business community. The prospect of Greek Exit and subsequent disintegration of the whole Eurozone leading to a global recession was a major obstacle for the global economy however this risk has been averted for now which is a major positive for the global market place. A continuation of the Crisis would have eroded business confidence and derailed the economic recovery in the Eurozone; however the recovery now has the freedom to advance. A stable and growing Eurozone is highly beneficial for the global economy given the Eurozone accounts for 17% of global economic output and is the second largest economic region in the world after the United States.
What does it mean for the P&P portfolio?
The P&P portfolios are positioned to benefit from improving global economic growth and improving business confidence and activity following the resolution of the Greek Debt Crisis. Consequently the P&P portfolios are overweight in growth assets such as Equities and are underweight in defensive assets such as Fixed Interest. The portfolios equity allocation has 90% exposure to developed market equities and the remaining 10% exposure is to emerging market equities. The developed market exposure is primarily through UK, US and Japanese equities, all of whom are highly correlated to economic developments in the Eurozone, particularly UK equities where we have a material allocation. The emerging market exposure has a strong bias towards Asia, particularly China and India. Both countries are highly correlated to the Eurozone consumer who will be emboldened by a resolution to the Crisis, and supported by low inflation, improving employment and a growing economy.
The P&P portfolio allocation is driven by valuation, economic fundamentals and the impact on portfolio risk, and we believe the above allocation provides attractive value supported by robust economic fundamentals and strong diversification benefits within a balanced multi-asset portfolio.
"The P&P portfolio allocation is driven by valuation, economic fundamentals and the impact on portfolio risk…"
Mark Owen (Investment Analyst)