What is going on in Europe?

How serious is a European country defaulting?

In the May/June 2010 editions of Dividend Alerts, I predicted that the situation in Europe would only get worse. In fact, I forewarned that the future of the EURO as we than knew it was on the cards.

Now some 14 months later, let’s see if we can make sense of it all . . .

Should we care if Greece defaults on its debts?

Yes, we should!

Remember the 2007 – 2009 banking crises?

Back then, during the fall of 2008, it didn’t start with Lehman Brothers and AIG failing. Instead, the closure of some smallish regional subprime lender, early in 2007, triggered the start of financial disaster, claiming bigger and bigger banks over time.

Large financial services companies, most of us in Europe had never heard of, such as NovaStar Financial, New Century Financial or American Home Mortgage, all fell.

Then it was the turn of Wall Street stalwarts such as Bear Stearns, in March 2008. That at least made us sit up.

Followed by mega mortgage providers Fannie Mae and Freddie Mac. Super-banks, such as Washington Mutual and Wachovia, and finally the crises’ most important defaults of Lehmann Brothers and AIG during the fall of 2008.

Following the crash of 2008, stock markets bounced in March 2009, ready for a “W” shaped recession – recovery.

Have we learned anything from all this?

Back then the rot started from the weakest link on the periphery and then it gradually progressed to some of the largest financial institutions at the core of Wall Street.

Looks sort of similar what’s happening right now, doesn’t it?

It does, but instead of private lenders and banks collapsing, several sovereign governments and their countries are seriously under threat.

A default of (or, at least, the prospect of an increasingly likely default of) some of the smaller European countries, such as Greece, Portugal, Ireland or Belgium will cause major losses throughout the banking system, not only Europe, but also the UK and to some extent the USA.

However, the (potential) default of the two major PIIGS countries: Italy or Spain is of an altogether different magnitude. I would say, if that were to happen a once in a lifetime experience, such as the 1929 – 1933 depression.

Is it time to batten down the hatch?

Can Greece restore its finances without a default?

I just can’t see how.

It’s just simple high school macro economics.

For each dollar of goods and services that Greece’s economy produces, its government is $1.43 in debt, i.e. Greece has a massive debt-to-GDP ratio of 143 per cent.

In the current situation, Greece just can't repay its debt. Its technically in default.

And, what’s more, Greece has a projected gap between its revenues and expenses of an enormous £242 billion for 2012-2014.

Where’s that kind of money going to come from?

From Europe, the IMF, the Chinese, the Middle East, the tax payer . . . your guess is as good as mine.

Of course, Europe’s policy makers, nor the IMF, see it (yet) in this way, but, there’s just no viable option for Greece other than wholesome restructuring, default, bankruptcy, exit from the EURO, hyper inflation – all this, and in no particular order.

Last year’s bailout of Greece only bought it a couple of quarters(!) of respite. To no avail. Greece’s interest rates are now even much higher than they were back then, despite tens of billions of EUROs in aid received and consumed.

Again, European policymakers claim that they can ring-fence Greece’s problem by a second bail-out. However, the latest bailout won’t generate much breathing space. Expect Greece’s default in the next couple of months. It's inevitable.

What about the rest of Europe?

Unfortunately a number of countries are already lined up right behind Greece, who, in tandem or subsequently, will severely threaten if not sink the European project.

How’s that?

I have already mentioned Greece’s debt-to-GDP figures being the worst of the PIIGS at 143 per cent. But Italy is right behind it at a whopping 119 per cent. Currently any central-government lacking Belgium is 97 per cent. Ireland has 96 per cent, while Portugal’s debt-to-GDP is 93 per cent.

Also, just look at where some of the mid-term debt of these countries are trading at in the market. Portugal’s 2-year note yields have more than quadrupled to more than 13 per cent from 3 per cent. Ireland’s yields have almost quintupled to 12.6 per cent from 2.6 per cent. And Greece’s 2-years yield has topped 30 per cent recently!

This is clearly not sustainable.

So what may happen next?

The only long-term solution is a default and deleveraging and not just in Greece and Portugal. Ireland, Italy, Belgium and Spain all face the same threat, to varying degrees as Greece.

What if indeed a country in Europe defaults?

The nightmare scenario . . .

Banks in core European countries such as France, Germany and The Netherlands would take huge losses. That’s not only negative for the Euro, but, in turn, it will drive share prices sharply down, loan rates up, and contribute to an even deeper economic slowdown, potentially heading for a full blown depression.

And, while relatively speaking the fundamentals are much stronger in the UK than for most of Europe, thanks to UK’s early embrace of long-term fiscal reforms, UK banks are unlikely to be spared, nor are many London listed company’s share prices.

Expect financial turmoil to hit the fan!

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