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14 April 2010

Global Strategy
Alternative view

Popular Delusions
Greece as a front row preview for the sovereign crises to come

Greece misrepresented the true state of its finances, it has enormous off-balance
Dylan Grice
(44) 20 7762 5872 sheet liabilities, it is expected to run a double-digit budget deficit to GDP this year, it
has a heavy bond issuance schedule this year – it was bound to have a crisis at some
point wasn’t it? But what’s the difference between Greece and the rest of the OECD?
Only that it is small enough to be bailed out ….

Q Back in January, when Greece’s problems first surfaced, I thought it would be the first in
a series of fiscally driven market seizures in the following months which would potentially
offer up some decent opportunities to buy stuff cheap … I guess I got that one wrong ... but
I still think Greece is the beginning of a wave of government funding crises, not the end.

Q For starters, we’re not out of the woods yet. The chart below shows my back-of-the-
envelope calculations for the colossal amounts of debt governments need to issue this year
relative to that already outstanding. I’m not a bond strategist and I’ve not done anything
sophisticated or clever, but by taking Bloomberg’s data for existing debt maturity for each
government (red) and using the OECD’s projected 2010 deficits as a proxy for net new
issuance (grey) my numbers shouldn’t be too far out. But if my numbers are even roughly
right and issuance is the problem, Greece should have had almost the least to worry about!

Q But it’s not just about getting this year out of the way. If it can happen in Greece, it
can happen everywhere else too, because Greece just isn’t that different. OK, so it
misrepresented the size of its liabilities … but so too do most other governments; its real
Global Strategy Team fiscal problems are hidden off-balance sheet in the enormous welfare obligations it can’t
Albert Edwards afford to pay … and so are most other governments’ (first chart inside); its debt maturity
(44) 20 7762 5890 isn’t notably different from the rest of the OECD’s (at about eight years it’s actually longer
Dylan Grice than those of the US and of Japan – second chart inside); and its projected budget deficit is
(44) 20 7762 5872 lower than those projected in the UK and the US (third chart inside).

% of stock of outstanding debt to be issued this year; Greece is nearly best in class!!

Maturing bonds New Issuance






USA Spain France Germany Ireland Japan Portugal Italy Greece UK

Source: SG Cross Asset Research, OECD, Bloomberg

Macro Commodities Forex Rates Equity Credit Derivatives

Please see important disclaimer and disclosures at the end of the document
Popular Delusions

Greece isn’t that different 1: its real fiscal problems are in its off-balance sheet unfunded
pension and health obligations, like everyone else’s

Official Net Debt, % GDP* Total net liabilities (on and off balance sheet), % GDP**




Germany Spain France Italy UK EU US Greece
* 2010 OECD projections
** 2005 estimates of total Fiscal Imbalance

Source: Gokhale, OECD

Greece isn’t that different 2: its maturity of existing debt is one of the longest in the OECD (yrs)




UK Greece Italy France Spain Ireland Portugal Germany Japan USA

Source: SG Cross Asset Research, Bloomberg

Greece isn’t that different 3: projected 2010 government budget deficits (% GDP)
United United
Germany Italy Portugal Japan France Greece States Ireland Kingdom








Source: OECD

2 14 April 2010
Popular Delusions

In fact, the charts above show that there are no clear thresholds which say when a country will
undergo a fiscal crisis – the UK had to call in the IMF in 1976 with a debt to GDP ratio of
around 45%. Japan has a debt to GDP ratio in excess of 200% and hasn’t had any funding
problems (yet). What counts is confidence, and what hurts is when weakening confidence
pushes up the market risk premia on a country’s debt, pushing bond yields and therefore
interest costs to such a level that government finances becomes unsustainable.

The unavoidable arithmetic behind debt sustainability is that the interest a country pays on its
debt must equal the nominal growth rate of that country. If it does, the incremental
government revenue generated by the economic growth will pay for the coupons on the debt.
If it doesn’t, a shortfall develops between incremental revenues and incremental coupon
payments and in the absence of further austerity, more debt is required to finance the deficit.

This might sound abstract, but it’s exactly what happened in Greece. When the first austerity
plan was presented, Greece cut public sector wages by a painful 10% causing angry protest
and social unrest, although it saved the government €650m. But the same austerity plan
assumed Greece’s interest cost would be 4.7% and by late February it was paying 6.25%.
According to the WSJ, this has blown a €700m hole in its budget, more than offsetting the
savage public sector wage cuts already enacted. Public sector pay would have to have been
cut by an additional 10% to achieve the same budget repair that had originally been intended
because interest costs were spiralling faster than expenditure could be brought under control.
Even after the bailout agreed this weekend (which at €30bn falls significantly short of the
€75bn The Economist believes is required) the cost of borrowing from Mr Market as I write still
stands at (a bestial …) 6.66%, and that is even after the EU rescue plan was announced.

So I’d be surprised if this is the last we’ve heard of the Greek crisis. But without wishing to
belittle their plight, the more terrifying spectre is of similar dynamics unfolding in larger
economies. For the most chilling similarity between the Greeks and everyone else isn’t in the
charts above showing that their various debt metrics are in the same ballpark, it’s in the
realisation that we too are subject to the same iron-clad laws of budget sustainability
and that we too are as helplessly vulnerable to any reassessment of sovereign risk by
the famously fickle Mr Market. The Greek tragedy of being unable to pay for the debt built
up during the years of unprecedented low yields reads across to the rest of our governments
all too well. The fact is most of us are living on the same knife edge.

But Greece is a small enough economy to be bailed out by Europe. If we add in Portugal,
Ireland, Italy and Spain (the rest of the so-called PIIGS group), the risk could be systemic (see
table overleaf). And in recent months I’ve written about the time bomb that is Japan’s
government bond market, where I think the end game is in sight. Who, when the time comes,
will bail them out? US health costs are escalating explosively and represent arguably the least
tractable of all sovereign issues today. They too are subject to the arithmetic of budget
sustainability, from which there is no hiding place. The difference between the rest of the
OECD and Greece is merely that Greece could be bailed out.
European banks’ external exposures to the PIIGS group (aggregate bank lending as % of GDP)
Europe Austria Belgium France Germany Ireland Italy Neth Portugal Spain Switz UK
Portugal 1.5% 0.7% 2.5% 1.4% 1.5% 2.6% 0.3% 1.7% 6.0% 0.7% 1.2%
Italy 6.6% 5.6% 11.4% 18.5% 6.5% 20.6% 9.4% 2.6% 3.5% 5.5% 3.7%
Ireland 3.8% 2.3% 9.2% 2.6% 6.0% 1.1% 4.0% 2.2% 1.0% 4.0% 8.7%
Greece 1.7% 1.7% 1.8% 3.0% 1.3% 3.8% 0.4% 1.5% 4.8% 0.1% 16.2% 0.6%
Spain 5.3% 2.5% 10.3% 7.0% 7.4% 14.8% 1.6% 15.9% 13.7% 0.0% 3.4% 5.5%
Total 19.0% 12.8% 35.2% 32.6% 22.7% 41.8% 3.4% 32.6% 23.3% 10.5% 29.8% 19.7%
Source: SG Cross Asset Research, BIS

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Popular Delusions

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