The European Debt Crisis: Why’s it washing up on our shores?

There was a time, not long ago, when the affairs of a small economy would have minimal effects on its neighbors and no impact on the US. Unfortunately, the debt situation in Greece, Portugal and Spain reminds us of the interconnection of our world and, while we think that long term, the impact of Europe’s challenges are going to be fairly minor on the US, more immediately, the problems of Greece are a reminder that the imbalances of deficits at home share much in common with the EU.

The problem is much worse than in the US

Greece, Spain, Portugal, Italy and Ireland are all carrying enormous debts relative to their economies. On May 1, the New York Times put up a chart breaking this down: Greece owes $236 billion, the smallest debt among these five countries. Portugal’s debt stands at $286 billion – and it owes roughly a third of that to Spain. Spain carries around $1.1 trillion in debt, and its economy is in horrible shape (20% unemployment). According to the Bank for International Settlements, it owes $220 billion to France and $238 billion to Germany. Ireland has $867 billion in debt, with about 40% of that owed to the U.K. and Germany. Italy owes $1.4 trillion, including $511 billion to France (almost 20% of France’s GDP).

After the euro was launched, Greece had access cheap financing and took advantage of it to borrow aggressively to finance public services. In the years since the establishment of the euro, Greece’s debt-to-GDP ratio has remained repeatedly above 100%.

Europe’s biggest banks are heavily exposed to debts to weaker member states’ debts, as are Citi, Bank of America, Goldman Sachs, JPMorgan Chase and Morgan Stanley. In fact, these five banks have $2.5 trillion of cross-border exposure in the crisis, with Citigroup the most exposed. So you have potential risk to most banks, the euro, the European — and thus, the world economy.

Greece’s package will be expensive and painful

Specifically, Greece has the chance to accept a $146.5 million bailout from the International Monetary Fund and the European Union in exchange for austerity measures (less government spending and, probably a lower standard of living). This would help Greece avoid default – that is, having to “restructure” its debt (as a sovereign nation, Greece cannot go bankrupt.) It’s realistic to expect that the consequence of this will be Greece will go into a painful recession, probably for several years.

Is there political will to tolerate the austerity required?

With the recent interest rate increases demanded by investors to buy Greek bonds (having hit as high as 22% in some recent trades), the country has little choice, so it looks like the bailout will be accepted by Greece and its EU partners. This generates confidence will return and other Eurozone nations with big debts will be slightly less threatened. However, Greece still has a risk of default if they cannot force the austerity measures through their parliament – meaning that the situation is still quite dangerous.

Europe’s mega-bailout

This morning’s announcement of the creation of a $1 trillion dollar bailout plan is more about preserving the economies of France, Germany and the US than it is about “saving the Euro”

Should Greece default even with the bailout, some major lenders in France and Germany would be hit very hard. They would have to raise capital ratios and reduce the frequency of loans. That would hamper economic growth in France, Germany and in turn across Europe. In coming months, the U.S. and other nations could feel the pinch from such a slowdown.

Greece only represents about 2% of the Eurozone economy. The impact that we’ve seen recently on global markets is more about fear about the other “PIGS” (Portugal, Ireland, Greece, Spain) and n the roughest scenario, Spain or Italy defaults and the shock wave to European banks (and U.S. banks exposed to the debt) is significantly greater.

So is the bailout truly a solution?

It was unpopular throughout the EU, but probably the right step to take in the short term. The move certainly should help defend the stability of the euro; in fact, German Chancellor Angela Merkel and French President Nicholas Sarkozy have jointly pledged to preserve the euro’s value.

We all hope these countries can effectively manage their debt levels, for the sake of the stock market and the economy in our country. The question is whether the existence of a bailout will provide “breathing room” to gradually reduce government spending. The experience in the US with our bailout package has been mixed in this regard. If we don’t see changes in spending patterns, then we can expect future crises of confidence in the coming months.

Strategy: Underweight International stocks and wait for a real crisis

We don’t expect that the Greeks, Portuguese or Spanish governments will have sufficient political will to cut spending and investors will increasingly eschew debt from these countries that’s not explicitly backed by France and Germany. Neither of these counties are models of health, but they have a better history of rational budgeting and stronger overall economies on a per capita basis and eventually the patience of the wealthier countries will run out. This is likely to truly threaten the EU’s stability and cause bond interest rates regionally to increase. Only then, we expect, will European populations be willing to accept the bitter medicine of fiscal reform.

Consequently, we’re maintaining lower than average allocations to international and emerging markets stocks and we continue to tread very cautiously in international debt markets.