Forex focus: the Greek crisis

Liz Phillips, 10:22, Wednesday 22 June 2011

If Greece defaults on its debts, will Europe be sent into meltdown?

It is tempting to look at the mayhem unfolding in Greece and the ructions it is causing on the Continent and think "Thank goodness we’re not in the euro".

But there’s no way we can take relief from a little islander stance. Even though on the face of it we only have £1 billion exposure to the Greek debt, the chain reaction that would be set off if Greece can’t repay its debts would be catastrophic.

Firstly, the debt flu is catching. If Greece is allowed to default on its debt, Ireland (Berlin: IIK.BE - news) and Portugal may start wondering why they are bothering with savage cuts and higher taxes to meet their obligations to pay back the money they borrowed. And we have far higher exposure to Irish debt than we do to that of the other two countries..

“If Greece decides it is not worth cutting off its arms and legs one by one to appease Frau Merkel and Monsieur Sarkozy, Ireland might come to the same conclusion and engineer a default of its own," says David Kerns of Moneycorp . "So the idea that the Greeks will not get the next lump of cash unless they become even more austere by next Thursday is, on the face of it, risible. But it is very far from a done deal, as the baying mob in Athens is well aware.”

And like many contagious illnesses it may not stop spreading even there. The real danger is that Spain, which is already sneezing, could go down with a full-blown case of debt 'flu. Already it is battling with spiralling borrowing costs while its banks are burdened with mortgages linked to house prices plummeting daily in value.

"Should we see Spain start to spiral lower, then it would make the falls of three years ago look like a picnic," says Jeremy Cook, chief economist at World First.

Banks in most developed nations, including the US and our own banks, lend to each other or have taken on some of the lending risk through insurance. The domino effect if debts won’t or can’t be repaid will spread throughout the global banking sector.

As a result, Britain is said to be exposed to the Greek tragedy to the tune of £200 billion. Whatever happens the situation cannot be ignored, especially as the EU is our main trading partner.

The credit rating agency Moody’s is already reviewing France’s top three banks meaning they face a possible downgrade on their credit status because of their exposure to the Greek situation. German banks are equally exposed and the agencies are questioning the Italian economy.

So although Greece is a bit part player on the global economic stage, it could be the catalyst that brings down the curtain on the whole production, tipping us into another recession while we’re all still trying to climb out of the last one.

The problem is there’s no obvious solution. Instead there's a variety of options with no consensus. The one that’s being discussed at the moment is pouring more money into the bottomless pit of the Greek economy. But, in order to do that, Greece has to show it will knuckle down and properly introduce the austerity measures it agreed to last time.

Germany wants the private sector the banks and pension companies which also hold Greek bonds to share the pain. By this it means that it wants firms to agree to extend the date when these bonds have to be repaid.

Chris Towner, director of FX Advisory Services at HiFX says: "For the French and the Germans failure is not an option. However, the German suggestion to reduce government involvement by incorporating private sector money has so far fallen on deaf ears."

In the meantime, Greece needs a further €12 billion (£10.6 billion) just to see it out to the end of the month, with the prospect of more billions to keep it afloat after that from the triumvirate of the International Monetary Fund, the EU and the European Central Bank (ECB). Yesterday, the IMF muddied the waters even more by holding back on the extra €12 billion funding until a new aid package is in place.

With markets believing there’s an 80 per cent chance that Greece will default on its debts, the other option is to let it default now. Some say it’s only a matter of time anyway. Bailing it out again now, they argue, is just kicking the can further down the road.

"The fear of the ECB is that any effective default could potentially plunge the EMU into a financial meltdown, reminiscent of that witnessed post-Lehman Brothers," says William Poole, strategist at FC Exchange .

If Greece does default, it heightens the possibility of the other two Ds decoupling and devaluing. If Greece left the eurozone and devalued its currency, its exports would be boosted and it could try to grow its way out of its problem.

"The financial crisis has exposed the underlying flaw that the eurozone ship was built on," adds Poole, "and the rough waters have seen it come very close to sinking. Given what is now apparent, it would be far more appropriate for two eurozone currencies to exist; one for the core, more durable states, and another for the peripheral regions struggling with high unemployment, low growth and high levels of debt."

Whatever happens, the prospects for sterling are mixed. "Any bail-out will restore confidence in the euro and bring the focus back on interest rates which would see sterling weaken," says Nick Ryder, global currency analyst for Smart Currency Exchange . "Yet a full blown default in Europe would leave the UK’s economic prospects in doubt. Either way, it is not a clear path for the pound."

At this stage, no-one truly believes Greece will go back to the drachma. The bigger danger is if it defaults.

Richard Driver from CaxtonFX believes it may not be entirely negative for sterling.

"The GBP/EUR rate would climb significantly if Greece defaulted, regardless of the harm it would cause the UK economy. A Greek default would see sterling climb against the commodity-linked currencies such as the Aussie, Kiwi and Canadian dollars due to the diminishing impact it would have on risk appetite. The major winners if Greece defaulted and others followed would be the safe-haven currencies such as the US dollar, the yen and the Swiss franc.”

The way the euro has kept its exchange rate up throughout the debt crisis has been to increase its interest rate. ECB chief Jean-Claude Trichet has said that next month rates will go up again probably to 1.5 per cent. No-one is expecting him to back down at this stage despite the turmoil.

Simon Smith of FXPro is unequivocal in his condemnation of this move.

"In the wake of the ECB meeting last week, I detailed why I thought Trichet would go down in flames for signalling a July interest rate increase at a time when there were so many risks to the eurozone outlook, not least the fragility of the banking sector given the risk surrounding Greece. These risks are now playing out, offering even more evidence that a tightening of monetary policy next month would be a disastrous move."

Kathleen Brooks, Director of Research UK, Forex.com, 15:11, Friday 24 June 2011

When the euro was being hashed out by Europe's leaders of yester-year they were creating a currency that would be the equivalent to the Hummer of the motor world.

The euro would rival the dollar as the world's most widely used currency and would become the icing on the cake of a united Europe.

But a mere 10 years since it came into circulation, is the euro is at risk of collapse?

One of the most interesting debates in the midst of Europe's sovereign crisis has been the outcome for the currency. Some have called for the end of the euro over the past year. However, it has shown remarkable resilience and it is still worth 40% more than a dollar.

But a year into the crisis and the harsh truth is finally coming out: Greece is insolvent. Ireland, Portugal and even Spain look increasingly vulnerable. If the Iberian nation falls then it can only be a matter of time when Italy follows suit, maybe even France would suffer.

That would leave Germany, the Netherlands, Austria and Finland as the only members in the currency bloc not in need of financial assistance.

This may be an extreme scenario, but if things were to get this bad, you can imagine that the euro would not be able to exist in its current form.

The trouble with Greece

Right now we don't know what will solve Greece's chronic fiscal problems. We can assume that Greece won't be allowed to go bankrupt next month when some large debt repayments come due. Instead, the EU, led by Germany, the ECB and the IMF will come to the rescue and release funds.

If they don't then the alternative is carnage in the financial markets. If Greece misses a payment it will be labelled as having defaulted.

The fact that the various branches of the EU could let one member go to the wall would lead to questions of the strength of the union and the future of the currency.

In the immediate aftermath of the Lehman Brothers bankruptcy in 2008 the euro crashed 15% against the dollar; if the problem happened in its own backyard you could imagine the impact on the single currency would be even more severe.

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So what next?

At this stage there are three outcomes for the euro.

The first outcome is that the single currency dies from a thousand cuts. Every time Greece looks like it is taking a step towards disorderly default then the euro gets hit. Eventually it weakens so much that it causes inflationary pressure and international investors no longer treat it like a world-class currency.

This makes Germany, a nation of savers, mad because it hates inflation and wants a strong currency for the prestige. So it dumps the euro on the weaker peripheral states and reverts to the Deutschmark, possibly taking Austria, the Netherlands et al with it.

The second scenario is far more brutal. Greece runs out of money, panic ensues, financial markets crash. The union breaks up leaving the currency null and void, as each country reverts to its former unit of value.

The final outcome is that the euro survives and the sovereign debt crisis goes down in history as a minor blip. For this to happen Greece cannot default.

Spain and Italy are much more fundamentally sound than Greece, Portugal and Ireland. If Greece can stave off default and the EU and ECB can make it look like the country's fiscal position is improving then this buys time for Spain and Italy to get their fiscal houses in order.

Light from the east

This scenario also depends on China. Essentially the single currency's stability in the past year is down to continued demand for euros and euro-based assets from China.

It is essentially the world's greatest piggy bank. It has been supplementing the US's debt binge for years to the tune of $1 trillion and wants to diversify its eggs out of one basket. The only market and currency deep enough to provide what China wants is Europe and the euro.

China's continued interest in the currency bloc throughout this crisis suggests that Beijing thinks it will pull through.

This support should stem the euro's decline, and may even solve the crisis: If China has faith in Europe's abilities to pay back its debts then other investors might follow. This might not save Greece, but it could protect Spain and Italy.

Traditionally the Chinese take a long-term view on their investments. They still have faith in Europe; perhaps the naysayers calling the euro's demise should instead follow the money.