WEALTHSON

Past 40 years has been a period of unprecedented economic growth. Humankind has probably never seen such a growth in entire history. Stock markets rising, banks lending at low interest rates, companies making big profits and general public having easy access to money to buy luxury cars, posh homes, holidays in exotic places around the world and what not. But all of a sudden it seems that the economic models which looked so correct few years ago are tearing apart now. We, it seems, are heading into an era of low economic growth, high unemployment, public unrest, bankruptcies. Was there something very wrong going behind the exponential economic rise of last 40 years?

Yes. Behind all these monumental growth stories there was something fundamentally very wrong. Last 40 years saw economic growth fuelled by credit boom. Governments around the world, especially developed world, took on lots of debt to keep their country’s economy booming. Interest rates were kept artificially low so that more and more money could be borrowed. Governments forgot the fact that these high debts had to be paid at some point of time. They neglected the fact that a time would come when it wouldn’t be possible to amass more debt. Worst thing is that they had a live example of Japan in 80s and 90s but failed to learn. Japanese high debt brought country to standstill for almost 2 decades now. Debt situation in Japan was less harmful for rest of the world because Japanese government debt was largely owned by the banks of Japan. So, there was less fear of contagion in that case. But story is entirely different with debt crisis we are seeing now where all the big banks have exposure to government debts of several countries. So if one fails then in just a matter of time others will follow. Well, that time is almost here.

There are only 2 things that are possible with these debts, either they should be paid back or someone takes all the losses. Now the problem is that the size of  these debts is so huge that taking losses means a total catastrophe of financial system where liquidity would freeze as banks would start going bankrupt. Secondly, if we think of paying back these debts, it would be possible only if governments’ income from taxes are good enough which is not possible because those who should pay high taxes get rid of them by help of government and common public that pays taxes can never fulfill insane debt repayment obligations of government.

So, we are finally at a juncture where banks and governments sitting on big piles of debts that can start bursting anytime. To start this process the catalyst is already ready, GREECE. Greece is the biggest economic horror of current times. Let us see why is Greece such a pain for financial system around the world.

According to a study by Barclays on Greek exposure to Euro banking system, Greece has total exposure of around EUR290 Billion in Euro area. Exposure via bilateral loans and EFSF are around EUR126 Billion. As part of the first Greek bailout package (May 2010), EUR53bn has been disbursed by member states out of the EUR80bn committed over a three-year period. These disbursements are in the form of bilateral loans between Greece and the other member states. In February 2012, a second bailout package was signed, but this time funds would be transferred to Greece by the EFSF and the guarantees passed on to member states according to (adjusted) ECB capital key allocation. This second package has taken over the unused funds from the first package and no further bilateral loans have been made since then. To date, the EFSF has issued EUR73bn out of the EUR145bn committed by member states. Altogether, the euro area states currently have a total exposure of EUR126bn, representing 1.3% of GDP. Exposure via refinancing and interventions are somewhere around EUR 130 Billion and Exposure via IMF is EUR4.4 Billion.

Look at Spain’s and Italy’s exposure. Where is Spain going to get EUR37 bln from? And Italy’s 59 Billion Euros are almost gone if Greece exists. No surprise why they are trying so hard to keep Greece in monetary union.

Greece’s derivatives contracts worth almost $90 Billion. So there is big counterparty risk mainly to banks like Goldman Sachs, JP Morgan.

Greek youth unemployment is reaching 50% which is a disastrous figure. No surprise that we see so many revolts, marches and unrest in people on the streets of Greece.

Around $72 Billion deposits have been withdrawn from Greek banks in past 2-3 years. Bank runs can arrive anytime.

GREECE is just a starting point. Signs are already ripe for countries who would follow. Yes, next obvious country in my list is SPAIN. Spanish banks were recently downgraded by major rating agencies. Bond yields nearing that level of 7% after which countries do default historically, at some point of time. Spain’s GDP dropped by 0.3% which means the country is in recession. Government debt is little less than 1 trillion dollars and youth unemployment around 50%. Isn’t this sound like complete mess?

Italy is in no good shape either. 26 banks were recently downgraded. GDP drop by 0.8% in last 3 months. France’s debt is almost 1.3 Trillion dollar and youth unemployment around 25%.

Only country which is still going well in EU is Germany but I bet its bank would find it hard to survive the financial meltdown once euro breaks.

So, what about the rest of the world. Is it safe?

No, if Greece can bring down European economy then be certain that Europe will bring down world economy. An example of how is this possible is the fact that US banking system’s exposure to CDS in EU is 4 Trillion dollars. Entire banking industry is 12 trillion dollars.

There should always be a correction and consolidation in markets, a correction after 40 years will be a lot more painful and prolonged but it has to happen for better growth stories can be written in future.