12 December 2009

Greece, China, USA and the Euro - All Connected?

Hat tip to Charles Powell for this one.

I spoke with some friends who are Greek and also in the shipping business. They hate the problems that Greece is facing. The 12.7% budget deficit is the highest in the EU and is not sustainable. Efforts to cut government expenses have caused a political backlash against PM Papandreou. The only available solution is to raise taxes and crack down on tax evaders.

The Shippers are largely untaxed on their global operations. Their status is ‘protected’ under the constitution. Taxing the shippers would go a long way toward closing the budget gap. The changes in tax laws will not come easy. There is no certainty of the outcome. The sense that I got from these discussions was that there is a short window open for Greece to come up with a plan to cut its deficit to approximately 9%. I asked for both a ”good” and a “bad” news scenario. Although the responses to the question I asked are speculation, they have interesting implications.

"If Greece is able to restructure its tax code and install a plan to reduce its deficits to 8% of GDP, then China will invest Euro 25 billion in Greek bonds."

The issue of the Chinese investing in Greece was first raised on November 29 by the WSJ. I think it was one of those well placed rumors. If this were to happen, it would be of significance. It would establish that China is assuming a role as some form of 'lender of last resort'. The bilateral trade conditions that would be attached to a deal of this magnitude would re-raise the issue of China’s trade hegemony and economic muscle. For me, the most significant aspect of this is that it would represent yet another significant diversion of China’s investable funds away from the US.

If this were to happen, the $40 billion under discussion would not impact the supply demand equation for US debt. But the direction of this would be significant. The US desperately needs China to significantly increase their holdings of US IOU’s in the coming years. They are under no obligation to do so. What if they were to take a stance with the US similar to Greece? We would get a headline that looked like:

China to Purchase $200 Billion of US Debt
Terms include: Higher interest rate, a commitment to buy Chinese goods and a promise to reduce the deficit.

Of course we are not going to see a headline like that anytime soon, but the developments in Greece are a possible first step in that direction. If China bails out Greece in 2010 it is a game changer from a number of perspectives.

"If Greece is unable to address its budget deficit the Chinese will not invest and financial conditions for the country will deteriorate quickly. One consequence would be that Greece would be forced to separate from the Euro."

This is not a high probability outcome. However, talk of it would have a very significant impact on the FX markets. The people who I spoke with made an interesting observation, "Switzerland is very much integrated with the EU and the Euro, but they have maintained their own currency. If Greece had its own currency it could adjust it to achieve a trade advantage that would address the fundamental imbalances." (Same argument as "the weak dollar is good for the USA"). These same people point to the fact that the Swiss National Bank has been intervening in the currency market to weaken the Swiss Franc in order to achieve a trade advantage. The thinking is, “If it works for the Swiss, then Greece should do it too!”

Consider where this could go. If there is talk of this happening, it would raise the same issue for Spain and Italy who are suffering from their association with they Euro. This could lead in the direction of a two-tiered Euro. One would be strong. The other weak. The implications for the dollar would be significant in both the short and long term. It could be the source of instability as the process unfolds.

The Greece story has already gotten the money moving. It is a story that could take us in some surprising directions. I got the sense that there was a short fuse on this. The next three months may put some powerful forces into play.

Is there anything behind the Chinese/Greece connection? I think so. I always assume there is something to it when you get statements like the following. Asked whether Greece is negotiating with China to sell bonds, a government spokesman said:

"It may be true, and if it is true, we do not want to comment. But even if it isn't true we wouldn't want to comment.”


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