Aussie Implications From a Greek Default

It took awhile, but are the wheels finally coming off in Europe? Last year, I figured either a Greek default or an Italian default on government debt was a certainty. It didn’t happen. But it may happen this year. And it may happen soon. What should you do before it does?

To be honest, all the news from Greece and Europe is discouraging. If the Greeks don’t get a second bailout of €130 billion by March 20th, they’ll probably default on the €14 billion worth of bonds that mature on that date. That would trigger a default and probably bankruptcy. Those are just the financial consequences. The social and political consequences are more troubling.

To avoid defaulting, Greek politicians are being forced to accept years and years of austerity measures imposed by the European Union (EU) and the International Monetary Fund (IMF). Now don’t get me wrong. Some structural changes to the Greek welfare state are long overdue. The trouble is, even under the IMF’s projections, austerity measures will reduce Greece’s debt-to-GDP ratio to 120%…by 2020.

That’s absurd. And in the meantime, Greece will have to accept a long list of politically unacceptable limitations on government spending. It’s hard to imagine the Greek people putting up with this for much longer, especially when the alternative to permanent austerity (and subservience to Berlin) is a simple default.

Default and devaluation are quicker solutions to Greek’s debt problem than austerity. But they’re also more painful in the short term. And a Greek default means Greece would either leave or be kicked out of the euro. The Greeks would still need a central bank to borrow from to issue their new currency and pay away their existing debts with new money.

All of this can be worked out because it’s happened before. The most recent example is Argentina in 2002. It wasn’t necessary to endure years of micro-management and austerity. The debt was wiped clean with default and devaluation. The country returned to relative prosperity soon enough.

Argentina is not Greece, of course. Argentina has lots of valuable goods to export. Greece has a tougher road to becoming a competitive economy. But it’s becoming clearer by the day that that road does not run through Berlin. Greece will leave the euro.

The European banking system has been preparing for this day for months. The Long Term Refinancing Operation (LTRO) scheduled for the end of this month should cash up any European banks that are worried about exposure to a Greek default. You get the impression the Europeans are hoping Greece can be cut loose without any collateral damage to other European banks or governments.

The hope that Greece can default without doing damage to the credit markets is a false hope. The damage has already been done globally. The cost of credit has gone up. Australia feels the pinch too, with the Big Four banks raising interest rates independent of the Reserve Bank of Australia.

But the most direct implication of a Greek default will be a fall in “risk” assets. At the top of that list, from an Australian perspective, is the Aussie dollar. You can see below that the Aussie lost momentum on its way to challenging its all-time high (against the US dollar).

Expect to see a stronger greenback as Greece comes unstuck from Europe. And as liquidity becomes scarce in the financial system, I’d expect to see the Aussie correct severely. At the very least, the carry traders who’ve been borrowing in Europe to bet on the Aussie will have a profit taking opportunity that’s too good to resist.

There’s a widespread belief that the ECB will simply not allow a Greek default to impact the global financial system in the same way Lehman Brother’s did in 2008. Cashing up the banking system through the LTRO contributes to this belief. But we’re about to see whether it’s true. Prepare for some nasty surprises.

Dan Denning
Editor, Australian Wealth Gameplan

Publisher’s Note: Dan Denning will be appearing at After America: the Port Phillip Publishing Investment Symposium, March 14th-16th at Sydney’s Intercontinental Hotel.

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Tagged as: aussie dollar, EU, Europe economy, european debt crisis, European Union, Eurozone, greek debt, greek default, Greek economy