Over the past several weeks, much ink has been spent on the insolvency of Greece and how it’s inevitable default will impact the rest of the Euro zone, banks and the global economy. Euro bank balance sheets are full of Greek bonds as well as bonds of the other fiscally dilapidated countries like Italy, Ireland, Portugal and Spain. German banks are the most chocked full of this bad paper as shown in this chart.
“From the creation of the euro zone in 1999 up until late 2007, lending between European central banks was modest — but then, when the financial crisis hit, the German Bundesbank in particular went on a lending spree, while the PIGS central banks all started a borrowing spree. Since then, the Bundesbank has essentially been singlehandedly financing the PIGS central banks: it’s now owed a whopping €325 billion, and rising. Government insolvencies would now also threaten the solvency of debtor country central banks. This would then impose large losses on creditor country central banks, which national taxpayers would have to make good.”
See: FT’s Martin Wolf today: Sovereign debt crisis: Time for Common Sense on Greece
In fact Germany and China have a lot in common. Both used their artificially low currency exchange rates the past 10 years to sell boat loads of exports to debtor nations. Both provided excessive credit to their foreign customers by recycling export proceeds into bonds issued by these same customers so that the customers could keep on buying goods. It seemed like a perfect and infinite line of credit, until the realization hit that their customers are now so indebted, they will never be able to pay them back.
This reminds us of the age old warning, “neither a borrower nor a lender be”: when defaults hit, both sides lose heavily. And this pain crosses the Atlantic too: US banks greedily gobbled fees for underwriting the lion’s share of credit default swaps on European debts the past few years. As the default tsunami finally crests in Europe, American banks, already hopelessly undercapitalized, are the insurers of the European debt implosion. As I have said many times, there is not enough money on planet earth to make good on all of these claims. Zeros must be written off on all sides.
And while the risk trade rallied yesterday on more hopes for miracles in Greece, it is crucial to keep our sights on the real story: the global economy is in a major cyclical slowdown today heading into the second half of 2011. Meanwhile, stock and commodity prices are still jubilantly juiced from government and Central Bank stimulus injections all around the globe.
The onset of this major contraction or recession in the economy is not dependent on the fate of Greece. The default of Greece and its knock off effects on the global banking system will be an extenuating factor, but it is one of many coincident irritants; not the cause of the slowdown underway. Greece is the market word this week; but make no mistake, it is not the main story.