Impending global financial crisis caused by loan default by the Greek economy

By: Tejas Shah, Staff Writer

via dullhunk, Flickr

Only 15 days remain before Greece may default on all its loan payments. As days go by, this impending disaster appears to be imminent because of the soaring market interest rates and growing pessimism in the economic environment. Put it simply, consumers do not want to buy the high yield bonds because of the risk of losing their investment. From Eurozone’s periphery, the walls are falling and now the crisis appears to have its eyes set on the heart of the Eurozone. Ireland, Portugal, Italy and Spain are all facing default risk which has increased the bond yields to astronomical levels.

But we’ve already witnessed this. Italian bond yields have risen above 8% and Portugal’s bonds have been downgraded to junk status. Now it appears as the safe haven Eurozone debt, Germany appears to be headed down the same rocky road. With an unexpected quarter last week, investors have become very keen in purchasing Germany’s AAA-rated bonds. Furthermore, many of the periphery countries also want to pool their debt with Berlin’s. However, what they failed to realise is that pooling their debt with Berlin’s would pull up German yields and cause the walls to collapse.

So the question looms – is the Eurozone headed for yet another recession? It appears likely after Germany’s failed auction last week causing Bonds to sharply decline; and bids at Wednesday’s auction of 10-year securities amounted to 3.889 billion euros ($5.2 billion), out of a maximum target for the sale of 6 billion euros. But that’s just one component. On the menu of this disaster meal are 3 key components: Tightening Fiscal Policy, Credit Crunch, and Declining Consumer Confidence.

Let’s take a look at the tightening fiscal policy. If the government did not increase its stimulus spending the natural logic would be more money saved and thus an improvement of the economy. This is wrong. The folly of this logic is that as the economy slows down, the tax revenues collected by the government will fall as well. Hence, despite decreasing stimulus spending, the amount of tax dollars flowing into the government is dropping as well, which is why the deficit can actually still increase as the economy slows down. So now we have elevating chances of government deficit.

So what about the credit crunch? Lending activity by banks has already started to slow down and in some cases is grinding to a halt. Banks are quickly shedding their toxic assets to raise as much cash as possible to meet next June’s target as ascertained by the EU. The problem that is created is that an overwhelming 75 per cent of private-sector financial assets in Europe are held by banks, which means that many large businesses and even small investors will be negatively impacted by this painful crunch since they finance themselves with bank credit.

At the heart of the Eurozone crisis is investor confidence. Investors are what stimulate the economy and without their investments, the crisis expands world-wide. With soaring bond yields and the Greek default now appearing probable, these factors alone would set off a chain reaction wherein investors would lose confidence over their own domestic countries debt. This would mean that, despite offering high yield bonds, investors would unlikely invest in their respective countries, setting the stage for more potential defaults. This would impact trade agreements around the world since the EU is an important trading partner. In addition investors in foreign exchange would also negatively suffer from this because a lot of other countries have taken on the Greek debt as well; and with tighter credit policies this could create more pessimism in the economic environment causing yet another recessionary-like environment; not just in the EU but in the global economy as well.

With Christmas looming just around the corner perhaps the festivities may, for a brief moment, hide the looming crisis in the horizon. In the meantime however, put those seatbelts on, because a rocky road lies just around the corner.

ARB Team
Arbitrage Magazine
Business News with BITE.

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