Understanding Greece and the European Debt Situation
For the past several weeks, attention has focused on the debt crisis plaguing Greece and the contentious negotiations with its creditors.
The situation in Europe is probably affecting your portfolio to some degree right now. But how can the problems of a country so small and so far away create such turmoil in the world's financial markets? It may be helpful to consider how Greece got to this point, what might happen from here, and, equally important, how events in Europe might impact the markets in general and investors specifically.
How did this happen?
Greece, like most major economies, borrowed money to help pay its bills. However, the Greek economy was hit hard by the recession of 2008-2009. To make matters worse, in October 2009, the government admitted that the nation's deficit had been understated for years, raising serious concerns about the soundness of the country's finances. As a consequence, interest rates on Greece's sovereign debt spiked and the government was essentially unable to borrow on international markets, as investors feared they might not get their money back.
By the spring of 2010, Greece was running out of money and heading toward bankruptcy. In an attempt to avert further financial crisis, the European Central Bank (ECB), the International Monetary Fund (IMF), and the European Commission (EC) issued the first of two international bailouts for Greece totaling more than 240 billion euros, or in excess of $260 billion at current exchange rates. As a condition of the loans, lenders demanded strict austerity measures intended to cut Greece's budget deficit and debt burden.
The bailouts and austerity measures were intended to provide time for Greece to stabilize its finances. Unfortunately, the economic problems that plagued Greece haven't vanished. The country's GDP has shrunk and unemployment is above 25%. By the end of 2014, the debt-to-GDP ratio for Greece had climbed to over 170%--far exceeding any other country in the eurozone. As a condition for more bailout funds, Greece's creditors demanded additional budgetary requirements. However, many Greeks, including the country's ruling party, Syriza, blame the prior austerity measures for much of the country's current economic hardships.
With no agreement in place, loans were stopped and Greece became the first developed country to default on a loan payment to the IMF. In addition, Greek banks were essentially closed to avoid a large scale run on what little cash was available, allowing depositors access to no more than 60 euros ($66) per day. On July 5, in response to a special referendum called by Greek Prime Minister Alexis Tsipras on whether to accept the creditors' latest austerity requirements, Greek citizens voted a resounding "no." With money quickly running out, what will Greece do to maintain its solvency?
What are the possible scenarios?
Greece and its creditors could reach an accord, putting a new agreement in place that would provide the country with more bailout funds, presumably including emergency monies allowing banks to reopen. The potential terms of such a deal are open to speculation, but they could likely include some debt reduction coupled with a measure of government reform.
Otherwise, short of an influx of cash, Greek banks could soon run out of money. This would likely force the government to start printing its own currency by reintroducing the drachma while imposing heavier capital controls on lending and limiting access to depositor funds. In this scenario, Greece could exit the eurozone ("Grexit"), which no country has done since the eurozone's inception in 1999. In any case, Greek debt would be converted from euros to drachmas, the value of which would likely plummet, causing inflation to soar, driving down purchasing power. Greek bank depositors who had euros in their accounts would now have drachmas, one for one, but they would be worth substantially less than the euro.
Could a Greek default cause a financial crisis?
Most banks and financial institutions should be able to weather losses related to a potential Greek default. Much of Greece's debt is held by governments and the IMF, as opposed to private creditors and banks, so they may have little exposure to what happens with the country.
In addition, other countries that have faced economic hardships in the past, such as Portugal, Spain, and Italy, have taken steps to reform their economies and are much less susceptible to bond market contagion than they may have been in years past.
What about my portfolio?
Suffice it to say, performance of the stock markets may be influenced by a litany of factors. It's unlikely that the U.S. markets in particular will suffer long-term negative effects solely due to the Greek financial crisis. In any case, during periods of market volatility, it's always a good time to review your portfolio with your financial professional.
Generally speaking, financial markets hate uncertainty, and the current situation has contributed to market volatility. A volatile market, whether due to global troubles or domestic influences, can make it hard to protect your investments through diversification alone, which can't guarantee a profit or protect against potential loss. So it might be worth exploring ways to hedge your portfolio's exposure to possible market volatility. Uncertainty in the financial markets could persist for a while, but it's important to keep it in perspective. Though you should monitor the situation, don't let every twist and turn derail a carefully constructed investment game plan.
Kenneth S. Rakes has 25 years of experience in public accounting and is a graduate of John Carroll University. Ken provides tax planning and preparation services for individuals, partnerships, corporations, estates, and trusts. Ken is a Personal Financial Specialist (PFS) providing retirement, estate, investment, insurance, and education planning for individual clients with an emphasis on the tax implications of planning decisions. Ken's other areas of expertise include: Manufacturing, Wholesale, Retail and Service Industries, Non-Profit Organizations and Sub-Chapter "S" Corporations.