For the last few months, we have been hearing that Stock Markets across the globe are being held back by some problems in the Greece economy. As an investor in Indian stock markets one might ask, "How on earth does a problem in a smallish country somewhere in Europe affect us in India? We seem to be doing alright. Why should our stock market even react to this issue?"
Well, whether we like it or not, we are indeed impacted through a logical economic sequence which is what I intend to dwell upon today. First of all, we need to understand the concept of ‘Sovereign Debt’. When a government is in need of funds to finance its spend, it often borrows money from its public by issuing bonds to them. These bonds are called ‘Government Bonds’ and the government returns this money with interest over a stipulated time period. In the same way, governments often issue bonds in international currency to borrow from other countries. These bonds are called ‘Sovereign Bonds’ and this sovereign debt too needs to be repaid by the government. As long as the GDP of a country is healthy, the government is able to repay its sovereign debt. But sometimes this debt builds on a country and brings it to the brink of sovereign default.
Greece is in a miserable situation as its sovereign debt is 150% of its GDP. There is no doubt that it is going to default at some stage. Last year, the European Union and IMF came to its rescue by offering a bailout package to temporarily plug the crisis. Apart from Greece, other weaker nations in the Euro Zone – Portugal, Ireland, Italy and Spain have also been showing sovereign defaulting tendencies. These 5 nations(commonly known as PIIGS) along with the US and Japan to a lesser extent are all facing immense sovereign debt pressures.
The entire focus right now is on saving Greece because of another economic phenomenon called the ‘Contagion’. Contagion refers to the phenomenon where significant economic changes in one country spreads to other countries just like a transmitted disease. An infamous example is the ‘Asian Contagion’, which occurred in 1997 and started in 1 small country, Thailand. The economic crisis in Thailand spread to bordering Southeast Asian countries like Indonesia and then eventually spilled over to Latin America. Greece being a relatively small economy can still be bailed out to a point (but not for long). But if contagion strikes and we start moving across the PIIGS countries, then the combined debt of these economies is just impossible to bailout because somebody needs to be paying for this bailout. For instance, in case of Greece, it is the people in stronger countries like Germany paying for this. This is certainly not sustainable for long. In case of a ‘sovereign contagion’, huge and eternal bailout packages would be required. The money would have to be generated from somewhere and problem will easily exceed the capabilities of the bailout facilities put in place. There lies the makings of a mega financial crisis originating in Europe. In such times of crisis, panic will prevail. There would be mass exodus of money from risky instruments like stocks to relatively safer havens like US Treasury Bills. Banks and financial institutions exposed heavily to the defaulting countries will become bankrupt. Stock markets globally will get impacted. Since the Indian Stock market is a lot more volatile, FII’s will want to withdraw the money from Indian markets and park it in relatively safer and less volatile markets like the US or pump that money into short-term debt. This outflow of funds from the Indian stock market will lead to a catastrophic crash till the situation settles down over a period of time through a mix of fiscal austerity measures and financial intervention by the stronger economies. By the time that will happen, the stock market would have corrected by 30-50%.
Hence, we can see, it all appears so small today - a single country, Greece, but its repercussions to the global markets directly or indirectly can be so devastating. It is this fear of ‘potential sovereign contagion’ that is dogging the mindsets of investors today and preventing the markets to go up freely. As an investor, I too am concerned and following the situation closely. The news this week is not too good from Italy. Whether, this holds back markets for long, is something time will tell. But one thing is for sure, we need a robust and concrete solution to these sovereign debt issues in the PIIGS countries, a solution that goes beyond temporary bailout packages which only delay the eventual catastrophe.
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