For those not following the sovereign debt crisis overwhelming most of Europe, I'll give you a quick rundown. Greece, one of the 16 countries that make up the Eurozone, spent more money than it had -- and the money it spent was borrowed money. The more it borrowed, the higher the interest rates it received on its loans, until it became painstakingly obvious that this was not sustainable.
After it was revealed that Greece had … errr … erroneously fudged some numbers, the country's true fiscal picture became clear: In 2009, Greece's budget deficit clocked in at about 12.7%, and its national debt as a percentage of GDP has reached about 125%.
Well, for one, all of the other members in the European Union care. All 16 countries signed a "Growth & Stability Pact," drawn up to ensure that all members stay on the straight and narrow path toward fiscal responsibility. The two criteria imposed on members are they have an annual budget deficit no more than 3% of GDP, and a national debt lower than 60% of GDP.
Hmmm, looks like Greece has broken both of those rules. The problem is, so has almost every other member in this motley crew of countries. Although the objective of the growth pact was well intended, the rules have never been enforced, so there has never been any incentive for fiscal conservatism.
As an investor, you should also care -- for two reasons. First, Greek companies are understandably feeling the pressure of their governments inability to reign in debt and balance the books. In the last week, Greek companies like DryShips (Nasdaq: DRYS ) , National Bank of Greece (NYSE: NBG ) , and Capital Product Partners (Nasdaq: CPLP ) have all seen their share prices drop. Is this a buying opportunity, or do these companies deserve to be hammered because of the irresponsibility of their government?
Second, if you believe like I do that the euro is going to come under extreme pressure, then you'll want to watch your exposure to euro-centric companies like Philip Morris International (NYSE: PM ) or Vodafone (NYSE: VOD ) . And I'm not necessarily advocating this last approach, but if you really want to take advantage of the crisis, you could short the euro by investing in ETF's like UltraShort Euro Pro Shares (NYSE: EUO ) or Market Vectors Double Short Euro (NYSE: DRR ) .
When PIIGS fly
So where do we go from here? Well, there are basically three options that the EU has in order to get itself and Greece out of the current mess:
- EU members can bail Greece out.
- Greece can go to the International Monetary Fund (IMF), hoping for a loan and a lighter than usual slap on the wrist.
- A European Monetary Fund (EMF) is created by the EU to act as a lender of last resort.
Don't look for EU members to bail out Greece. Germany, the de facto leader of this bunch, has made it clear that it does not want to reward capriciousness. In addition, the EU has a "no bailout" clause, which more or less says that no country's liabilities should be assumed by the EU. Angry with Germany's unwillingness to play nice, Greece's deputy Prime Minister -- no stranger to controversy when, in 1993, he referred to Germany as a "giant with a child's brain" -- recently resorted to Nazi-era rhetoric blasting the Germans for stealing their gold during WWII.
So, call me skeptical on the prospects of a German-led EU bailout.
Greece may just go to the IMF. Originally, I didn't think it would because of the stigma attached to taking a handout -- and the imposition of austerity measures required by the IMF. However, Greece has made it clear that it would get much lower interest rates (maybe around 3.25%) than it would on the open market (closer to 6%). Nevertheless, I have a feeling the EU has too much misplaced pride to allow one of its own to ask the IMF for help.
The last option seems more and more feasible. German Chancellor Angela Merkel has said that "the idea [of an EMF] is a good one." Yet in order to do create an EMF, Germany is pushing for a rewrite of the EU treaty -- not exactly an easy task, considering the intense politicization of the process and the nationalism that typically overrides EU solidarity. Creating an EMF would be popular on the one hand because it would allow EU members to solve these types of problems on their own, and on the other hand would calm debt markets by providing a financial backstop.
However, Germany also wants to include a retroactive "exclusion pact" that has the power to kick out current EU members that aren't living up to EU standards. Any talk of exclusions hints at widespread frustration and a major disconnect between members. Moreover, an EMF would also send a terrible signal to the other members of the EU that are currently on the precipice of disaster.
Yes, Greece is not the only one in trouble. The PIIGS -- Portugal, Italy, Ireland, Greece, and Spain -- all have broken covenants regarding deficits. They all have enormous amounts of debt coming due and will most likely be facing a similar crisis in months to come. Check out this chart of the upcoming liabilities due this May:
The worst possible scenario -- and one that is growing more and more likely with every day that EU members spar over differences -- is that once the EMF is created, troubled countries rush to maximize any benefits they hope to receive. Anticipating a run on the fund, distressed countries will dash to the EMF as they try to deleverage their balance sheets. The fund, this early in its infancy, would most likely not be able to sustain such a panic.
IMF Managing Director Dominique Strass-Kahn has said "modest reforms that maintain a pretense of progress but continue business as usual are not sufficient ... Europe needs a fundamental overhaul of its financial stability architecture." Whatever option is chosen, whether it's a combination of an IMF/EU loan package, or the creation of a new EMF, it's clear that this whole thing is a big row of dominoes just waiting to fall.
This morning one domino actually tumbled: Fitch downgraded Portugal's debt. Although the markets seem to have expected the downgrade, it's yet another sign that as one country goes, financial exposure throughout the EU will be uncovered and the lack of fiscal federalism will serve to ripple its way through stormy EU waters. And Ireland looks to be next in line.
The Foolish bottom line
The Greeks are threatening to go to the IMF for aid, a gesture that humiliates other EU nations. The Greek Prime Minister, however, refutes this fact and insists that the EU must resolve the problem when the EU meets this Thursday and Friday in Brussels. The Germans have established their stance as "Heck no, we're not writing the check!" The French are flabbergasted and want to help Greece. The Netherlands is siding with the Germans.
The result: a Eurozone that is even more discombobulated and segregated than it was when the Treaty of Maastricht took force in 1993, with a currency that's hitting all-time lows.
If this is the beginning of the end for a group of disgruntled, stymied countries, get ready for a major change in the financial world order. Keep your investments limited to companies with minimal exposure to the euro, and watch for the flight to safety in the good old U.S. dollar. European sovereign debt may just implode before we know it.
Want updates from a team of Fool analysts who set off to Greece to get answers on the crisis? We're documenting all of the Fool's Greek research in real-time at www.FoolGreece2010.com. That includes what we're hearing from companies and investors as well as first-hand, on the ground accounts of what's going on!