This week, the markets will have to grapple with two rather significant events that happened over the weekend.
First, Greece now seems to be on a slippery slope leading to an exit from the euro and, second, the Chinese central bank cut its policy rates after a crash in the markets.
There seems to be little connection between the two events. But dig a little deeper and a common factor emerges—both these countries suffer from very high levels of debt.
A study by the McKinsey Global Institute in February said Greece’s total debt was 317% of its gross domestic product (GDP), while China’s was 217%. That estimate was based on data for the second quarter of 2014 and is certain to have gone up since then.
The difference is that while the Achilles heel for Greece is government debt, China’s is corporate borrowing. A more recent worry for China is the level of margin lending, which some brokers say is the highest in history.
Let’s look at China first. Will the rate cut lead to a continuation of the monster rally we had in the Chinese markets? One interpretation of the rate cut is that the markets now have the government’s blessings in bidding up equity prices to sky-high levels. But investors in China would do well to ask themselves instead why the Chinese government is so desperate to perpetuate what everyone agrees is a huge bubble. What is it they are hiding? If it has forced the Chinese central bank to hit the panic button, what lurks beneath must be a really huge problem. And China’s growth matters immensely—not only for much of Asia, but also to the top international corporations. But then, perhaps, one shouldn’t underestimate the ability of the Chinese Communist Party to rescue capitalism.
As for Greece, its ramifications go far beyond mere economics. Will Greece be better off outside the euro? Perhaps, but who can say for sure? It could rise from the ashes like Iceland or stumble along after a default like Argentina. History will judge whether it’s a tragedy that Sophocles would be proud of or just a farce. It will also be the judge of whether the current EU leadership sacrificed the European dream for a bit of cash. But, historically speaking, letting Germany get its way has not turned out very well for Europe.
What of the markets? Recent surveys show that investors believe a Grexit will be just a ripple on the surface of the markets. Unlike many international banks, Greece is certainly not too big to fail and the European Central Bank will do whatever it takes to provide liquidity and shore up European banks outside Greece and prevent contagion. Little of the Greek debt is now owed to the private sector. And a euro without Greece will be a stronger euro.
Therefore, while in the short run, a Greek exit could lead to a bout of risk aversion and the Chinese central bank’s intervention will help stabilize markets, over the longer term, the impact may be very much the reverse.
Investors should also keep in mind that any turmoil in global markets could make the US Federal Reserve postpone a rate hike.
What is absolutely clear is that, eight years after the financial crisis first reared its ugly head in the US, it continues to claim victims.