Ian Nar­ine

This col­umn placed the fo­cus on Greece de­fault­ing on its debt oblig­a­tions more than two years ago. I have al­ways main­tained that it was a ques­tion of when, not if, this event would oc­cur. This as­ser­tion was made even in the face of as­sur­ances that came from the Eu­ro­pean Union, the Eu­ro­pean Cen­tral Bank and many oth­er an­a­lysts. My ra­tio­nale was sim­ply that the num­bers did not add up. As of last week, Greece has an­nounced a debt re­struc­tur­ing that in sub­stance, if not form, amounts to a de­fault. It is an event im­por­tant enough to force me to di­gress from the top­ic of gov­er­nance in the CL Fi­nan­cial de­ba­cle that has held sway for the past cou­ple of weeks.

Last Thurs­day, Greece con­vinced in­vestors to par­tic­i­pate in what Bloomberg has deemed the biggest sov­er­eign re­struc­tur­ing in his­to­ry. More than 95 per cent of Greece's pri­vate­ly-held bonds is­sued un­der Greek law amount­ing to more than eeu­ro 100 bil­lion has been ten­dered for re­struc­tur­ing. It may all seem very re­mote and just an­oth­er news head­line, but the is­sues sur­round­ing this debt re­struc­tur­ing are far-reach­ing and should be not­ed by any and every­one in­vest­ed in­ter­na­tion­al­ly.

Le­gal­i­ty

The first les­son is that the le­gal ju­ris­dic­tion that gov­erns an in­vest­ment is im­por­tant. While this has of­ten been tak­en for grant­ed, in an era where politi­cians are rewrit­ing the in­vest­ment rules to serve var­i­ous short-term in­ter­ests, the is­sue of ju­ris­dic­tions and law take on ad­di­tion­al im­por­tance. Much of Eu­rope and Latin Amer­i­ca deals with a civ­il law code while the Unit­ed States, the Unit­ed King­dom and the Com­mon­wealth deals with a com­mon law code. In very sim­ple terms, the for­mer em­pow­ers the state at the ex­pense of the in­di­vid­ual, while the lat­ter os­ten­si­bly seeks to pro­tect the in­di­vid­ual from the state. The Greek gov­ern­ment was able to uni­lat­er­al­ly and retroac­tive­ly al­ter the terms of ex­ist­ing con­tracts so as to es­sen­tial­ly force pri­vate Greece sov­er­eign debt hold­ers of bonds is­sued un­der Greek law to ac­cept write-downs on their debt.

The suc­cess of Greece in this ven­ture leaves the door open for any coun­try un­der a sim­i­lar le­gal code to adopt a sim­i­lar ap­proach if they con­sid­er that the cir­cum­stances de­mand such ac­tion. Lo­cal in­vestors have a knack for find­ing all sorts of "great" in­vest­ments from far away places (usu­al­ly be­cause it is not suit­able to of­fer in more de­vel­oped mar­kets), so you should be very care­ful from now on when ven­tur­ing out­side of the com­mon law le­gal sys­tem. The sec­ond is­sue is the sanc­ti­ty of a sov­er­eign debt in­stru­ment. In the past, in­vestors bought a coun­try's debt and saw it as be­ing backed by the full faith and cred­it of the is­su­ing coun­try. The pre­vi­ous point un­der­scored the fact that it is now pos­si­ble for a con­tract to be changed uni­lat­er­al­ly.

The sec­ond cause for alarm is that a sov­er­eign na­tion would seek to ac­tu­al­ly make such changes and in­voke them for their uni­lat­er­al ben­e­fit. The in­abil­i­ty to pay has now giv­en way to the un­will­ing­ness to pay back a debt. You will re­call that Ja­maica had a debt re­struc­ture a cou­ple years ago. At the time, I wrote an ar­ti­cle ti­tled, Buy­er Be­ware. Con­sid­er this an­oth­er warn­ing on the road to nav­i­gat­ing this tu­mul­tuous in­vest­ing land­scape. As a re­sult of the Greece ac­tion, some sov­er­eign debt will car­ry a new risk pre­mi­um ab­sent any ex­ter­nal mar­ket forces, such as liq­uid­i­ty pro­vid­ed by Cen­tral Banks to fa­cil­i­tate sov­er­eign bond pur­chas­es.

Peck­ing or­der

The third is­sue for in­vestors to con­sid­er is the role of the Eu­ro­pean Cen­tral Bank and the Eu­ro­pean Union. It was a con­di­tion for any ad­di­tion­al bailout of Greece that pri­vate bond­hold­ers of Greek debt take a "hair­cut" on the val­ue of their in­vest­ment. Pri­vate in­vestors, such as pen­sion funds, banks and in­di­vid­ual in­vestors, hold a coun­try's debt but, of course, there are cen­tral banks and oth­er in­sti­tu­tions that al­so hold such debt.

Tra­di­tion­al­ly, these were all viewed as one class of in­vestor in that all in­vestors in the same in­stru­ment had to be treat­ed equal­ly. In this in­stance, it is the pri­vate in­vestors of Greece's bonds that have been asked to take a write down. This means that there are now im­plic­it­ly two class­es of bond­hold­ers for the same bond, even if this is not specif­i­cal­ly stat­ed in a con­tract.

In a cor­po­rate bal­ance sheet, bond­hold­ers sit above eq­ui­ty hold­ers in the cap­i­tal struc­ture. The ac­tion tak­en by Greece, done with the ap­proval of the Eu­ro­pean gov­ern­ing en­ti­ties, in­tro­duces a sim­i­lar lay­er­ing for sov­er­eign debt in that pub­lic in­sti­tu­tions now seem to rank above pri­vate in­vestors. Ap­pre­ci­ate that this is not some rouge state that has re­fused to abide by ac­cept­ed rules. These con­di­tions have been in­tro­duced be­cause the gov­ern­ing Eu­ro­pean au­thor­i­ties man­dat­ed that it be so. The rules of the game are chang­ing and, one can ar­gue, has changed. The im­pli­ca­tion is that any­one seek­ing to pur­chase debt in the Eu­ro­zone has to fac­tor this in­to the equa­tion go­ing for­ward, al­so any­one hold­ing such debt as col­lat­er­al against loans.

There is the is­sue of moral haz­ard as oth­er heav­i­ly in­debt­ed Eu­ro­pean coun­tries may do the same to get out of a fis­cal and eco­nom­ic bind.

Look­ing for­ward

The ac­tion tak­en by the Greek gov­ern­ment is un­prece­dent­ed, but it is not a guar­an­tee of suc­cess. It may sound sil­ly, but Greece ac­tu­al­ly owes more now. This is be­cause they re­struc­tured ex­ist­ing debt in or­der to bor­row more so the to­tal li­a­bil­i­ty has grown. Then there are con­tin­gent li­a­bil­i­ties as­so­ci­at­ed with these re­struc­tured bonds that can have a neg­a­tive im­pact across the sys­tem. On Fri­day, Bloomberg re­port­ed that an Aus­tri­an bank needs a US$1.3 bil­lion in­jec­tion of cap­i­tal in or­der to cov­er cred­it de­fault oblig­a­tions on the Greek bonds that were writ­ten down. Recog­nise that there are un­knowns in the equa­tion that may take time to man­i­fest them­selves and can im­pact in­vest­ments in places that do not seem ob­vi­ous at first glance.

Aside from the fi­nan­cial and in­vest­ment im­pli­ca­tions, it is the so­cial im­pli­ca­tions that car­ry the biggest un­known across Eu­rope. At the turn of the decade, I sug­gest­ed that this will be a decade of so­cial un­rest and the "Arab Spring" has borne this out to date.

Now con­sid­er that the mea­sures in­tro­duced to the pop­u­la­tion of Greece amounts to a 50 per cent re­duc­tion in their stan­dard of liv­ing. This is nev­er tak­en place in a democ­ra­cy dur­ing peace time, it is as un­prece­dent­ed as the le­gal machi­na­tions de­scribed above. The pri­vate in­vestors that were be­ing dis­cussed above com­prise pen­sion plans of the cit­i­zens of Greece, so not on­ly is their cur­rent stan­dard of liv­ing be­ing dec­i­mat­ed, but their safe­ty net is al­so gone. The un­em­ploy­ment rate in Greece is above 17 per cent.

Look­ing out across Eu­rope, note that the un­em­ploy­ment rate for per­sons aged 25 and un­der across the Eu­ro­zone is 21 per cent. It is well doc­u­ment­ed that a per­son who is un­em­ployed for a sig­nif­i­cant part of their 20s, is like­ly to be less fi­nan­cial­ly suc­cess­ful, all oth­er things be­ing equal. Aside from the ob­vi­ous lack of in­come dur­ing these years, the ab­sence of struc­ture that comes from not work­ing means that such per­sons will like­ly qual­i­fy for low­er-pay­ing jobs dur­ing the course of their life­time and be less able to main­tain a fam­i­ly and save for their re­tire­ment.

If I now point out that the un­em­ploy­ment rate in Greece and Spain among peo­ple un­der 25 years is over 51 per cent, recog­nise the so­cial chal­lenges that face these coun­tries on top of the oner­ous debt bur­dens. The fact that un­em­ployed youth are now greater in num­ber that those em­ployed cre­ates a very volatile so­cial en­vi­ron­ment. If you think all of the above is as bad as it gets, let me al­so point out that the un­em­ploy­ment rate among 25 and un­der in the Unit­ed States is at its high­est lev­el since 1948. The rate hov­ers around 45 per cent and is glossed over by the fact that a num­ber of per­sons with­in this de­mo­graph­ic are go­ing back to school. Well done, ex­cept that this ac­tiv­i­ty is be­ing fund­ed large­ly be debt, which has to be paid back on low­er salaries, for when they do step back in­to the job mar­ket, they will re­alise that this de­mo­graph­ic has al­so suf­fered the biggest de­cline in re­al wages. Sort­ing out the cur­rent debt cri­sis is one is­sue, un­der­stand­ing the so­cial im­pact over the com­ing years is just as im­por­tant. The so­cial frame­work of the fu­ture will de­ter­mine the lev­el of growth and eco­nom­ic pros­per­i­ty that ob­tains at that time. Re­mem­ber, in­vest­ing is all about the fu­ture. Con­sid­er care­ful­ly what lies ahead.

Ian Nar­ine is a bro­ker reg­is­tered with the Se­cu­ri­ties and

Ex­change Com­mis­sion.