Up and Down Wall Street

Why Greece Will Stay in the Euro Zone

A respected analyst says the country will approve an austerity package and boot out the current leadership. Plus, why China’s stock market doesn’t work.

By Jonathan R. Laing

Updated July 3, 2015 12:46 a.m. ET

Tired of the seemingly never-ending Greek financial crisis? I know most financial writers are. And last week was no exception, when the ever-tieless Alexis Tsipras and his leftist Syriza Party thumbed their noses at the supposedly last and best offer by European authorities for a new bailout. Greece also defaulted on a scheduled $1.7 billion debt payment to the International Monetary Fund and closed its banks to all but 60-euro-a-day withdrawals at ATMs.

And, oh, did we mention Tsipras’ bizarre call for a national referendum Sunday on whether the terms of the bailout offer calling for more tax increases and pension cuts were acceptable or unacceptable. The only problem is that the offer expired at the end of June.

Is the endgame nigh for Greece, leading inexorably to its expulsion from the 19-nation euro zone and, perhaps, even the European Union itself? That seemed to be the consensus last Monday as stock markets in Europe and the U.S. sold off, with the Dow industrials down 350 points. But as last week wore on, stock prices steadied and even bounced back some in Europe, the U.S., and Asia. Still, fears abound that, if Greece exits the euro zone, there will be serious knock-on effects, if not contagion. That wasn’t the case even a few years ago, when most of the hundreds of billions of euros of Greek debt were still in the hands of banks and other private investors, and the European Central Bank had yet to use quantitative easing to shore up the sovereign debt of weak euro-zone members.

Yet, to some acute observers of the European scene, concerns over Greece are overblown and likely to subside in the coming months. That’s certainly the opinion of Anatole Kaletsky, the Kal of GavekalDragonomics. Despite or, perhaps, because of Tsipras’ “suicidal incompetence” in negotiating with European authorities, says Kaletsky in a report, developments are afoot that will actually “prove bullish for risk assets around the world and especially in Europe.”

His reasoning is simple. Syriza and Tsipras are likely to lose the referendum, with a majority of the Greeks voting to accept the latest austerity package in order to remain in the euro zone.

The alternative of going back to their former currency, the drachma, is just too scary for many to contemplate. That’s especially true, given the propensity of Greek politicians to debauch the national currency by running the printing presses nonstop. The resulting loss in value of savings accounts, pensions, and wages in a depreciating currency would only add to the depression-like conditions the population has endured over the past five years. Greeks also would have to give up the nice subsidies and other goodies they receive from the European Union.

Kaletsky previously thought it would take a month or two of chaos in a new drachma regime before the Greek government would fall. But with the likelihood that the referendum will go against the Syriza-led government and Tsipras’ zany missteps, the transition could take place far quicker to a technocratic, caretaker government willing to endorse any plan the troika—the EU, ECB, and IMF—puts forth.

And in exchange, that dominatrix of austerity, Angela Merkel, is likely to soften some of Germany’s demands. After all, the Germans should recall the beneficence the U.S. showed with the Marshall Plan after World War II and West Germany’s immense expenditures made to rebuild East German after the 1990 reunification. Surely the Greeks, for all of their endemic corruption, fraudulent governmental accounting, widespread tax evasion, and apparent lack of entrepreneurial spirit, deserve some additional debt relief after enduring more than five years of soaring unemployment and collapsing gross domestic product.

THERE’S A SAYING IN the Army that soldiers never hear the mortar round that gets them—just the shells that miss them. Keeping that in mind, we should dismiss many of the market concerns, such as Puerto Rico’s impending municipal-bond defaults, the Federal Reserve interest-rate hikes, and Iran. They are all knowns.

Perhaps of greater concern, however, is the relative insouciance with which the pricking of the Chinese stock market bubble is regarded around the globe, which has seen the main Shanghai Composite fall nearly 25% over the past few weeks. (For more on Shanghai’s current travails and prospect for margins calls, see my colleague Shuli Ren’s Asian Trader column.) Sure, the Shanghai market is still up nearly 100% in the past year, and stocks on the tech-heavy Shenzhen stock market are up over 150% in the same time span.

The bull argument for mainland stocks righting themselves and continuing their run has many facets. For the first time, foreign investors are being allowed inside the walled garden of domestically traded Chinese stock markets. Foreign money flows will only increase once MSCI permits the increased weighting of Chinese stocks in its indexes to properly reflect the country’s growing size in global stock trading. After all, the domestic Chinese markets are No. 2 in the world, with a capitalization of some $10 trillion.

Moreover, investors at home and abroad are fired by the conviction that a vibrant stock market is crucial for Beijing’s mandarins to steer the economy away from an export-driven, capital-investment model to one stressing service industries and consumption. A strong stock market will enable Chinese companies and banks to deleverage their debt-laden balance sheets by raising permanent equity to pay down debt.

Many investors want to get positioned now for what they see as an inevitable recovery in China, as it embraces the new paradigm and embarks on a more stable growth path. This confidence in China’s future is only bolstered by government reforms to loosen the nation’s tight capital controls and connect mainland markets with Hong Kong. Likewise, the government has been doing all it can to inflate a domestic stock bubble with easy-money policies and cheerleading editorials in state media. In short, many feel that the stock markets are too important for Beijing to permit them to plummet.

But the vicissitudes of free markets and swings in investor psychology are something that the centrally planned Chinese system has scant ability to contend with. Take China’s overwhelming debt load, backed by many troubled real estate developments, harebrained infrastructure projects bereft of any foreseeable cash flow, and redundant industrial capacity.

A recent McKinsey Global Institute estimate places China’s debt load (government, corporate, and household) at a towering 282% of its GDP. Since 2007, just before China went on its lending binge, it almost quadrupled, from $7 trillion to $28 trillion, through mid-2014. This debt level is off the charts when it comes to developing nations with relatively undeveloped capital markets.

Despite a surge in initial public stock offerings and rising share prices in the past year, Chinese debt continues to grow, according to longtime China watcher, Anne Stevenson-Yang of consultancy JCapital.

She points to figures recently issued in its internationally designated currency, renminbi, tabulating money flowing to Chinese corporations. Year to date, funds raised from equity issues totaled RMB2.8 trillion ($452 billion). That compares with loan volume of RMB52.6 trillion and RMB6.9 trillion in corporate bond issuance.

Thus, it seems that the stock market is playing an almost nonexistent role in delivering funds to Corporate China.

Stevenson-Yang, who admits to becoming a cynic after decades living in and travelling around China, has an explanation for this anomaly. She contends that the owners of many of China’s most storied private companies use the proceeds of IPOs to feather their own nests, rather than invest in the listed companies.

That may mean investing in a constellation of private companies they control, or sending the proceeds overseas. In addition, they often monetize their personal stock in the listed company, a far bigger pot of honey, using it to collateralize large loans from Chinese banks.

Stock ownership in China is an opaque affair. There are, of course, the highly publicized celebrity tycoons, but hidden from view are various members of the Party elite who use their power to advance the fortunes of listed companies and in return get a piece of the action.

If the stock market keeps falling, as it did in 2007-08 when the Shanghai Composite dropped almost 70% and then remained there for six years, China’s investing public, the many corporations that have taken to speculating in the stock market on the side, and the banks that extended collateralized loans to insiders, will be in a world of hurt. This would only add to the capital destruction that impends in China’s wobbly real estate market.

The tycoons and Chinese elite will be fine. They monetized their interests at nicely inflated prices. But many others will find their life in tatters, like Jake Gittes, the woebegone detective played by Jack Nicholson in the 1974 movie classic Chinatown.

The film noir’s story is rooted in Los Angeles’ Chinatown, a place where motives are mysterious, desire is thwarted, and the connected triumph over ordinary folk. As he’s led away from his dead lover at the end of the film, his sidekick delivers the memorable line, “Forget it, Jake. It’s Chinatown.”

The line still resonates.

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