But the Greeks are not alone in suffering the affronts
of debt collectors. Closer to home, in late June the governor of Puerto Rico
announced the U.S. territory would be unable to fully repay its $73 billion
of obligations, and that creditors would have to "share the sacrifices"
needed to restore economic growth and fiscal balance. This frank admission
could unsettle part of the U.S. tax-advantaged bond market. Puerto Rico had
been one of the largest issuers of municipal bonds. Due to their tax-free
status for American buyers (free from both state and federal taxes), Puerto
Rican bond issues were especially popular with high-bracket taxpayers in
high-tax states.
In addition to being an attractive place for bond
buyers, Puerto Rico enjoyed tax benefits in the form of incentives designed
to attract businesses to the island. These policies worked well
(pharmaceutical companies, for example, invested heavily in Puerto Rican
facilities) until they lapsed about a decade ago. Since then both investment
and the Puerto Rican economy have been in steady decline, to the point where
the population has fallen as residents decamped to the U.S. mainland seeking
better prospects. Projected and actual tax receipts have fallen as well,
making financial planning difficult and resulting in the territory's debt
climbing to 100% of GDP.
The governor's comments aside, Puerto Rico's
territorial status prevents it from taking advantage of U.S. bankruptcy
protections, although there has been some talk of devising a plan to grant
it relief. The repercussions of such actions would fall heavily on some
municipal bond mutual funds that had loaded-up on Puerto Rican obligations,
the hedge funds that now own a chunk of the island's outstanding debts, plus
a couple of bond insurers. Hedge funds are often attracted to financial
disasters and have their own ways of dealing with them. Already at least one
fund has objected to any debt restructuring talk — expect more news from that
quarter in the months ahead.
Greece promises to be even more "newsworthy." Its
crisis is very serious, and the impact on the lives of ordinary Greek
citizens has already been severe. Given the variables and uncertainties at
play, the impact of a solution (or non-solution, kicking the can further
down the road) to Greece's problems from an investment standpoint is
speculation at this time. Markets have a way of "discounting" unsettled
conditions, a characteristic that helps make them unpredictable. What does
appear to be highly likely, however, is the outcome of a continuation of
austerity and imposed reform. A humanitarian crisis is possible, and there
is talk of a "failed state on Europe's doorstep." That possibility is
potentially much more serious and costly than demands for financial
sacrifices on the part of the Eurozone, an idea fiercely rejected by some of
its member countries.
Perhaps Europeans' impatience with the Greeks has roots
that are really closer to home. Much of the Greek "bailout" money extended
so far has flowed to the big European banks that were, in years past, only
too happy to lend to poor Greek credits. Little has gone to helping the
Greek economy restructure and recover. Whether they like it or not, in one
way or another Europeans will be dealing with Greece for a long time to
come. Sacrifices will be needed, not only on the part of Greece. The
International Monetary Fund (one of the institutions overseeing the Greek
bailout) announced in early July that loans to Greece will need to be
extended, and that additional funding, perhaps totaling 60 billion Euros in
the coming years, will be required. Failing a resumption of economic growth,
a large part of the country's debts may have to be written off even if it
accedes to creditors' current demands.
Even as the Greek debt crisis comes to a head, China
may be incubating yet another. Potential problems involving non-bank lending
in the country (by so-called "wealth-management funds," for example) have
been discussed for years. But during the past year a new threat has emerged
in the form of margin debt, or loans secured by stock holdings. China's
stock market began a spectacular rise in July 2014. In early April 2015
stocks had gained 68% in the previous six months alone, as Chinese savers
put hundreds of billions of dollars from property, deposits, and wealth
management accounts into the stock market. Last March saw 4.8 million new
retail stock accounts opened, followed by an additional two million during
the first two days
of April. In the fashion typical of unsophisticated market players
everywhere, margin lending also saw "explosive growth," rising to $258 billion in early April,
fully 2.5 times the total six months earlier.
Buying stocks on margin is an ill-advised step for most
market participants, especially so for the first-time punters that appear to
be driving the Chinese market boom. Stock price declines can lead to margin
calls (demands that debts be repaid) that can deplete a brokerage account in
short order as stocks are sold at a loss. As if on cue, the Chinese market
ran into difficulty as new companies rushing to sell their shares and cash
in on a market bubble diverted interest from existing stocks and sucked
liquidity from the markets — in other words, supply and demand at work. After
peaking on June 12, stock prices fell sharply. As typically happens during a
speculative frenzy, the declines took on a momentum of their own. The
Shanghai Composite Index dropped 22% by June 29, losing $2.3 trillion of
market value (more than the market capitalizations of France and Canada).
Daily declines of 7% took place, and many individual stocks fell the daily
limit of 10%. Government efforts to provide "market support" and institute a
"soft landing," — steps that include the corralling of funds to purchase
shares and easing the terms of margin loans — are indicative of the
seriousness with which Chinese authorities view the market turmoil. In spite
of these measures, sizable declines continued into July.
While the flow of negative news put a damper on
sentiment, U.S. stocks chugged along nonetheless, experiencing only a small
amount of selling at quarter's end. The major indexes finished the
three-month period a little lower, and flat for the year-to-date. Bond
yields have risen modestly in anticipation of changes in Federal Reserve
monetary policy, as well as expectations of better economic performance both
here and abroad. Interest rates remain abnormally low, however, with all of
the market distortion that breeds, from excessive debt accumulation to the
impact of low discount rates on future obligations such as insurance and
pensions. How the fiscal and monetary authorities deal with the
"normalization" process to come will undoubtedly be the source of much Wall
Street opinion and chatter during the next few years.
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