The following is an investment viewpoint by Mohamed El-Erian, chief executive officer and co-chief investment officer of at Pimco.
Given the tragic events in Greece and the financial contamination of other eurozone peripheral countries, most people now recognize that sovereign risk matters and it matters a great deal. Unfortunately, the recognition lag has already caused significant damage, including forcing the current approach to European integration to an historical juncture.
What is less well understood at this stage is that the externalities, negative and positive, are not limited to Europe. It is only a matter of time when this issue, too, becomes a driver of policies and market valuations and correlations.
The general context is critical here, and should never be forgotten. As argued in my March 11 FT commentary, the sovereign debt explosion in industrial countries involves a regime shift with consequential long-lasting effects. And what is happening in Europe is yet another illustration how, in our highly interconnected world, previously unthinkable phenomena can become reality in a surprising and highly disruptive manner.
Rather than just observe, other countries are well advised to understand the debt dynamics at play. They should draw the appropriate policy implications given their own debt burdens, maturity profiles and funding sources.
They must also go well beyond this.
Most countries around the world will feel aftershocks of the Greek tragedy. The transmission mechanisms involve trade, capital flows and the very functioning of markets; and the consequences range from the certain, to the balanced, and to the truly unpredictable.
It is certain that the Greek crisis will undermine aggregate demand and, therefore, trade flows – directly and, more importantly from a global perspective, by imparting an additional fiscal drag to other European countries.
This will strengthen the structural headwinds that are already weakening what has been a robust global cyclical recovery. It will also complicate the much needed handoff from temporary drivers of growth (government stimulus and inventories) to more sustainable ones (components of private final demand).
This is most consequential for countries that export heavily to the eurozone. Some are neighboring countries, such as Norway, Sweden, Switzerland and the UK. Others are further away, such as Singapore and Russia.
The second transmission mechanism pertains to capital flows and is more nuanced. Several countries, led by the US, stand to benefit from a reallocation of capital away from the eurozone as investors react to both the deterioration in sovereign risk and the surge in volatility. As for the capital that flows just within the eurozone, there will be an even greater differentiation in favor of the solid core countries, particularly Germany.
These flows are already happening. They will become even more pronounced in the weeks and months ahead as institutional investors revise their investment guidelines to exclude highly volatile government exposures from their “interest rate” bucket.
But there is an important qualifier here. Since Greece is part of a general phenomenon of bloated public finance and higher systemic risk, we should also expect a generalized and volatile step-increase in risk premia around the world. Capital will thus be more selective in terms of destination, as it opts for liquidity over returns and for safe government bonds over equities.
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The third transmission mechanism is the most unpredictable. Over the next few months and years, we should expect politically driven changes to regulations that aim to lower the risk of contagion and dampen cross-border capital flows. And for the next few days, we should worry about cascading disruptions in the European banking system as interbank activities are undermined by renewed uncertainties about each institution's exposures to peripheral European names.
Where does all this leave us?
The Greek crisis has already morphed into a regional (eurozone) shock. It now stands on the verge of morphing into a more global phenomenon.
Some countries will benefit, mainly on account of capital flows coming out of the eurozone. The majority will not. And even those that do benefit should remain vigilant and responsive. Like most other countries in the world, they will also end up suffering from the consequences of lower international demand and renewed disruptions to the global banking system.
1 All investments contain risk and may lose value.
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