From John Stepek, across the river from the City

Dear Money Morning Reader,

There are at least three big things that markets are fretting about just now. There are the potential new banking rules in the US. There’s China’s economy and its general direction - will the authorities tighten too fast or too slow? And then there’s Greece.

As one worry temporarily fades, attention turns to the next. So with bankers queuing up in Davos yesterday to smother Barack Obama’s plans to regulate them with the ‘Volcker rule’ - limiting bank sizes and activities - investors decided to worry about Greece instead.

There was a sharp sell-off in Greek bonds - only days after we’d seen strong demand for a bond issue on Monday - as reports spread that the country was trying to sell €25bn-worth of bonds to China. The yield on the ten-year Greek government bond went as high as 6.91%. To put that into perspective, a ten-year German bund yields about 3.2%.

But why is the idea that Greece is courting China to buy its bonds so scary? Let’s have a look...

How Greece rattled the markets

There are a few reasons why markets were rattled by reports – denied by Greece – that the country was seeking to sell a big dollop of bonds to China.

If the Greeks are turning to the Chinese, then perhaps it’s because there’s no appetite among Europeans to bail them out, something that many investors had assumed was a given. On top of that, the Chinese don’t seem to be keen on the idea either. Beijing has foreign currency reserves to burn. If the Greeks can’t tempt them with what look like attractive yields, then the situation must be really bad.

Indeed, a former adviser to the Chinese central bank, Yu Yongding, effectively told Bloomberg that China shouldn’t touch Greek debt with a ten-foot bargepole. “Even if pricing is attractive, one key problem for Greek government bonds is the lack of credibility. We trust US statistics on debt and deficits. The numbers are not pretty, but we have a pretty good idea of what we are buying. In contrast, Greece’s statistics have been sharply criticised by the European Commission.” In short, says Yu, “It is unreasonable for an economist to support a diversification away from an unsafe asset class [US Treasuries] to a much more unsafe asset class [Greek government debt]. Let European governments and the European Central Bank rescue Greece.”

Hardly a ringing endorsement.

But the main reason for the sell-off is because the story simply reminded investors what a precarious situation Greece is in. The country has a budget deficit of 12.7% of GDP. Bear in mind that one of the original conditions of eurozone membership was to keep your budget deficit to below 3% of GDP. It needs to get that deficit down. But more importantly, and painfully, it needs wholesale reform to become more competitive. That means lower wages, higher productivity, and less corruption, among other things.

Greece has three options

As Lex puts it in the Financial Times, in the long run, Greece has three options. “It can painfully deflate the economy. It can even leave the euro.” Or the European Central Bank can bail it out. The best option for the eurozone as a whole, would be for the country to knuckle down to sorting itself out. But while the Irish have so far proved capable of doing this without too much upheaval, Greece, with its powerful unions and arguably more volatile populace, is another kettle of fish.

Leaving the euro might seem more politically palatable for Greece, in that politicians could then blame external forces for the economic pain that would undoubtedly result. But it would be bad news for the euro, as investors would look for the next country to fall. As Tim Lee at Pi Economics puts it, a default in Greece, “will obviously then lead to the pressure going on the next ‘weakest links’ in the eurozone, namely Ireland, Spain, Portugal and possibly Italy. Further government defaults would then put pressure on the major economies, including the US and UK.”

So that leaves the bail-out option as “the most likely bet”, says Lee. But that effectively involves taxpayers and savers in wealthy countries – well, Germany basically – paying the price to keep the likes of Greece afloat. So it might be easier said than done. And even if there is a bail-out, it could have major consequences for Eastern Europe, says Lee, which could see its hopes of joining the euro smashed. “It is difficult to imagine that Hungary, for instance, will be let into the euro if Greece is in the process of being bailed out. This realisation could then well be the trigger for the next phase of the crisis in Eastern Europe, thereby impacting other emerging economies.”

Lee reckons that Greece’s woes are just the tip of a very large iceberg. “A global sovereign debt crisis seems fairly inevitable” regardless of the outcome for Greece.

How to profit from Greece's debt woes

We’ll look into this notion of a global crisis in the near future. But for now, one thing seems certain - the euro will remain under pressure because of this. So I’d stay short the euro versus the dollar. Probably the easiest way to do this is via spreadbetting - you can learn more about spreadbetting generally here, and if you’re looking for an account provider, check out our comparison tables here.

Of course, spreadbetting is a risky business and you have to make sure that you know what you’re doing. Remember that your losses can stack up very quickly.

An alternative is to use an exchange-traded fund. There is a US-listed exchange-traded currency fund, the ProShares UltraShort Euro (NYSE: EUO) which is designed to rise by 2% for every 1% the euro falls. Or there’s the London-listed exchange-traded currency fund, ETFS Short EUR Long USD (LSE: SEUR), which is broadly designed to rise as the euro falls against the dollar.

You could go with one of these, but you must remember that they are not ‘buy and hold’ investments. You must monitor their performance closely and make sure you understand how they are designed. You can learn more about why leveraged, short and other more complex ETFs are not for casual investors in our recent MoneyWeek magazine cover story on ETFs, here: All you need to know about exchange-traded funds (if you're not already a subscriber, claim your first three issues free here). This complexity is one reason why I prefer spreadbetting in this instance – you know exactly what you’re betting on and the high-risk element encourages you to keep a close eye on your trade.

Until next time,

John Stepek
Editor, MoneyWeek UK
New Business Editor of the Year, BSME Awards 2009

Turning to the markets...

The JSE all share index closed up 1.23% yesterday. The gold mining index rose 2.18%. Resources gained 2.79%. Banks and financials shed 0.39% and 0.14% respectively. Industrials added 0.31% down and the platinum mining index soared 4.71%.

London’s FTSE100 closed up 0.68%. The Dow Jones gained 1.09% and the Nasdaq added 0.87%.

Tokyo’s Nikkei closed 0.19% up. Hong Kong’s Hang Seng gained 1.29%.

Brent crude is currently trading at $75.87 per barrel.

Spot gold’s trading at $1,113.80 and platinum was last quoted at $1,575.50.

And here’s how the rand is performing against the major currencies:
R/$7.47
R/£11.95
R/€10.43