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For more back ground information as to what’s happening with Greece, you can read my
previous posts:Greece – The fire is out, but there are still problems (May 2010)
Greece – A short-term disruption? (February 2010)
Otherwise, for a current analysis please read on.
An uphill battle continues
Just over a year ago, European policy makers approved a €750 billion stabilisation package to provide troubled Euro area countries with enough money and time to get their financial houses in order. A further €110 billion package was specifically targeted for Greece.
These bail-outs came with strings attached. In accepting the rescue package, Greece agreed to reduce its budget deficit to 3 per cent of GDP over a five year period.
This was always going to be a massive task, given how high the starting point was initially perceived to be.
At the beginning of last year, Greece agreed to reduce its 2009 budget deficit from what was thought to be 13.6 per cent of GDP to 8.1 per cent of GDP in 2010 – a recession inducing adjustment of nearly 5.5 per cent of GDP.
Surprisingly, Greece came very close to reaching this target, as shown by figure 1, except that revised estimates show the task to be greater than first thought.
It’s now estimated that the 2009 deficit was really closer to 15.4 per cent of GDP, which means that when last year’s deficit came in at 10.5 per cent of GDP, it was also above target.
It’s a similar story for Greece’s debt to economic growth projections.
A year ago, the Greek government’s debt to GDP ratio was expected to peak at around 150 per cent of GDP in 2012/13. But recent revisions show that ratio reached just under 145 per cent at the end of last year. It’s now expected to rise to almost 170 per cent in 2012/13.
On current estimates, Greece is going backwards as it tries to go forward.
Figure 1: Reduction in budget deficits as a % of GDP
2009 to 2010
Source: European Commission and AllianceBernstein
Europe looking for the lesser of evils
Interest rates on Greek debt have continued to rise dramatically over the past week. It now costs the Greek government 22 per cent to borrow in Euros for two years. This compares with 1.8 per cent for German two year Euro debt.
Initially, the stabilisation packages were about avoiding a debt restructuring programme for Greek government bonds.
Recent developments mean that the problem has entered a new and more challenging phase in which some form of restructuring or further additional support has become more likely.
Restructuring can involve a ‘soft’ process, which allows bond holders and issuers to agree to an extension of due dates for payments or maturities.
The process, often referred to as ‘reprofiling’, is less disruptive than an imposed ‘hard’ rescheduling process and significantly less disruptive than outright default.
One problem is that this potential solution doesn’t have widespread support across Europe.
The alternative ‘hard’ rescheduling process could involve a ‘hair cut’ arrangement, where all bond holders incur a loss and have their credit cut back to reduce Greece’s overall debt position.
This solution would help keep Greece solvent, but would incur large losses for European governments and banks.
The European Central Bank (ECB) remains very motivated to avoid a default event on Greek bonds, or even a ‘soft’ restructuring event.
Authorities consider that the risks of contagion, and of a collapse to the Euro itself, are too high.
Greece needs to raise €27 billion of medium and long-term finance from the markets over the next year, and is unable to fund this new debt through the capital markets without European support.
If Europe’s leaders decide to cover this gap with additional financial support, then depending on the maturity of these purchases, the overall exposure of the EU, IMF and ECB to the Greek government could be as high as €200 billion by the end of next year.
Figure 2 shows that’s equivalent to the EU, IMF and ECB holding around 50 per cent of outstanding Greek government debt by the end of next year.
European authorities are likely to view this outcome as the lesser of evils, providing it avoids debt restructuring.
The cost for Greece will be even tighter targets for budget savings and demands for increased asset sales, all deepening an already serious economic recession.
Figure 2: Projected share of Greek debt held by the EU, IMF and ECB
Source: European Commission and AllianceBernstein
What this means for the markets
Greece’s debt problems have been out of the mainstream media for a while, but they have not gone away.
In fact, the situation has worsened and nervous investors can expect more volatility across all markets, as governments and central banks wrestle with this issue in the coming weeks and months.
Bond markets are clearly already pricing in potential losses. Greek government bonds have been downgraded to ‘below investment grade’ by major credit rating groups.
Equity markets are likely to react negatively in the short term if current negotiations look like failing. But the most likely outcome looks to be European leaders agreeing to further support rather than precipitating a more risky environment.
