Still in a spin - Impact from Greece, Portugal, and Spain

A rescue by the European Union and the IMF has given Greece some breathing space. But much more may need to be done to avert eventual default

Apr 15th 2010 | From The Economist print edition

TWO months ago the governments of the euro zone agreed in principle to offer emergency loans to Greece. A near-panic in the bond markets has now forced them to spell out the terms of support for their stricken colleague, should it be needed. If push comes to shove, the other 15 euro-zone countries are willing to provide Greece with up to €30 billion ($41 billion) of three-year fixed- and variable-rate loans in the first 12 months of any support programme. The announcement was made by Olli Rehn, the European Union’s economics commissioner, and Jean-Claude Juncker, chairman of the Eurogroup of finance ministers, after a telephone conference of the Eurogroup on April 11th.

The chief obstacle in previous negotiations had been the interest rate to be charged for the rescue loans. Germany had insisted on “market rates”—ie, with no element of subsidy. That made little sense: if a backstop were provided only on such terms, what would be the point of it? Eventually a formula was found that both met Greece’s needs and satisfied the Germans. The interest rate for emergency aid will be 3.5 percentage points above the benchmark “risk-free” rates for euro loans. That works out at around 5% for a fixed-rate loan, which is less than markets were asking of Greece before the deal was struck but still steep. Portugal and Ireland, the next-riskiest borrowers in the euro area, pay less than half as much for three-year money. Germany pays a mere 1.3%.

The IMF is expected to chip in €15 billion, at interest rates that are likely to be a little kinder to the Greeks. The resulting package of €45 billion would be enough to finance Greece’s budget deficit for the rest of this year as well as repay its maturing debts. Yet Greece is likely to need far more support than this as it struggles to put right its public finances.

Cracks in the masonry

An earlier analysis by The Economist (“Safety not”, March 27th) suggested that Greece would need at least €75 billion of official aid. We based this figure on several assumptions: that Greece would need five years to stabilise its ratio of debt to GDP; that it could take the pain of a brutal fiscal retrenchment; that private investors would still be willing to refinance existing debts, at an interest rate of 6%, if a rescue fund covered the country’s new borrowing; and that the economy would start to grow again in 2013.

An updated set of projections is set out in table 1. We have made two changes so the analysis is a bit rosier. We now assume that Greece cuts its budget deficit, as a share of GDP, by four percentage points this year, as planned, so it has less to do later. We also assume that the interest charged on all maturing and new borrowing is 5%, in line with the cost of the aid offered by Greece’s euro-zone partners. With those changes, we reckon Greece would need to cut its primary budget deficit (ie, excluding interest costs) by 12 percentage points to cap its debt burden—a slightly less fierce adjustment than in our first simulation. On that basis Greece will run up an extra €67 billion of debt by 2014, by which time its debt will stabilise at a scary 149% of GDP. That sum is less than our previous estimate, but still half as much again as the amount on offer.

Some will see this scenario as too pessimistic. It is far gloomier, for instance, than that envisaged in the EU retrenchment programme, which assumes that Greece will get its deficit below 3% of GDP in three years and that the economy can continue to grow as it does so. However, even with a more benign assumption about growth, Greece’s debts would still be very large. For instance, suppose that any losses in nominal GDP during recession are quickly recovered. Debt would still then stabilise at 142% of GDP.

It will be hard for Greece to make such savage cuts in its budget and emerge from recession at the same time. Furthermore, prices and wages will have to fall if Greece is to regain the cost competitiveness needed for sustained economic growth. That will drag down nominal GDP in the short term, and make budget cuts more difficult to carry out.

Our analysis may even be too optimistic. If economic growth does not return, deficit reduction proves too painful or interest rates are much higher than we assume, the debt ratio is likely to spiral upwards until default becomes all but inevitable. Even if that is avoided, Greece’s rescuers may have to shoulder more of the financing burden than we have estimated, should private investors reduce their exposure to Greece.

They have plenty of reasons to do so. On April 9th, two days before the euro-zone rescue package was announced, Greek government bonds were downgraded by Fitch, a credit-rating agency, to BBB-, just a notch above junk status. As Greece’s debt mountain grows, investors are increasingly likely to shun its bonds in favour of those of other, more creditworthy, euro-zone countries. Though IMF cash is welcome, private investors know that the fund is first in the queue when money has to be paid back. A euro-zone rescue party may also demand priority.

The bolder sort of investor may reckon that the high yields on offer are ample reward for the risk that Greece may be unable to repay all it has borrowed. But some will be more cautious. And others may judge that an interest rate big enough to compensate for the risk of default would only add to the pressure on Greece, making default more likely. Mohamed El-Erian, the head of PIMCO, the world’s biggest bond fund, said on April 12th that his firm was steering clear of new Greek bonds. “Based on what we know right now, we would not be a buyer,” he told Reuters television. Asian central banks that want to balance their dollar holdings with euros may choose to park their cash in France or Germany and save themselves any worries about Greece and its politics.

The signs are not encouraging. An issue of Greek six-month and one-year bills on April 13th was hailed as a sign of robust private demand because the auction, which raised €1.6 billion, was heavily oversubscribed. The interest rate that investors demanded told a different story. Greece had to pay 4.55% to borrow for six months, just two days after the Eurogroup had all but promised to refinance Greece for the next year and at a time when central-bank interest rates are a paltry 1%. A day later yields on ten-year Greek bonds rose to 7%, 3.9 percentage points more than those on comparable German Bunds.

Greece’s euro-zone partners could find themselves with a large and open-ended commitment to roll over the country’s existing debts and to provide cash to cover its budget deficits. The rescue package announced this week may over time evolve into a rolling series of soft loans, at ever-lower interest rates and increasing maturity, designed to prop up Greece and keep default at bay. Such loans—in effect, grants—would amount to a kind of fiscal drip-feed. That could spur a political backlash, and perhaps legal challenges, in the countries supplying the funds.

Our debts, your problem

Yet the alternative to a bail-out—default—is too grisly to contemplate, not least because of the dire consequences for Europe’s banking system. Banks in Greece hold €38.4 billion-worth of the government’s bonds, according to Deutsche Bank. This amounts to almost 8% of their total assets. A big write-down in the value of those bonds would leave the banks crippled. But around 70% of Greek government bonds, €213 billion-worth, are held abroad, mainly elsewhere in Europe.

There are no solid figures on how much of this is held by banks but it is possible to make rough guesses. The Bank for International Settlements (BIS) provides figures for foreign banks’ lending to the Greek government, Greek banks and the private sector combined. Furthermore, according to analysts at the Royal Bank of Scotland, banks bought a bit less than half of the Greek bonds sold between 2005 and 2009. Based on these figures, table 2 contains our estimates of which countries’ banks own Greek public debt.

The “low” figure is calculated using the weight of each country’s total exposure to Greece in the BIS figures. For instance, French banks account for a quarter of all foreign-bank loans to Greece. If we assume that half (ie, €106 billion) of the €213 billion of Greek government bonds owned outside Greece are held by banks, and that French banks have a quarter of that, their share is €27 billion. On the low estimate, euro-zone banks own €62 billion of Greek government bonds.

The true exposure is probably a bit higher, perhaps €70 billion. It is more likely that holdings within the euro area are weighted more towards commercial banks than pension and insurance funds, because banks are able to use Greek government bonds as collateral for cash loans from the European Central Bank (ECB). The “high” estimate assumes public debt accounts for all the foreign banks’ lending to Greek entities in BIS data. This is surely an overstatement, but the exposure of German banks, for instance, is likely to be much closer to our high estimate, €30 billion, than the low one. As Laurent Fransolet of Barclays Capital points out, Hypo Real Estate, a state-owned German bank, has already reported an €8 billion exposure to Greek sovereign bonds.

Given the pain that a Greek default would inflict on the euro area’s banks, it is perhaps not surprising that the currency club’s governments have rushed to announce firmer details of a bail-out. A default that would reduce Greece’s debt burden to, say, 60% of GDP would cut the value of its bonds by half. Because banks are still fragile, euro-zone governments would probably have to cover their losses, at a cost of at least €31 billion (ie, half of €62 billion). A €30 billion loan that gives Greece a chance to right its public finances looks good value compared with a €31 billion loss for bailing out banks should Greece fail. Euro-area governments are thus ready to lend money to Greece so that it can repay euro-area investors, many of them banks that are backed by the same governments. In effect, they are offering to bail themselves out.

There are other good reasons to try to postpone any reckoning. The world economy will, with luck, be stronger in a few years. A rescue package buys time, and not just for Greece. There is a risk that contagion could affect Ireland, Italy, Portugal or Spain, the other euro-area countries with some mixture of big budget deficits, poor growth prospects and high debts.

Of these, Portugal and Spain have most in common with Greece, because of their reliance on foreigners’ savings. Italy draws more from domestic resources to finance its debt and deficits. It has a worryingly large debt burden, around 120% of GDP, but is closer to a primary budget balance than the others. Perversely the sheer size of its debt is a strength. Italy’s bond market is the third largest in the world and is thus very liquid. Ireland is also less reliant on foreign savers and has a better record of deficit-cutting than most countries. And as one of the euro zone’s more flexible economies, its medium-term growth prospects seem less dire.

Were Portugal and Spain to get into the same sort of trouble as Greece, the resulting problem might be too big even for the deep pockets of Germany, France and the IMF. So Europe has a direct interest in making sure trouble does not spread to Iberia. Foreign banks’ exposure to Greece, Portugal and Spain combined comes to €1.2 trillion. European banks have lent most of this. German banks alone account for almost a fifth of the total (see chart 3).

Spain is a much bigger worry than Portugal, because it has a much bigger economy. Its public finances are not in as poor shape as Greece’s, thanks to good fiscal discipline during its boom years. Spain’s debt burden is half that of Greece: last year government debt was 54% of GDP. Even so, its debts are rising too quickly for comfort. The European Commission expects the budget deficit will be 10% of GDP this year. A bigger fear is that Spain will not recover from recession with any vigour because, like Greece, it is hampered by high wage costs and a rigid economic structure.

Optimists point out that the problem of cost competitiveness is exaggerated. Even during its long consumer boom, Spanish exporters maintained their share of world markets, unlike their French and Italian rivals. Yet Spain’s export sector is too small to spur a recovery and the high cost of laying off permanent workers in dying industries means it is hard to shift resources to exporting firms. The rapid expansion of temporary work contracts since the 1990s has given the Spanish economy more flexibility. But this came at a cost. Firms have little incentive to train the young temps whom they will soon lay off, and that has contributed to Spain’s dismal record of productivity growth.

The trouble engulfing Greece ought to startle Spain’s policymakers out of a dangerous complacency. The euro-zone rescue package for Greece, to which the Spanish would contribute, buys Spain time to secure bond investors’ trust. The government has said it will press for reforms to the country’s complex system of wage agreements. These are urgently needed to ensure that pay responds to changes in business conditions. The gap between the two tiers (permanent and temporary workers) in Spain’s job market needs to be tackled, to boost productivity and speed up the flow of workers to rising industries. Regulations should be dismantled to make it easier for firms to challenge stodgy incumbents, particularly in services.

The offer of support for Greece is worthwhile if it gives the country a chance of getting its house in order and if other members of the euro area make the most of the chance to carry out growth-enhancing reforms. Yet there is a risk that the rescue is treated as an opportunity to relax.

A further danger is that measures to help Greece now may complicate matters in the years ahead. The head of the ECB, Jean-Claude Trichet, confirmed on April 8th that the central bank would continue to take bonds rated BBB- or above as collateral for its cash loans to commercial banks. Although low-rated private asset-backed bonds will be subject to bigger discounts after this year, government bonds will not. So banks will be able to get ECB cash in exchange for Greek government bonds as easily as for Bunds.

This change in policy was surely designed to send a signal. If Greek bonds are good enough for collateral at the ECB, they ought to be good enough for private investors, too, whatever the (mostly American) rating agencies say. The trouble is, the policy only encourages a greater concentration of Greek bond holdings among European banks. That will increase the vulnerability of Europe’s financial system to concerns about a Greek sovereign default.

The default option

Is such a thing imaginable? Conventional wisdom has it that sovereign defaults are always messy and painful. In fact the lesson of such defaults over the past decade or more is that this is not necessarily so. More than a dozen emerging economies have restructured their sovereign debt in the past decade without huge losses of output and without paying enormous penalties in exclusion from capital markets or higher spreads. With a few exceptions (notably Argentina) the process has been much quicker than in earlier sovereign restructurings, and governments and creditors have managed to work together. Governments sometimes negotiated a restructuring with creditors before formally missing a payment of interest or principal—a process known, in the jargon, as “pre-emptive” restructuring. Legal innovations to encourage creditors to take part in restructurings and make it harder for holdouts to litigate have helped.

In 2003 Uruguay restructured all its domestic and external debt, exchanging old bonds at par and at the same coupon rate for new ones but stretching maturity dates by five years. The country returned to capital markets a month later. The “haircut”, or loss to bondholders, was small (13.3%, in net present value), as were the amounts restructured ($5.4 billion), but it showed that orderly sovereign workouts are possible. Countries such as Jamaica and Belize have had orderly restructurings recently.

Greece is different because it has much more debt outstanding and because bondholders may face a more severe haircut—although with sufficient fiscal consolidation a more modest restructuring could be feasible. Sovereign-debt lawyers say that in some ways a restructuring of Greek debt would be easier than many people think. But other things would be new and harder, especially the complexity caused by credit-default swaps, which have not yet played a big role in any sovereign-debt restructurings. It is uncertain, for instance, whether a pre-emptive restructuring would trigger the default clause in credit-default swaps. But Lee Buchheit, a leading sovereign-debt lawyer, says that the biggest risk in most debt-restructuring cases is governments that try to put off the inevitable. “By far the greater risk is pathological procrastination by the debtor in the face of an obviously untenable financial situation,” he argues, in which a country pursues frantic and ruinously expensive emergency financing in the lead-up to an eventual restructuring.

Would a defaulting country have to leave the euro? No. It is perhaps natural to conflate default with devaluation because they often occur together. But a euro member has no currency to devalue. Nor is there a means to force a defaulter out, since membership is meant to be for keeps. A new currency would have to be invented from scratch, a logistical nightmare. All contracts—for bonds, bank deposits, wages and so forth—would have to be switched to the new currency. The changeover to the euro was planned in detail and in co-operation. The reverse operation would be nothing like as orderly. A country that had lost the faith of investors in its public finances would find it hard to reconstruct a sound monetary system. Default by a member would be a body blow to the euro’s standing. But it need not spell the end of the currency.