Get set for a Greek default
By Michael Collins, Investment Commentator at Fidelity
An event looms over the global economy that many Greeks, policymakers worldwide and investors see as almost inevitable. That event is a Greek default.
People think a default is coming because the IMF, one of the “troika” of Greek rescuers, can only help a country if it assesses that a country’s debt load is on a sustainable trajectory. The body’s long-term aid for Greece is conditional on Athens reducing its ratio of debt to GDP to 120% by 2020. The problem is that the IMF and the other two troika members, the European Central Bank and the European Commission, now forecast Greece’s debt to peak at 190% of output in 2014, from a forecast in March of about 165%. That makes the 120% within seven years problematic.
Reducing debt to GDP becomes a function of the pace of nominal economic growth, the average level of interest rates on the debt and the state of the government’s budget. If a budget is at least in balance, and nominal GDP growth exceeds the average interest rate on debt, a country should be reducing its debt ratios. It’s almost impossible, however, for a country to prune debt ratios if its economy is shrinking and Greece’s economy has contracted for the past 17 quarters due to austerity policies backfiring. The Greek economy is expected to have shriveled about 6% in 2012 – meaning it would have shrunk more than 20% over the past five years. The IMF forecasts it to dwindle another 4% in 2013.1
Greece’s ratio of government debt to output is more likely to breach 200% than tumble to sustainable levels. That’s why IMF Managing Director Christine Lagarde flagged a Greek default in September when she said: “Greek debt will have to be addressed.”2 Bundesbank chief Jens Weidmann in November talked about a Greek write-down as a way to “create trust” in Greece’s economy – “after reforms are actually carried out, of course”.3 More ominously, in December German Chancellor Angela Merkel hinted Greece could default but said it was “not going to happen before 2014-15”4 – or so she hopes.
A large debt write-off for Greece would be its second big default. The first occurred in March 2012 when private creditors accepted write-downs of more than 100 billion euros (A$136 billion) on Greek debt. They “voluntarily” accepted losses of more than 50% to avoid triggering the credit-default swaps tied to Greek debt, fireworks that would have ricocheted around the global financial system. Policymakers did well to control the side effects of what is the biggest default in history.
Official debt challenge
A second big Greek default will test the mettle of the Eurozone’s rescue plans (especially its 700-billion-euro firewall called the European Stability Mechanism) and the imagination of policymakers. They will be challenged not least because more than 70% of Greece’s outstanding debt is now held by public bodies, namely the troika and Eurozone governments. Germany is against defaults on loans held by official bodies, claiming it would be “illegal”5 and would set a precedent that other troubled countries could mimic.
The ECB, to take one troika member, is riddled with Greek debt from three actions. The first is that since 2010 the central bank has bought distressed sovereign bonds including Greek debt to help countries roll over debt at affordable rates. Another way the ECB loaded up on Greek debt was through its refinancing facility, which used to accept Greek government debt and government-guaranteed bank bonds as collateral from Greek banks. These banks would collapse if Athens defaulted; so too their bonds. The other way the ECB is exposed to Greek debt is via its emergency liquidity assistance program, whereby the central Bank of Greece issues loans to Greek banks that are implicitly backed by the ECB. (The emergency lending program is one of Mario Draghi’s key methods of doing “whatever it takes” to support the euro, the other being the ECB’s promise to buy unlimited amounts of distressed government bonds.)
The Institute of International Finance, the Washington-based global association for banks and other financial firms, estimated in February that the ECB’s exposure to Greece stood at 177 billion euros or “over 200% of the ECB’s capital base”.6 The association reckons the total cost of a “disorderly” Greek default at more than 1 trillion euros, a sum Eurozone taxpayers would ultimately foot. This bill includes substantial support to other Eurozone strugglers such as Spain and Italy to prevent contagion, ECB and Eurozone bank recapitalization costs and tax revenue forgone due to weaker economic growth.
A country should only default when its government budget is in balance or surplus before interest payments on its debt. A government can renege once its finances are in this state because it has the money to function.
Athens, due to the cost-cutting and steps to boost revenue, has bludgeoned its budget close to so-called primary balance now. It must know that history shows that most debt-ridden countries only recover when they default, no matter how much short-term help they might receive from outsiders.
In November, Greece’s creditors scrambled to give Athens overdue aid money to stave off a default by concocting a plan to tackle Greece’s debt millstone that was credible enough to win the IMF’s approval. Basically, according to reports, the IMF pushed for a default (which wouldn’t hit it as its loans gets repaid ahead of others) while politicians resisted because they didn’t want their taxpayers to be burdened with the costs of a default. Lawmakers instead offered tweaks to put Greece on a sustainable path. These adjustments are not expected to require fresh money from taxpayers (which for many countries including Germany would need parliamentary approval). The final deal involved debt buybacks (one was conducted in December), reduced interest rates on Greek debt, delayed principal repayments by extending maturities and giving Athens the profits the ECB had made on its Greek holdings. The solution is supposed to reduce Athens debt to 124% of GDP by 2020 from 145% otherwise.
There’s a chance this and forthcoming deals will avert a formal default, at least until 2014 anyway. (Any debt renegotiation is technically a default.) The 100-basis-point-cut on interest rates (to reduce the average rate to about 3%) on Greek debt mean that Athens’ debt repayments this year and next appear sustainable at about 6% of GDP and principal repayments can always be extended. A rebound in the Greece’s economy – and the sharper the decline the higher the likely rebound – would automatically trim Greece’s debt-to-GDP ratio. Standard & Poor’s displayed great optimism on December 18 by upgrading Greece’s sovereign debt rating six notches from selective default to B- after the successful debt buyback in December, citing the “strong determination” of Eurozone governments to keep Greece in the euro.7 The next day the ECB fanned the rally in Greek bond yields sparked by S&P’s decision by saying it will now accept Greek government bonds as collateral, after shunning Athens’ debt since July.
These are token moves, however. There are few signs of a recovery in Greece’s economy that will help reduce its debt load in any meaningful way. It’s more likely that only a default on official loans can ensure that Greece’s debt ratio drops towards a level the IMF regards as sustainable. The fudges by Eurozone politicians in November are conditional, anyway, on Athens sticking with the economic poison of austerity. The concern is that the longer Greece stays in de facto default (the arriving aid money largely goes out as debt payments to stave off default), the greater the risk that massive public unrest brings down Greece’s coalition government and triggers an uncontrolled default and, most likely, a euro exit.
Greece’s social cohesion is collapsing under austerity – the jobless rate is officially 25% – and political stability is far from assured. On November 8, for example, more than 50,000 protesters besieged Greece’s parliament when Greek Prime Minister Antonis Samaras gathered just enough votes to pass the austerity measures needed to win more bailout money from Greece’s creditors. These steps included cuts to wages, benefits and pensions. The demonstration, which was only kept under control by tear gas and water cannons, took place amid a 48-hour general strike that closed hospitals and schools and froze government services including transport.
Another Greek default could be the pivotal moment for the Eurozone crisis (though it’s easy to think of others). A messy Greek default could bring down the Eurozone. Or it could be the trigger that forces Germany and others into the massive fiscal transfers that save the euro.
On past form, if a Greek default is unavoidable, Eurozone policymakers will skirt these extremes by crafting inventive solutions that somehow help the Eurozone stumble further along its decades-long climb to recovery. Part of their resolution will probably entail easing Greece’s austerity vice to allow its economy to recover and to ease public disquiet. They will probably devise a timetable whereby Greece can default in stages on privately and officially held debt if Athens enacts reforms. This is the formula the IMF and World Bank offer to struggling countries under their “Heavily Indebted Poor Countries Initiative,” which is granting “full debt relief” – including on official loans – to 34 mainly African countries.8
While it might be humbling for a Eurozone country to be on a similar program as Burkina Faso and Mali, there’s no excuse if Eurozone policymakers are not ready with some plan that reassures global investors. Greece is broke. A Greek default is almost unavoidable.
Financial information comes from Bloomberg unless stated otherwise.
1 IMF. World Economic Outlook. October 2012. Table A2. Advanced economic: real GDP and total domestic demand. http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/tables.pdf
2 Bloomberg News. “Europe pushed by IMF’s Lagarde to consider Greek debt write-off.” 25 September 2012.
3 Bloomberg News. “Greece may need 2nd write-down after reforms, Weidmann says.” 16 November 2012.
4 Financial Times. “Merkel prepared to consider Greek losses.” 2 December 2012. http://www.ft.com/intl/cms/s/0/59d5db0e-3c85-11e2-a6b2-00144feabdc0.html#axzz2EiVswpJf
5 Financial Times. “Greece edges closer to 44 billion euro bailout.” 19 November 2012. http://www.ft.com/intl/cms/s/0/2f18bf22-326b-11e2-ae2f-00144feabdc0.html#axzz2CtynYINI
6 Institute of International Finance. “Implications of a disorderly Greek default and euro exit.” February 2012.
7 Bloomberg News. “Greek credit rating raised at S&P after debt buyback program.” 18 December 2012.
8 IMF. “Factsheet. Debt relief under the Heavily Indebted Poor Countries (HIPC) Initiative.” 30 September 2012. http://www.imf.org/external/np/exr/facts/hipc.htm