The Greek default

Much of discussion happens these days about sorting out Europe’s problems: a sovereign debt crisis, a banking sector still not fully recovered from the financial crisis, and a currency crisis. The debt crisis focuses on Greece. The fears concerning banks relate to their exposure to government bonds as from countries like Greece, Portugal, Italy, and Spain and a degree of undercapitalisation. The currency crisis is all about the future of the Euro. When peripheral countries in a debt crisis are being forced out of the Eurozone, then the latter tends to become smaller and arguably Europe ends up in a messy situation.

Is Greece defaulting? Unless core European countries and IMF inject more funds or provide guarantees, Greece will restructure its debt, which by some measures is called default. The Greek government has accumulated too much debt and thus is close to insolvency. To service existing debt or roll over debt, they need new debt, which because of bad borrower status comes with huge interest rates. In parallel, because of austerity measures, recession and systemic issues like a broken tax collection system, the government’s main revenue stream from taxes isn’t boosted as one would like.

Slightly simplified the dynamics are as with a private individual’s bankruptcy: too much debt, not sufficient income to service the debt, loss of credit rating, more debt required to service existing debt, however at higher interest rates, erosion of equity, inability to service debt -> flat on the nose with default. The cycle can be broken if a friendly party stands in to provide a helping hand in form of a credit guarantee. If someone with good standing offered a guarantee for Greek debt (say some collateral), then financial markets would have second thoughts and reduce the interest rates demanded from Greece.

In the last months, experts discussed how to come up with a credit guarantee for Greece. Idea: All the Eurozone countries club together, pretend ‘acting as a single state/government’ and jointly issue bonds (Eurobonds) to the market, bonds they guarantee with the economic power of all states together. That sounds good as the Eurozone countries as a whole are unlikely to go bust if considered as a single entity. As soon as such bonds are issued, some of the raised money can be funnelled to Greece.

Good idea but little traction. Experts say that a precondition for Eurobonds is a fiscal union in the EU, which is e.g. from a German government point of view pretty unthinkable. Just on Friday 23 Sept, Berlin reiterated their ‘no’ to Eurobonds. Variations of the theme popped up last week, like the Euro countries with still top AAA credit rating to issue joint bonds (at low interest rates), and then funnelling some cash to Greece (Viviane Reding, Vice-President of the European Commission). Commentators, experts and politicians from outside the Eurozone give politicians inside the zone six remaining weeks to solve the problem. Not enough in my view.
Financial markets view? Insurance costs against government default are correlated with the likelihood of default. Insurance costs measured by Credit Default Swaps indicate a high probability of default. On 15 Sept, 5 year CDS spreads for Greece were about 32 times higher than for France, thus financial markets have already anticipated a default. The question is to which extent they have anticipated the mess following the default.

So then, when is Greece defaulting? The hope has been not too early. There are two clocks ticking in competition. One is an alarm clock which ticks down every day closer to the Greek default. The other one ticks down to zero upon which time the European banking sector can be declared sufficiently recapitalised to withstand the losses from a government going bust. The second process clearly needs some time.  The laxer the rules were for the European bank stress tests, the more truly undercapitalised some banks are still today and the more months it requires for them to get into a safe harbour before a government default wave hits the harbour walls.

Are the banks safe? Worthwhile to watch the rating agencies. Condemned by having been complacent during the subprime mortgage crisis, they seem to act faster and bolder these days (mind, the American rating agencies dared downgrading their own home country, the USA, which is remarkable). Moody’s has downgraded two Greek banks last week to B3 and some other banks to Caa2, all below investment grade. If not safe enough for smart investors, then safe enough for retail depositors and mums and dads? Is it just a matter of time until a bank run is reported from Athens on YouTube and Facebook?

The wider problem is of course contagion. It’s less like ‘One kid has a cough and soon the other kids in the family start coughing as well’. It’s more like ‘One family kid as got measles; its friends stay away from him but equally then stay away from the kid’s brothers and sisters as they might have captured the measles from their sibling. This is ‘prophylactic staying away’. That’s the kind of bond market reaction vis-à-vis Spain and Italy post a Greek default. Staying away from government bond auctions and thus driving yields up through the Spanish and Italian roofs.  Admirable how some governments like in the UK try to walk a tight rope: sticking to plans for austerity measures and debt reduction thereby staying free from measles (and not suffering a downgrading in credit rating), and thereby appeasing the bond markets whilst unavoidably risking a dent in economic recovery. We do hope the acrobatic manoeuvre succeeds.

So, are these kinds of trouble new to the world? Seems not new to the world, but new to some generation(s) of people. Here some numbers from a famous paper of Carmen Reinhart and Kenneth Rogoff [1]. From their tally of default and restructuring from a country’s year of independence to 2006:
For countries who are supposed to bail out the Eurozone periphery:

  • Austria: default and/or restructuring: 7 times
  • Germany: 8 times
  • Netherlands: once (seems great; good treasury).

And the candidates for default, or for attracting ‘financial measles’:

  • Greece:  5 times (so then, we have been there before)
  • Portugal: 6 times (on the heels of Greece so to speak)
  • Spain: 13 times (this sounds like a Western European record, doesn’t it?)
  • Italy: once (came as a surprise to me. Might need new spectacle wipes)

More worrying is a statistic which measures the share of years a country has spent in default or restructuring in above time period: According to [1], Angola in Africa spent 59.4 % of the time in default or restructuring since 1975 and Greece 50.6% of the time, compared to e.g. Spain with 23.7% of the time. Think about being more than half of your time in a state of default or bankruptcy? In case of Greece, how did a country with such great and rich history and contribution to democracy but equally with such bad financial track record make it into the Eurozone in the first place, one might wonder.

The mentioned paper raises the question ‘how a country might “graduate” from a history of serial default’ over time. Greece and Spain are mentioned as two countries which over time have improved their track record and grown out of national debt teething problems. The paper mentions as possible reasons reforming of institutions and benefiting from the anchor of the European Union. From today’s perspective one may comment: First, reforming of local institutions (like e.g. the Greek tax collection system) seems more pressing than ever before and not a finished job yet. Second, for Eurozone peripheral countries like the PIGS (Portugal, Italy, Greece, Spain; don’t interpret the financial markets’ abbreviation wrongly) the European Union as an anchor, specifically the common currency aspect of it, turns out to be a doubled-edged sword: It has delivered various benefits whilst it has handcuffed those countries in a state of Eurozone economic imbalance (core versus peripheral countries) with for instance no local currency adjustment (like a devaluation) possible.

So then, sovereign defaults are not new. Maybe such defaults are a bit new – in a world of highly interconnected and highly complex financial markets, of a shaky banking system, of lenders of last resort soon pointing to empty pockets as they just bailed out our good banks, in a world of already low interest rates. Let’s see. In the end, there is no ‘real’ default, if the Eurozone and the IMF produce some magic in time. What are the odds?

[1] Carmen M. Reinhart, Kenneth S. Rogoff. This time is different: A panoramic view of eight centuries of financial crises. April 2008. University of Maryland, Harvard University.