By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
The language is reminiscent of the start of the sub-prime mortgage problems. The problem is “small” and “contained”. Despite the “solution” announced by the European Union (“EU”), the problems of Greece have deepened.
Greek borrowing costs have increased sharply. Greece now must pay around 4.00 % p.a. more for their debt than Germany, the most creditworthy EU borrower. That is, if anyone will lend to them. This is a rise of over 1.00% p.a. over the last few days and roughly a doubling of the margin since January 2010.
Recent Greek debt issues are now deep under water. The most recent attempt by Greece to raise money was substantially under subscribed, proving almost as popular as Ebola fever and. This combined with the day-to-day volatility of the risk margin for Greece makes it difficult for traders to price and investors to commit to purchases of Greek securities.
Greek banks are now experiencing difficulties in funding in international markets and have been forced to seek government support.
Greece’s immediate problem is one of liquidity – it must find cash to roll over existing debt. Greece needs around Euro 50 billion in 2010, of which around Euro 25 billion is needed by June. With characteristic insouciance, Greek officials have assured creditors that they are fine till end April 2010!
Unfortunately, the Greek problems run far deeper. Beyond 2010, Greece needs to re-finance borrowings of around 7%-12% of its Gross Domestic Product (“GDP”) (around Euro 16 billion to Euro 28 billion) each year till 2014. There are significant maturing borrowings in 2011 and 2012. In addition, Greece is currently running a budget deficit of over 12% that must be financed. Greece total borrowing, currently around Euro 270 billion (113% of GDP), is forecast to increase to around Euro 340 billion (over 150% of GDP) by 2014.
Greece’s problems were inevitable. Like many of the economically weaker EU members, Greece fudged the numbers to meet the qualifications for entry into the Euro. One example of this is the use of derivative transactions with Goldman Sachs to disguise the level of its real borrowing.
Membership of the Euro resulted in Greece losing its costs competitiveness. The sharply lower Euro interest rates set off credit driven a real estate boom and chronic over-borrowing.
Membership of the Euro also reduced the ability of Greece to manage its economy. It lost the ability to use its currency, via devaluations, to improve competitiveness and stimulate exports. It also lost the ability to set interest rates (now set by the European Central Bank (“ECB”)). It also cannot print its own currency to fund sovereign borrowing.
Greece also has low levels of domestic saving and is heavily reliance on international capital flows.
The current episode exposed an underlying weak and unbalanced economy with few sustainable competitive advantages. It has also exposed poor political leadership and inadequate financial controls.
Stephen Jen, a former economist at the International Monetary Fund, told the New York Times on 8 April 2010, that: “This is no longer about liquidity; it’s a solvency issue.” The language was eerily similar to statements earlier in the global financial crisis (“GFC”).
Pouring Olive Oil on Troubled Finances…
In March 2010, after protracted and acrimonious negotiations, the EU and International Monetary Fund (“IMF”) announced a “bailout” package. The flowery rhetoric of “familial” duty and EU “unity” was taken at face value by gullible investors who assumed that the problem was “fixed”. In reality, despite changes announced in April, the package is highly conditional and does not address core issues.
The now Euro 40-45 billion package (up from the original Euro 22 billion) proposed may still fall short of the Euro 50-75 billion that Greece needs at a minimum to get through the immediate future.
The package requires that Greece must exhaust commercial debt market sources prior to accessing the package. The aid requires “unanimous” agreement amongst the EU members. All money will be provided at market rates, rather than on concessionary terms (although under new proposals full market rates will not be used). The entire package requires IMF participation, which limits the amount of any bailout package and also makes it conditional on Greece meeting the Fund’s stringent economic prescriptions. Germany’s original support was also conditional on enacting changes in the EU framework to tighten control over future bailouts of this type.
The poor design of the “bailout” package is evident in the fact that it assumes that the announcement will cause Greek risk margins to fall to the level prescribed under the “bailout” funding. If it does not and remains above the 3.00% p.a. agreed, then Greece will have no incentive to fund in capital markets and will need to access the package.
The position is exacerbated by Greek’s indifferent attitude to its current problems. For much of this year, the Greek government insisted that it did not need and had not asked for any help. Lack of transparency about the level of debt, actions taken to deliberately disguise borrowings and generally poor information about public finances has presented an increasingly unfavourable image to foreign investors and international agencies. Greece appears unwilling or unable to meet the draconian conditions prescribed.
Greek fund raising has bordered on the farcical. Earlier in the year, Greek officials hinted at Chinese purchases of Greek debt, which was promptly denied by the putative investors. Most recently, seeing its problems as one of marketing and branding, Greece proposed to re-position itself as an “emerging country” borrower, rather than an advanced EU member. As one wag pointed out, “submerging country” would be closer to the reality.
Earlier in the year, the Deputy Prime Minister of Greece blamed Germany for it troubles: “They took away the gold that was in the Bank of Greece, and they never gave it back. They shouldn’t complain so much about stealing and not being very specific about economic dealings…” The Greek version of “How to win friends and influence people” did little to endear them to potential saviours or investors.
Greece’s problems are probably incapable of solution and terminal. Temporary emergency funding may help meet immediate liquidity needs but do not solve fundamental problems of excessive debt and a weak economy.
Orthodox economic theory suggests that the Greeks must cut government expenditure and raise taxes to reduce its stock of debt. But the government is too large a part of the economy and the suggested austerity measures will put the economy into a severe recession. In turn, this will drain tax revenues making it difficult to reduce the budget deficit.
Greece has limited opportunity to grow or inflate itself out of the problem. Without the ability to devalue the currency, Greece cannot address its fundamental lack of competitiveness quickly. The narrow economic base, primarily agriculture, tourism and construction, further limits options.
Greek’s level of indebtedness may already be too high. Kenneth Rogoff and Carmen Reinhart in their survey of financial crises “This Time It’s Different” argue that once the debt of a country goes above 60-90% of GDP, it acts to restrain growth. Greece’s high levels of debt mean that interest payment now total around 5% of GDP and are scheduled to rise over 8% by GDP. Rising interest costs will only worsen this problem.
High levels of sovereign debt are sustainable where three conditions are met. Firstly, the debt is denominated in its own currency. It is helpful if the currency is also a major reserve currency, an advantage enjoyed by the U.S. dollar. Secondly, there is a large domestic saving pool to finance the borrowing, such as exists in Japan. Finally, the country possesses a sound and sustainable economic and industrial base. Greece does not meet any of the above criteria.
There are no more easy solutions to Greece’s problems. Deep spending cuts, higher taxes and structural reforms will curtail growth. If Greece is unable to finance its debt or elects to default and exit the euro, then Greece will become isolated and enter a period of forced economic and financial decline.
The likely social and political consequences are extremely severe. They point to the real issue – Greeks have lived unsustainably beyond their means and now must face a sharp reduction in living standards.
Ironically, the optimal course of action for Greece may be to withdraw from the Euro, default on its debt (by re-denominating it in a re-introduced Drachma) and then undertake a program of necessary structural reform.
Lenders to Greece would take significant writedowns on their debt, reducing its debt burden and give it a chance from emerging as a sustainable economy. The current debate misses the fact that the “bailouts” are mainly about rescuing foreign investors. These investors were imprudent in their willingness to lend excessively to Greece assuming EU “implicit” support and are now seeking others to bail out them out of their folly. As Herbert Spencer, the English philosopher, observed: “the ultimate result of shielding men from the effects of folly is to fill the world with fools”.
Such default would not affect the Euro. Many countries have defaulted on their U.S. dollar obligation without any effect on the currency.
Much depends on the politics of the EU and the attitude of Chancellor Angela Merkel and succesors who is more Deutschland centric than her predecessors. Support for Greece may depend on her judgement of ordinary Germans’ willingness to aid its Club Med neighbour and the risk of future claims on the German taxpayer.
The chance of a clean and logical solution is minimal as the EU may mistakenly try to defer the inevitable. Greece may face a future of a “rolling crises” and stopgap measures, much like Argentina from 1999 until its eventual default in 2002.
Greece highlights a few new and old truths about the GFC. The level of global debt has not been addressed. Sovereign debt was substituted for private sector debt. As trillions of dollars of private and government debt matures and must be refinanced, the next stage of the process of de-leveraging will play out. Vulnerable borrowers, such as Greece and earlier Dubai, highlight this risk.
The problems of contagion in highly inter-connected economic and financial systems have not abated.
As at June 2009, Greece owed US$276 billion to international banks, of which around US$254 billion was owed to European banks with French, Swiss and German banks having significant exposures. What happens in Greece is unlikely to stay in Greece creating new problems for the fragile global banking.
Greece’s problems have also drawn attention to the looming financing problems of other sovereigns. In a world with significant reduced liquidity, the strain of funding these requirements is likely to restrain growth prospects.
The EU bailout of Greece would require the participation of Spain, Portugal and Ireland (the other three members of the debt laden “PIGS”) further straining their weak finances.
The bailout would also merely transfer the problem from the “weak” economies to the “stronger” European countries. In a nice irony, the EU attempts to ensure “financial stability” through the bailout increases the risk of longer-term “financial instability”.
The Greek bailout also has interesting parallels to the shotgun marriage of Bear Stearns before the precipitous collapse of Lehman Brothers.
Iceland’s problems brought forth creative headlines – “Iceland Erupts”, “Iceland Melts” and “Geyser Crisis”. The common refrain this time has been about the “Greek Tragedy”. The term describes a specific form of drama based on human suffering, rather than anything Athenian. But it seems this Greek tragedy may be coming soon to a location near you in the new phase of the GFC.