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Greece in troubled waters despite EU aid

By Satyajit Das
April 13, 2010 12:10 IST
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The language was reminiscent of the start of the sub-prime mortgage problems. The problem is "small" and "contained". Despite the "solution" announced by the European Union, the problems of Greece have worsened.

Greek borrowing costs have sharply increased. Greece now must pay around 4 percentage points more per annum for its debt than Germany, the most creditworthy EU borrower, that's if anyone lends to it. This is a rise of over 1 percentage point over the last few days and roughly a doubling of the margin since January.

Greece's immediate problem is one of liquidity - it must find cash to roll over the existing debt. Greece needs around 50 billion euros in 2010, of which around half is needed by June. With characteristic insouciance, Greek officials assured creditors that they were fine till end April 2010! Unfortunately, the Greek problems run far deeper. Beyond 2010, it needs to refinance borrowings of around 7-12 per cent of its GDP (around 16-28 billion euros) 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 per cent which needs financing. Greece's total borrowing, currently around 270 billion euros (113 per cent of GDP), is forecast to increase to 340 billion euros(150 per cent of GDP) by 2014.

The country's problems were inevitable since, like many of the economically weaker EU members, it fudged the numbers to meet the qualifications for entry into the Euro Zone. An example of this is the use of derivative transactions with Goldman Sachs to disguise the level of its real borrowing. Membership of the euro also reduced its ability 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). Besides, it cannot print its own currency to fund sovereign borrowing.

Greece also has low levels of domestic saving and is heavily dependent on international capital flows.

Pouring olive oil on troubled finances

After protracted and acrimonious negotiations, the EU and the International Monetary Fund announced a "bailout" package. In reality, the package was highly conditional and did not address core issues. The 45 billion euros package (up from the original 22 billion euros) falls short of the 50-75 billion euros that Greece needs at a minimum. All the money will be provided at market rates, rather than on concessional terms. The aid requires "unanimous" agreement amongst the EU members. The entire package requires IMF participation, which limits the amount of any bailout package and also makes it conditional on Greece to meet IMF's stringent economic prescriptions. Germany's support was also conditional on enacting changes in the EU framework to tighten control over future bailouts of this type.

The position is exacerbated by Greece's indifferent attitude towards its current problems. For much of this year, the Greek government insisted that it did not need and had not asked for any help.

Beyond saving…

Temporary emergency funding may help meet immediate liquidity needs but it does not solve fundamental problems of excessive debt and a weak economy. Greece must cut government expenditure and raise taxes to reduce its stock of debt. But the suggested austerity measures will put the economy into a severe recession, 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, it cannot address its fundamental lack of competitiveness quickly. The narrow economic base, primarily agriculture, tourism and construction, further limits options.

Greece's level of indebtedness may already be too high. Kenneth Rogoff and Carmen Reinhart in their survey of financial crises titled "This Time It's Different", argue that once the debt of a country goes above 60-90 per cent of GDP, it acts to restrain growth. Greece's high levels of debt mean that interest payment now totals around 5 per cent of GDP and is scheduled to rise to over 8 per cent of GDP. Rising interest costs will only worsen this problem.

High levels of sovereign debt are sustainable where three conditions are met. First, the debt is denominated in the country's own currency. It helps if the currency is also a major reserve currency, an advantage enjoyed by the US dollar. Second, there is a large domestic saving pool to finance the borrowing, such as the one that 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, it will become isolated and enter a period of forced economic and financial decline.

Greek lessons

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 programme of necessary structural reform. Lenders to Greece would take significant writedowns on their debt, reducing its debt burden and giving it a chance to emerge 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 "implicit" EU support, and are now seeking others to bail them out of their folly.

Such default would not affect the euro. Many countries have defaulted on their US dollar obligation without any effect on the currency. 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 global financial crisis. 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. The problems of contagion in highly inter-connected economic and financial systems have not abated.

As at June 2009, Greece owed $276 billion to international banks, of which around $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, thus 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 global 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, which also includes Germany), further straining their finances. The bailout would merely transfer the problem from the "weak" economies to the "stronger" European countries. What an irony, the EU attempts to ensure "financial stability"; the bailout increases the risk of longer-term "financial instability".

Iceland's problems brought forth creative headline - "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 is coming soon to a location near you in the new phase of the global financial crisis.

Satyajit Das is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives 

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