Worst of all worlds - the Greek tragedy?

I have already blogged here, here and here about the woes facing Greece, staggering as it is under the burden of a public debt that stands at 113% of GDP and fiscal deficit at 12% of GDP. The rigid conditionalities of the EMU Stability Pact coupled with the inflexibility of a single currency means that Greece cannot deploy any of the conventional instruments to fight recessions - running up deficits, lowering interest rates, and currency devaluations, and unconventional monetary expansions.

Adding to the constraints imposed by the Stability Pact, Greece is also facing the possibility of a much costlier bailout by its European partners than similar help by the IMF. Worried at the prospect of moral hazard effect of any generous Greek bailout on the other struggling peripheral nations of EMU, Germany is insistent on imposing severe terms on Greece in return for any bailout.

While the IMF is likely to lend to Greece at the rate of about 4% or so, which is consistent with the terms offered by the fund to other indebted countries, the Germans are looking at closer to the prevailing market rates in the range of 7%. With every passing day, Greek government bond yields are climbing as the market confidence gets shattered and a sovereign debt-default looms large.

Further, the deep recession and the dramatic erosion in the competitiveness of the Greek economy (manifested in the high GDP deflators) means that any prospects of a return to normalcy in economic growth looks remote. In fact, in view of the increased debt service burdens, the Greek economy will have to grow at a rapid clip just to ensure that public debt as a percentage of GDP does not go up.

As Paul Krugman points out, the Greek situation is much worse than that of many other countries in history (like the US after the War-II) who despite having much higher debt burdens, managed to overcome their debt crisis with relative ease. They had the benefit of benign economic conditions that sustained fast economic growth rates that brought down the public debt as a percentage of the GDP even though the absolute debt stock increased. In case of Greece though, with economic growth likely to remain at best subdued, further increase in public debt share of GDP looks imminent. In anticipation of this, the ratings agencies have already taken the country to the brink, with a downgrade of Greek bonds to junk status looking certain.

Any lowering of the relative debt burden by growing at a much faster pace than the increase in debt servicing would require the service of both the growth rate and the resultant higher inflation (which would erode the relative value of debts). However, the high Greek GDP deflators, manifested in its much higher costs and prices, means that Greek prices have to decline considerably to converge with the rest of Europe. This deflation (or subdued inflation) will only amplify the relative debt burden. And this deflation will invariably take its toll on economic growth too.

Any attempt to fiscally contract its way out of the debt crisis will rebound badly. Slashing expenditure at such times will damage aggregate demand and push the economy further down the abyss. Tax increases too will have much the same impact.

In the circumstances, a "generous" bailout is not only required, but is the only alternative to a much more damaging sovereign debt-default (with its attendant adverse impact on the credibility of Euro and Euroland). Whatever the permutations, the Greek economy is so weak that without the life-support from its European partners or the IMF (who administered the same to non-EMU East European countries like Hungary and Latvia), it cannot overcome this crisis.

For all talk of "contagion effect" of any Greek bailout on the other weaker economies, the sheer folly of the German brinkmanship in not coming to the rescue of Greece cannot be overstated. Some form of bailout of Greece is now inevitable. In view of the delay and the continuous run on Greek assets by market speculators (that have driven up yields by more than double), any the cost of any bailout, to both Greece and European nations, is much larger than would have been the case with a quick bailout.

Greece will suffer by way of the expensive cost of raising capital, which will only add to the debt burdens and drag down the pace of recovery and thereby widen the deficits. The European economies will now have to shell out a much larger sum to bailout Greece. Further, the largest losers in case of a Greek default will be German and French banks who have the largest exposure (over 100 bn euros) to Greek debt.

Update 1 (11/4/2010)
The 16 nations that use the euro offered to loan Greece up to €30 billion ($40 bn) at rates far below what the debt-laden country is paying now for raising debt from the markets. The interest rate charged on the European contribution would be around 5% for a three-year loan — slightly more than the amount charged by the International Monetary Fund (at about 4%). The IMF too are expected to announce their share of loans.

Update 2 (18/4/2010)
Nouriel Roubini feels that Greece cannot avoid default without a miracle. Its present public debt, current account and budget deficits at 120%, 10% and 12.9% respectively are so large that a sovereign default looks inevitable without massive and sustained external support. The anemic economy, high wage costs and resultant loss of competitiveness, and the constraints imposed by the Stability Pact only add to the problems.

He feels that the magic trifecta of sustainable debt and deficit ratios, a real depreciation, and restoration of growth looks unlikely to be achievable even with official financial support. He points to two pre-requisites for successful rescues of countries - credible willingness to impose the fiscal austerity and structural reforms needed to restore sustainability and growth; and massive amounts of front-loaded official support to avoid a self-fulfilling rollover crisis of maturing public and/or private short-term debts.

He argues that restoring sustained economic growth requires sustained real depreciation, and all the three ways to achieve it look difficult - deflation that reduces prices and wages by 20-30% (is associated with persistent recession and no country’s society and political system can accept years of recession and fiscal austerity to achieve real depreciation); accelerating structural reforms and corporate restructuring to increase productivity growth while keeping wage growth moderate (but it will take a long time to achieve, before which default will take place and the short-run costs would be unaffordable); euro could fall sharply in value (but in order for the euro to fall far enough, the risk of default in Greece would need to be so large, and the contagion to sovereign spreads of PIIGS so severe that the widening of those spreads would cause a double-dip eurozone recession before currency depreciation could yield benefits).

Update 3 (26/4/2010)
Robert Kaplan has this history and geography based explanation of Greece's problems. Philomila Tsoukala traces the country's problems to its closed, family-driven business (75% of Greek businesses are family-owned) culture with its stultifying influence on the economy.

Jack Ewing feels that a restructuring of Greek debt (a polite way of saying Greece is defaulting) may not be off the table. This is all the more so since the latest stats show that total government debt was €273 billion, or $365 billion, at the end of 2009, or 115% of GDP, and interest alone could come to €97 billion over the next five years. Fiscal deficit was 13.6% of the GDP. There is no way Greece can manage that burden without far more massive aid than the €30 billion that other European Union members have pledged and the €15 billion sought from the IMF.

However, instead of an Argentina style haircut (owners of Argentine debt took a 67% haircut in 2005) on debt/bond holders, a spacing out of debt repayments looks more probable. One proposal is to convert all Greek bonds due until 2019 into a pool that would be refinanced with 25-year bonds. Assuming a 4.5% interest rate, this plan would cut Greek financing requirements by some 60%, or €140 billion. Another proposal is to simply extend the maturity of existing notes by five years, at the same interest rate. In other words, a 5-year bond paying 6% annual interest would become a 10-year bond, still paying 6% interest.

Such a restructuring will also benefit the European banks who are heavily exposed to Greek bonds. According to the BIS, including the private sector, Greek debt to France is €75 billion, to Swiss banks is €64 billion and to German institutions is €43 billion, and even if only a third of the credit is owed by the government, the sums are still ominous. But there is no public information on which banks or investors hold the debt or how much. Nor does anyone know how many of the bonds sit on bank balance sheets, or in mutual funds — in which case private investors would suffer.

The biggest challenge for Greece and its E.U. partners would be to fashion a restructuring plan that would maintain the credibility of the euro, while avoiding a financial panic that could spread to other overindebted countries like Spain and Portugal. The other challenge would be to get bondholders on board. To get them to trade in their bonds for longer-term debt, Greece and its backers would need to convince creditors that restructuring offered them the best chance to get their money back.

Update 4 (28/4/2010)
Paul Krugman has a series of graphics capturing the widening spreads of Greek, Italian, Poruguese, and Spanish debts.

Update 5 (30/4/2010)
Paul Krugman analyses the underlying reasons for the Euroland crisis, not debts but rising prices and wages (faster than remaining Europe) which were sustained by large inflows of foreign capital (due to the belief that membership in Euro zone made Greek, Protugese and Spanish debt safe) over the past decade.

Update 6 (9/5/2010)
David Beckworth has an excellent graphic that captures the erosion of export competitiveness of Euro members since 1999.