Saturday, May 8, 2010

Default looks inevitable, is Euro-exit next?

The €110bn ($142 bn) EU-IMF joint bailout package for Greece (€80 billion by EU and €30 billion from the IMF) is surely a short pause in Euroland's fight for survival. The markets have clearly signalled that it is far from enough.

With every passing day, the Greek situation becomes ever more desperate. Some form of restructuring and even a default now looks inevitable. The only question is about its timing and the extent of "haircut" the bond holders may have to suffer. Further, as the market confidence about Greece's ability to repay its debts plummets, the million dollar question now is whether Greece will exit the Euro.

In a famous paper, Barry Eichengreen had argued three years back about the near impossibility of dissolution of Euro area or any member leaving it. He based his case on the grounds of economic costs (in anticipation of devaluation, workers would raise wage demands; and debt service burdens will increase), political costs (anatagonizing other members and the certainty of being treated as a second-class member in EU), and most critically procedural costs (reintroduction of the national currency would involve a massive logistics exercise). Further, any move to leave the euro would require time and preparation, and during the transition period there would be devastating bank runs. Households and firms anticipating that domestic deposits would be redenominated into the lira, which would then lose value against the euro, would shift their deposits to other euro-area banks.

However, others like Paul Krugman have argued that these challenges are not insurmountable and an exit from Euro is a real possibility. Krugman points to Argentina's sudden decision in 2001 to abandon its supposedly permanent peso-dollar convertibility peg on the face of a debt crisis that ultimately led to owners of Argentine debt taking a 67% haircut in 2005. He writes,

"The Eichengreen argument is a reason not to plan on leaving the euro — but what if the bank runs and financial crisis happen anyway? In that case the marginal cost of leaving falls dramatically, and in fact the decision may effectively be taken out of policymakers’ hands...

the Greek government cannot announce a policy of leaving the euro — and I’m sure it has no intention of doing that. But at this point it’s all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday — and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling."

In another post, Krugman highlights the enormity of Greece's fiscal mess by pointing to its massive primary deficit (fiscal deficit minus interest payments) of 8.5% for 2009. This effectively means that "even a complete debt default wouldn’t save Greece from the necessity of savage fiscal austerity".

In fact, as Peter Boone and Simon Johnson have shown here and here, the figures are so heavily stacked up against Greece that a default and more is inevitable. The EU-IMF bailout proposes severe fiscal austerity resulting in spending cuts amounting to 11% of GDP in 2010, 4.3% in 2011, and 2% in 2012 and 2013, with the total debt-to-GDP ratio peaking at 149% in 2012-13 before starting a gentle glide path back down to sanity. It assumes that these measures will lower the Greek GDP 4% this year, then by another 2.6% in 2011, before recovering to positive growth in 2012 and beyond. But, going by Daniel Gros's estimate that for each 1 percent of GDP decline in Greek government spending, total demand in the country falls by 2.5 percent of GDP, the spending cuts would devastate the Greek GDP by nearly 30%.

As Boone and Johnson writes, with more realistic figures, such steep GDP declines would only further increase Greece's debt stock (as a share of GDP) and debt servicing burdens. In fact, they argue that assuming the GDP falling by 12% in 2011, resulting in the debt to GDP ratio touching 155%, and 5% real interest rate and no growth, Greece would need a primary surplus at 8% of GDP merely to keep the debt-to-G.D.P. ratio stable.

In the circumstances, it would appear that Greece (and Euroland) has only two options. One, debt restructuring with help of a massive IMF-EU bailout with concessional rate loans to enable Greece to refinance its debt with long term bonds or to extend the maturity of its loan obligations at the same terms. Second, a sovereign default with debt holders taking a substantial haircut. In either case, "savage fiscal austerity" is a sine-qua-non.

And even with any of these, Greece can pull it off only if the economy bounces back quickly enough to generate the required revenue buoyancy and aggregate demand. Given its current economic condition, extremely remote possibility of its European partners offering any assistance beyond debt restructuring support, and the constraints imposed by the Stability Pact and single currency, the prospects for the Greek economy, even in the medium-term, looks bleak. In the circumstances, as Krugman argues, exit from Euro followed by devaluation looms large.

Felix Salmon writes that the choice now is whether to "default and devalue now, or... wait a couple of years". He feels that while Germany and France might want to wait, in the hope that their banks will be better able to cope with such a thing in a couple of years’ time, it may be in Greece's interest to "go through it now and bring forward the growth rebound, rather than push off the devaluation stimulus to an indefinite point in the future".

In a Vox post, Domingo Cavallo, Argentina’s former finance minister, draws four lessons from Argentina’s crisis - devaluation/exit is not the answer; orderly debt restructuring involving a ‘Brady Plan’ now is better than a disorderly one later; fiscal consolidation that improves external competitiveness is a must; and all these must be done simultaneously.

Given the inevitability of default-cum-bailout and long recession for Greece, Barry Eichengreen advocates four measures to contain the crisis - the IMF and the European Commission should encourage Greece to reach a social consensus on restructuring and reform by showing that the creditors will also contribute by way of providing credit enhancements, or guarantees, on the new bonds offered the creditors in the exchange; Portugal and Spain must do more to convince the markets they are not Greece by labor market reforms, spending cuts etc; the Iberians should be given time, so as to prevent them from being infected by the Greek contagion - the ECB will have to support their bond markets and buy their governments’ bonds directly on the secondary market; the Germans need to support European growth by spending and investing more.

Paul Krugman sees three options for Greece - large wage cuts for Greek workers would make Greece competitive enough to add jobs again; ECB could engage in much more expansionary policy, among other things buying lots of government debt, and accepting the resulting inflation, thereby making adjustment in Greece and other troubled euro-zone nations much easier; or fiscally stronger European governments could offer their weaker neighbors enough aid to make the crisis bearable. He argues that given the political difficulty of each of these options, leaving the euro does not unrealistic.

Update 1 (23/5/2010)
Simon Johnson and Peter Boone highlight the unsustainability of Greece's debt crisis. The IMF estimates that by the end of 2011 Greece’s debt will be around 150% of GDP, about 80% of which is foreign-owned (with a large part held by residents of France and Germany). Every 1 percentage point rise in interest rates means Greece needs to send an additional 1.2% of GDP abroad to those bondholders.

In the circumstances, if Greek interest rates rises to 10% (a modest enough premium for a country with the highest external public debt/GDP ratio in the world), it would need to send at total of 12% of GDP abroad per year, once it rolls over the existing stock of debt to these new rates (nearly half of Greek debt will roll over within three years). To put this in perspective, German reparation payments were 2.4% of GDP from 1925 to 1932, and in the years immediately after 1982 the net transfer of resources from Latin America was 3.5% of GDP.

In another article, Johnson and Boone examined the problems faced by Portugal whose challenges are no different from that of Greece. Over the last several years, Portugal's debt rose to 78% of GDP at the end of 2009 (compared with Greece’s 114% of GDP and Argentina’s 62% at default), and the debt has been largely financed by foreigners, and as with Greece, the country has not paid interest outright, but instead refinances its interest payments each year by issuing new debt. By 2012 Portugal’s debt-to-GDP ratio should reach 108% if the country meets its planned budget deficit targets, thereby forcing the markets to sit up and demand ever higher rates.

Like Greece, Ireland and Spain, Portugal too is stuck with a highly overvalued exchange rate and needs far-reaching fiscal adjustments. Just to keep its debt stock constant and pay annual interest on debt at an optimistic 5% interest rate, the country would need to run a primary surplus of 5.4% GDP by 2012. With a planned primary deficit of 5.2% of GDP this year (i.e., a budget surplus, excluding interest payments), it needs roughly 10% of GDP in fiscal tightening. It is nearly impossible to do this in a fixed exchange-rate regime — i.e., the euro zone — without vast unemployment. The government can expect several years of high unemployment and tough politics, even if it is to extract itself from this mess.

Update 1 (25/1/2011)

Excellent article about why Greece has no choice but to impose haircuts on its bond holders.

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