The Greek financial crisis: growing imbalances and sovereign spreads. Heather D. Gibson, Stephan G. Hall and George S. Tavlas

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1 The Greek financial crisis: growing imbalances and sovereign spreads Heaher D. Gibson, Sephan G. Hall and George S. Tavlas

2 The enry The enry of Greece ino he Eurozone in 2001 produced a dividend in he form of a sharp drop in ineres raes. The Greek crises saring in 2009 has reversed his gain. We consider o wha exen hese swings are due o fundamenals and how much is due o speculaion.

3 We invesigae he deerminaion of he spread beween Greek and German 10-year governmen bond yields We adop a single counry analysis using boh raeing daa and fundamenal analysis.

4 Plan of he paper 1 we ouline he developmen of he crises 2 we invesigae he exen which risk agencies raing can explain hings 3 we invesigae he way news abou he Greek siuaion can explain hings 4 we draw some conclusions

5 2. The Greek financial Crises: Origins Growing Imbalances /9 Benefis of joining in 2001 Lower inflaion and ineres raes No exchange rae flucuaions lower risk premia Encourages longer planning and invesmen

6

7 Alhough growh was high ( average 3.9%) wo main problems emerged Large fiscal Deficis Persisenly higher inflaion han he Eurozone average

8

9

10

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12 Secion 2b The wake up call The global financial crises began in augus 2007 Collapse of Bear Searns March 2008 Collapse of Lehman Brohers sep 2008 This had lile direc effec on Greece, he Greek banking secor had no aken par in he sub-prime markes. Spreads rose a lile bu no o a significan exen.

13 Bu wo shocks Ocober 2009, new Greek Governmen announced fiscal defici would be 12.7% of GDP. (more han double previous predicions) November 2009 Dubai world (owned by he Gulf Emiraes) asked for a 6 monh deb moraorium. This caused a sharp increase in invesor risk aversion. Financial markes began scruinising Greece

14 These wo shocks lead o a subsanial and unprecedened rise in Greek spreads as shown earlier Suddenly membership of he Eurozone did no seem o be an absolue guaranee. Spreads coninued o rise despie May 2010 suppor from IMF and EU Commimen o lower he fiscal defici ECB purchasing Greek bonds

15 Two applicable crises models 1 s generaion Governmen missbehaves 2 nd generaion Markes speculae agains a counry Are here ellemens of boh of hese in he Greek case?

16 3 Spreads and he Risk Premium The ECB Financial inegraion in Europe (April 2011) proposed a simple model of he risk premium. We exend his here for Greece. We may hink of he spread as R gr = R ge + ρ + ε

17 Now we decompose he risk premium ino wo pars R gr = 2 ) 1 Where ρ may be jusified on he basis of marke informaion 2 And represen irraional marke speculaion ρ ge 1 (1 + ρ R + ρ + ε

18 Now in erms of raional informaion, in his secion we focus on he informaion provided by he raing agencies and he gradual downgrading of he qualiy of Greek deb

19 Hence we may resae he relaionship as R gr 2 ge = (1 + ρ ) R + D1 + D2 + D3 + D4 + ε In he ECB sudy his model was esimaed in firs differences and by recursive OLS We argue ha boh of hese choices are wrong.

20 Hence we esimae he following model using he Kalman Filer R gr ge = β R + α D + α D2 + α D3 + α D4 + ε Where he sae equaion is β = β 1 + ϖ ω ~ N(0, e γ )

21 ) α α α α γ

22 The unexplained risk premia

23 So his would sugges ha a large par of he oal spread can no be aribued o he downgrading of Greek deb bu ha insead here is a large degree of speculaion going on. Bu of course here was a lo of oher hings going on, so we now urn o a more fundamenal explanaion

24 5 A fundamenal Approach Here we use coinegraion echniques o invesigae he link beween economic fundamenals and he equilibrium spread. Daa sample Jan 2000 o Sep We focus on he main macro fundamenals which are widely regarded as deermining he spread. In addiion we use a new news variable

25 The News variable We look a revisions o he European Commissions spring and auumn forecass for he Greek fiscal deb. These revisions reflec news in he marke We hen cumulae hese revisions over ime

26 Fiscal defici revisions (% of GDP

27 Cumulaed News

28 Oher variables considered Acual deb o GDP raio Acual defici o GDP raio Trade and curren accoun o GDP raio Relaive Greek o German prices The rae of growh of he economy (BoG indicaor) Oil prices We iniially esimae a coinegraed VAR reaing all variables as endogenous excep oil prices.

29 We are ineresed in idenifying he srucural relaionship so we mus consider formal idenificaion We begin by esimaing a sandard VAR(3) (resuls in he paper) = Δ = Δ ' p j s s A j A ε δ β α 1 j z z z = Γ Δ = Δ p j j A A A ε δ β α 1 j z z z

30 Tess of coinegraion

31 The idenified coinegraing vecor

32 The impulse responses of he full coinegraed VAR are generally reasonable

33 Bu our main ineres is in he deviaions beween he equilibrium spread and he acual

34 There is a period in he middle period where spreads were below he equilibrium, caused by he Euro repuaion effec A very significan overshoo a he end however. Suggesing again ha fundamenals can no explain a large par of he spread and again suggesing ha

35 Conclusion Enry ino he Euro provided Greece wih a number of benefis The Crises and news abou he Greek fiscal posiion has removed his benefi Bu our resuls sugges ha markes have over reaced o he Greek siuaion

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