Greece s Debt Crisis

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1 September 27, 2011 Greece s Debt Crisis Creating the Crisis From 2000 to 2007, Greece s economy grew at an annual rate of 4.2% as foreign capital flooded the country. A strong economy and falling bond yields allowed the government of Greece to run large structural deficits. Successive Greek governments have customarily run large deficits to finance public sector jobs, pensions, and other social benefits. In truth, it is not a recent problem; Greece has a long history of fiscal trouble. It has spent half of the past two centuries in default. Since 1993, debt to GDP has remained above 100%. Creditors, however, continued to finance Greek debt due to EU membership and euro zone (EZ) candidacy. Entry into the EZ was supposed to include harmonization of fiscal policies and debt burdens, so all member-states were treated as comparable credits risks. However, while monetary policy was harmonized, fiscal policy remained independent; and risk, while ignored by the markets, was increasing. Comparable treatment of EZ sovereign debt fomented a decade of over-lending by creditor banks. The problems came home to roost only as Greece revealed extreme debt/deficit figures in the aftermath of the Global Crash in late For years, Greece had misreported the country's official economic statistics to keep within the monetary union guidelines and to enable it to continue spending while hiding the actual deficit from the EU. Greece eventually lost market access as creditor states made their discontent clear. It was suddenly apparent that not only were EZ members un-converged, but that they might have to face hard times without full EZ support. Other countries with divergent fiscal policies also came to light, including Portugal, Spain, Ireland, and Italy.

2 Quantifying the Crisis The Greek sovereign debt was 328 billion at the end of It now stands at 370 billion. Of this total, 21 billion is due in March 2012 and another 8 billion is due in May. EU partners and the IMF have loaned Greece 160 billion, so the remaining/uncovered Greek sovereign debt is about 210 billion. Since Greek GNP was 230 billion in 2010, Greek sovereign debt was 143% of GNP at the end of 2010 and should reach 150% of GNP by Despite austerity measures to cut public sector expenses, the debt levels continue to increase for two reasons: first, the Greek government had a budget deficit of 10% in 2010 which increased the debt. Second, the severe recession in Greece reduced the GNP and therefore increased Greek sovereign debt as a percentage of GNP. Even if Greece succeeds fully in cutting its public sector deficit and instead begins to have public-sector surpluses, debt reaching 150% of GNP cannot be fully financed from the surplus, even at a relatively low interest rate of 5%. This will then result in a further increase of the accumulated debt. This is unsustainable. As of this writing, the interest rate of 2-year Greek debt is 25%. While Greek debt is unsustainable at 5% interest, it is a death sentence for Greece at a 25% interest rate. Despite this, Greece must convince the markets to lend it another 21 billion by March 20 th in order to stave off default. Resolving the Crisis While the number of possibilities is endless, at this time we see a high probability of resolution following the path outlined below. First, EZ members, the IMF, and the European Central Bank will continue financing the maturing debt. Last year, as the credit markets for Greece dried up, the so-called Troika the European Commission, the International Monetary Fund, and the European Central Bank reached

3 an agreement with Greek authorities on a belt-tightening plan for the economy. In exchange, the EU and IMF loaned Greece 110 billion to pay down maturing debt and meet their current obligations. It assumed the austerity measures would enable Greece to run a surplus budget by If so, Athens could then resume borrowing commercially early next year. However, with austerity measures reducing economic output, combined with substandard tax collection, the deficit continues to rise and commercial borrowing now appears inconceivable. As a result, the Troika is currently attempting to pull together enough money to enable Greece to meet its 2012 obligations. The chances that Greece will get an additional loan from the EU and the IMF in 2012 are decreasing. Subsequent to Greece s bailout, Ireland and Portugal received similar loans. In various EU countries there are significant political reactions opposing these programs. Governments are pushing for more public participation, but the banks are loath to be on the hook for any more than they currently have. By loaning Greece enough money to cover its 2012 obligations, it is assumed that Greece will run a surplus budget soon and be able to tap the public markets again for financing. While we do not believe this will solve Greece s long-term debt problems, we feel it has the highest likelihood of passing; maybe not meeting all 2012 obligations, but at least getting Greece financed until March By once again creating a loan program and hoping for future credit market access, the Governments avoid making the tough decisions and push the inevitable to a later date. This is the most politically expedient choice. There is also a practical reason to continue to kick the can down the road. It would allow the creditor banks at risk, mainly in France and Germany, time to raise capital to ensure their balance sheets remain stable should Greece default. It also enables Greece and its creditors to discuss an orderly debt restructuring which could soothe the markets. The latest news out of Europe seems to confirm our thoughts.

4 Because we believe financing does little to correct Greece s problems, we feel the next stage will include a voluntary debt restructuring. This means that Greece asks private creditors to voluntarily exchange their present Greek bonds with new bonds to be issued by Greece. While there are a number of possibilities, the best restructuring would require these elements: (a) Greece needs a guarantee from the ESM of the principal of its new bonds to get interest rates of 5% or less. This will be similar to the Brady bonds, issued by many Latin American countries (and others), that used US Treasury bonds as collateral. (b) The new debt issued will have longer maturities to make it more manageable. Greek debt now comes due in a large part very quickly: 19 billion in the second part of this year, 33.5 billion in 2012, 29 billion in 2013, and 32 billion in That is 114 billion (more than a third of the total debt) in two-and-a-half years. (c) In exchanging its debt, Greece reduces its obligations by 30% or more. Greek bonds, as of this date were trading at 30-40% below their par value. When the new bonds are exchanged for old bonds, the exchange should happen at market prices. This means that the old debt should be exchanged at prices approximately 50% of face value; that is, with a haircut (loss to the holders of the old debt) of 50%. (d) Restructuring should happen while Greece still has coverage of its loan obligations from the 110 billion EU and IMF loan. This means it should be done during the next four to six months. Bondholders should accept this type of restructure to avoid further loss of value. The reduction of the total Greek debt and elongation of its maturity increases the probability that in the future there will be no further haircuts. The incentive to the current owners of Greek sovereign debt to participate in the exchange is that the new bonds will have the guarantee (at least for their face value) of the ESM. The Brady method (here adapted to the ESM guarantee) used in 18 countries was very well received, and the new bonds issued appreciated over time. A voluntary restructuring does not mean bankruptcy. Greek banks, which have about a 40 billion exposure to Greek bonds, will have problems after a restructuring. Most of the Greek bonds are held by banks in their capital account at face value, not at the present market

5 value that reflects the haircuts. At restructuring, Greek banks will have to write down Greek bonds to market value (at which Greece will buy them to be exchanged). This would realize a loss of about 12 billion to Greek banks if the haircut is 30%. This loss has already occurred, but its accounting realization will happen at the restructuring. Greek banks have a present capitalization of about 15 billion in total. They need to recapitalize or get a significant injection of convertible bonds from the Greek government, just as Citibank received from the US government in Most other European banks should not have major problems after a restructuring. Most banks have relatively small exposure to Greek debt. A 20-60% haircut would mean a capital hit of 13-41bn, which represents only 1%-3% of total Tier 1 capital. Some banks, particularly in France and Germany, have larger exposure and may need recapitalization. As the largest creditor, the European Central Bank would bear the brunt of any haircut and is opposed to any restructuring at this time. Restructuring does not solve the problem of the Greek public sector deficit. More sacrifices, including lowering expenses and increasing revenue, will be needed for Greece to create a public sector surplus; however, restructuring lightens the debt load and the yearly interest burden. The probability of this happening in the near term has increased substantially. While we think the Europeans would like to postpone this alternative as long as possible, this seems to be the most probable midterm solution available. A voluntary restructuring will probably not be enough to solve Greece s problems over the long term. Greece is now in a vicious circle of insolvency, lack of competitiveness, and ever-deepening recession, exacerbated by arduous fiscal austerity that is worsening the recession. Greece s public debt is heading toward a level of 200% of GDP in two years time. And while fiscal austerity and structural reforms are necessary

6 to restore medium-term debt sustainability and growth, in the short run they will lead to an even deeper recession, thus making the deficit and debt even more unsustainable. Indeed, the latest economic data suggest that the Greek recession is becoming a near depression, with GDP expected to fall by over 7% this year and with forward-looking indicators of economic activity suggesting a deepening recession. Argentina in fell into the same trap of deficit, austerity, deeper recession, depression, higher deficit, greater insolvency. To rapidly restore solvency, competitiveness and growth, Greece could default in an orderly manner on its public debt, exit the euro zone and return to the drachma. Exit will require a conversion of euro liabilities into the new currency to limit the balance sheet effects that the depreciation of the new national currency will entail. To note, there is no way to exit the EZ without changing its constitution. Default and exit will be painful and costly, but the alternative of a decade-long deflation and depression would be much worse economically, financially and socially. As mentioned above, there are historical precedents for countries successfully taking the route of an orderly default on unsustainable foreign liabilities and exiting from unsustainable currency pegs and/or currency boards. What makes default unthinkable is the fear of contagion that if Greece were allowed to go under, the cost of borrowing for other troubled euro members would shoot up. (Banks holding troubled countries bonds would also suffer.) Portugal, as the sell-off on February 3rd suggested, is next in line. Its public-debt ratio is 77% and rising. Its current-account deficit is almost as big as Greece s. Italy has public debt of a similar scale, relative to GDP, to Greece s; but its budget deficit is only half as big and its current-account deficit is relatively small. The Italian bond market is the world s third largest. Such a large and liquid market is less vulnerable to speculative attack than a small one, such as Greece s or Portugal s. Ireland is small, too, but its government has shown itself willing to make unpopular decisions to right its public finances. The Irish economy is more flexible so its medium-term prospects seem brighter.

7 While no one in Europe wants to admit to the problems of the union and reduce the trading block s competitiveness, we see this exit strategy as the most likely way for Greece to become economically competitive. Although we do not expect Greece s departure to mean total dissolution of the EZ, it is a possibility. It is more likely that weaker countries will eventually exit, leaving the EZ with the more fiscally prudent countries. Also possible, but highly unlikely, is a coordination of fiscal policy among EZ members. With better coordination of governmental budgets, policies could be made in unison. We expect, however, that nationalistic tendencies, differing cultures, and history will be major impediments to this occurring. The current situation in Greece and in Europe is changing rapidly. We will keep you apprised of the major changes as they develop. Best regards, Rick Cloutier, Jr., CFA Vice President Senior Portfolio Manager