Part II
The Chickens Come Home to Roost
By Dimitris Doulos, Ph.D.*
The October 2009 elections brought the socialist government back to power after five years of conservative governance. The fiscal condition of the Greek economy was the worst ever.
Two developments changed the attitude of foreign investors towards the Greek sovereign debt.
A. On November 26, 2009, Dubai World, the investment vehicle of the emirate, proposed a delay in the repayment of $26 billion of its debt by six months, raising the specter of the largest government default since the Argentinian debt restructuring. This caused significant turbulence in world financial markets. International investors started taking a closer look to those economies that were heavily in debt, including Greece.
B. The newly elected socialist government in Athens announced that the deficit and debt figures reported by the previous government were not accurate and needed to be revised upward.
These two developments resulted in more thorough scrutiny of Greek economic conditions and a quick reduction in the ratings of Greek bonds by Standard and Poor’s, Moody’s and Fitch. As a result, the demand for Greek sovereign bonds plummeted, prices declined sharply and their yields increased to levels that made borrowing from the international markets prohibitive for the Greek government. Considering the large borrowing requirements of the Greek state and the imminent threat of default, in March 2010 the European Council decided to help Greece. However, markets were not persuaded and the spread (the difference between the yield of the Greek 10-year bond and the German equivalent) continued to climb. Greece was kept out of the markets, unable to finance its deficits and debt.
The fear that the Greek debt crisis could spread to other southern European countries led the European Commission, the European Central Bank (ECB) and the IMF (the so-called “troika”) to reach a deal with Greece. Athens was provided with 110 billion euros, the largest ever loan given to a country. In exchange it agreed to proceed with a number of measures listed in detail in the so-called “Memorandum I.” The agreement required that Greece proceed with fiscal consolidation (raising tax revenues and lowering government expenditures) and structural reforms in the public sector as well as in the products, services and labor markets. All these measures aimed at improving Greece’s finances and restoring its lost competitiveness in the world markets.
Unfortunately, very few – if any – of these measures were implemented and the credibility of Greece in the world financial markets was not restored, as this was reflected by the ever-rising spreads. Memorandum I failed for basically two reasons: First, and most important, it was never really implemented. The Greek government did not dare to go ahead with drastic structural reforms. And, second, several of the suggested actions were in the wrong direction (i.e. increased taxes in the midst of a recession). The deteriorating condition of the Greek economy led to a growing impression that the Greek debt was not sustainable.
In an effort to resolve the Greek sovereign debt problem, which in the meantime had spread to Portugal, Ireland, Spain and was threatening Italy and France, the Troika, on July 21st, 2011, decided to proceed with what was regarded as “unthinkable” up until that time: a voluntary 21% “haircut” of the Greek debt. That meant that for the first time the private sector was being asked to participate in the cost of the Greek bailout. This is Private Sector Involvement I (PSI-I), a good deal for the banks (creditors) since only the maturity of the bonds they held would increase and they would receive the face value of the bonds they held at a later date. Therefore, the “haircut” was only on the present value of the bonds. Obviously, the markets quickly sensed that the deal could not make the Greek debt sustainable since the “haircut” was too small. Spreads kept on rising.
A leaked report by the IMF confirmed the markets’ sense and on October 26, 2011 EU, ECB and IMF recommended PSI+. This new proposal called for a 50% “haircut” of Greek bonds worth 206 billion euros held by private investors. The deal, if successful, called for an exchange of these bonds for new ones. For every 100 euros, bond investors will receive 35 euros in new bonds with a lower coupon (below 4%) and longer maturity along with 15 euros in cash. The objective was to reduce the 206 billion euro portion of the Greek debt held by private investors (the total Greek public debt exceeds 350 billion euros) by approximately 60-70%, considering the decline in its present value, and reduce the total debt-to-GDP ratio to 120% by 2020. Once again, Greece was required to agree to proceed with fiscal consolidation and structural changes, as these will be listed in a new agreement – dubbed Memorandum II. In exchange Greece will receive 130 billion euros financing which will hopefully be enough to cover its needs until it is able to borrow from the international markets again. A significant amount of this loan will be used for the recapitalization of the Greek banking sector.
How will the Greek debt crisis end?
The Greek debt crisis will end when market trust on the Greek economy returns and Greece will be able to borrow again from the international markets. The success of PSI+, even though it will only offer a temporary relief, is essential for the survival of the Greek economy. The agreement should be followed by a plan, based on Memorandum II, to restore fiscal balance and proceed with structural changes that should have been implemented years – decades! – ago.
With PSI+ successful following its approval by both the creditors and the Greek parliament, the Troika is free to provide Greece with the agreed upon loans, so that the country can meet its immediate obligations. Greek bonds worth of 14.4 billion euros expired in March and Greece was able to meet its payments and avoid a disorderly default and the consequent exit from the Eurozone. For the time being, Greece remains a member of the common European currency club.
What does a return to a national currency mean?
A return to a national currency, which is advocated by some, would result in an automatic conversion from euros to the new currency – say, the ‘new drachma.’ All payments and reciepts domestically, deposits, salaries etc., would be denominated in drachmas. The external debt, government and private, however, would remain denominated in euros. The drachma would devalue by 50-60%, which means that the value of the external debt would almost double. Imports would become very expensive and essential imported goods like fuel and heating oil would become scarce since they would have to be paid for in hard currency, and in cash. Any gains in the competitiveness of Greek exports would be partially offset by domestic inflation, which would probably surge to 50-80%. The Greek banking system would suffer large losses and probably collapse since it would lose its access to liquidity in the interbank market, as no foreign bank will be willing to lend with Greek bonds as collateral. This would inevitably lead to the nationalization of those banks that will manage to survive. In a nutshell, exit from the Eurozone would be a huge shock for the Greek economy and society.
Which raises the question: proceed with the proposed measures of Memorandum II or exit the eurozone?
For now, the country has decided to go with the former.
* Dr. Doulos is professor of Economics at DEREE-The American College of Greece. He holds a BS from DEREE, an MA and MBA from Western Michigan University and an MA and Ph.D. from Wayne State University.