SERIOUS MONEY:It seems clear Greece will succumb to a debt trap, as interest rates in excess of growth cause debt to spiral
VOLATILITY HAS returned to the globe’s capital markets as the precarious fiscal predicaments of the so-called PIGS – Portugal, Ireland, Greece and Spain – have unnerved investors and contributed to a reassessment of risk positions.
The euro zone’s solidity is under scrutiny yet again, as the stress that originated in Athens has since unleashed a potentially lethal strain of “Greek flu” on its fellow suffering swine in the monetary union. Investors have smelt the bacon and are running for cover, appreciating that Walter Wriston, the former chairman of Citibank, was embarrassingly wide of the mark when he famously declared in 1977 that “countries don’t go bust”.
Greece remains the epicentre of the crisis and the financial markets have spoken. The premium for five-year Greek credit default swaps (CDS), which reached 270 basis points (2.7 percentage points) at the height of the credit stress last spring, jumped to more than 420 basis points. Current CDS levels indicate a cumulative default probability of 32 per cent for Greece, assuming a market-convention 40 per cent recovery rate, up from 21 per cent at the start of the year.
The credit stress has reached a critical phase and investors have good reason to distrust the Greeks given their historical record of fiscal profligacy.
Greece has defaulted on its external obligations five times since it gained independence from the Ottomans in 1829, most recently in 1932 at the height of the Great Depression. Fiscal indiscipline has continued through the country’s more recent history, as successive governments have failed to achieve budgetary balance since 1972 and the Regime of the Colonels.
Fiscal deficits have averaged 6 per cent of GDP through the past four decades, and there has been little if any improvement since Greece was admitted to the euro zone in 2001. Furthermore, the Greeks joined the euro zone in controversial circumstances, having recorded a deficit below 2 per cent of GDP for 1999, only for it to be subsequently revised upwards to a level above the Stability and Growth Pact’s 3 per cent limit. Greece shocked investors last October when the new socialist government revised up the estimate for the 2009 budget deficit by 6 percentage points to almost 13 per cent of GDP, and admitted that previous deficit figures had been misleading. This sizable jump has caused government debt to increase sharply over the past year to 113 per cent of GDP, as against the 90-100 per cent range that prevailed throughout most of the past decade.
The unenviable combination of a large fiscal deficit and a sizable and increasing government debt alongside rising borrowing costs means that the current situation is unsustainable, and a painful fiscal adjustment is urgently required. Indeed, in the absence of a sizable fiscal adjustment, it seems clear that Greece will succumb to a debt trap, as real interest rates in excess of the country’s growth rate cause outstanding debt to spiral higher.
The Greek government has promised the European Commission that it intends to reduce its fiscal deficit to below 3 per cent by 2012. The stability programme projects that the debt-to-GDP ratio will stabilise at roughly 121 per cent in 2011 and decline thereafter, but the underlying assumptions are heroic and the cumulative reduction in the cyclically adjusted primary position at almost 11 per cent of GDP is larger than any euro zone country has achieved in the past over a comparable period of time.
The heroic and implausible assumptions project nominal GDP growth of 3.5 per cent per annum over the forecast period, a cumulative adjustment in the primary balance of roughly 10 percentage points as revenue growth exceeds that of expenditure by more than 6 percentage points each year, and a relatively modest annual average increase in interest expense of roughly 4 per cent as interest rates return to pre-crisis levels.
Using more realistic assumptions for both GDP growth and interest rates suggests that the 2012 deficit is likely to be roughly 7 per cent of GDP, or 4 percentage points higher than projected, even if the Greek government delivers on its promised fiscal correction. The debt-to-GDP ratio would increase to 135 per cent and thus, in spite of the economic pain caused by the fiscal adjustment, the risk of a Greek default would not have diminished.
The question, therefore, is whether Greece will be allowed to default. The answer is no and, not for the love of Greece, but out of self-interest. First, financial institutions in other euro zone countries hold a significant share of Greek government bonds and a default would only aggravate the sector’s current woes and further curtail the availability of credit. Second, and more importantly, a Greek default would have contagious effects in the banking systems and bond markets of other financially constrained nations, including ourselves, and an avalanche of sovereign defaults could follow. This will not be allowed to happen and all avenues are sure to be pursued in order to prevent a further systemic blow.
Milton Friedman warned in 1999: “Sooner or later, when the global economy hits a real bump, Europe’s internal contradictions will tear it apart.” Investors are about to find out whether the great economist was right.
