Why Greece will default

By: Wolfgang Münchau

So, does last week’s agreement mean an end of the Greek crisis, as some of the optimists claim? Let us start with some simple back of the envelope analysis of Greek debt sustainability. This will show that default - under any realistic political and social assumptions - must now be the most probable outcome.

Greece currently has a primary deficit (before interest payments) of 7.9%. On the assumption of 2% nominal growth during the adjustment period, a marginal interest rate of 6% on future debt, the primary balance Greece needs to achieve debt sustainability is a surplus of almost 5%[i]. This is in line with this week’s bond auction, the first after Thursday’s agreement, in which Greece raised €5bn for 5.9%.

It is worth taking a look at different outcomes under different growth and interest rate scenarios – also to assess why insisting on “market interest rates” as Germany has done for a backstop loan will essentially drive Greece into insolvency.

 

Primary surplus needed for Greece to stabilise debt

 

	Interest rate at 6%	Interest rate at 3%
Nominal growth rate at 0%	7.44%	3.72%
Nominal growth rate at 2%	4.96%	1.24%

 

Under the scenario of interest rates at 6% and nominal growth rate at 2%, the total size of the adjustment would be a whopping 13 percentage points[ii]. If the growth rate falls to zero, the adjustment would be 15.5 percentage points. Note that Germany’s insistence on market rates raise the hurdle for the Greeks by some 3.5 percentage points in terms of necessary primary balance adjustment. The only advanced economies in modern times ever to achieve such a shift were Denmark, Sweden and Finland during the 1980s and 1990s. But they benefited from vastly superior growth. Here is the comparison:

 

 

The Greek general government had total expenditures of 44% of GDP in 2008, and tax revenues of 41% of GDP. If the 13% adjustment effort were to come entirely from expenditures, this would imply a cut in public spending of 30% of GDP. Conversely, if all the adjustment were to come from taxes, it would require a tax hike of a similar scale. Given the degree of corruption and the inadequacy of the Greek tax collection system, there is no way that taxation could take the lion share of this adjustment.

How does Thursday’s deal fit in? The two most important aspects of the European Council agreement in relation to Greece is the stipulation that money will only become available in a situation of distress, i.e. if and when Greece fails to raise funds from the capital markets. The second stipulation is that the loan will carry a “non-concessional” rate.

There is substantial disagreement between the French and the Germans on the definition of the term. The Germans are equating non-concessional with prevailing market rates. But if and when Greece were to be cut off from the capital markets, either there will exist no market rates (nobody wants to lend money to Greece), or market rates that are unacceptably high for the Greek government. If the German position were to prevail, it would be ready to lend at those unacceptable rates. This is, in fact, also how the agreement was understood by the German media. Frankfurter Allgemeine wrote the day after summit that the No Bailout rules had been preserved because prevailing market rates will be applied. You could also say that the No Bailout clause has been preserved because there will be no bailout.

The French interpretation is that the interest rates should be calculated by some past averaging formula. They have not worked it out in detail either, but they are referring to similar calculations applied in the cases of Latvia, Hungary and Romania. The Germans dispute that parallel vigorously.

There will, as always, be a compromise between the French and German positions, though we should not expect the French view to prevail completely. The compromise will be some reasonably high number, say the current 6% – if Greece is lucky. But at that number, we are back to our calculation above.

We are now faced with the following four options:

1.      Default;

2.      A nominal devaluation, i.e. leave the eurozone;

3.      A real devaluation, plus fiscal retrenchment, with the help of low interest rate loans;

4.      A real devaluation of plus fiscal retrenchment, without the help of low interest rate loans;

Of those, the third offers the best hope, but even in this case there is no guarantee that it will work. Option four is much tougher. Our scenario table shows how important it is to avoid a self-sustaining slump. The consolidation under option four would get progressively harder, and the danger of an Argentinian-style vicious circle would be immense. 

The real devaluation implicit in either option three and four is a complicating factor because Greece has both a fiscal crisis, and a competitiveness crisis. There are different metrics to determine the relative competitiveness differential with the euro area average, but on most counts the gap is somewhere between 15 and 30%. The current account deficit was 11.2% of GDP, a clearly unsustainable position, even inside a highly integrated monetary union.

 So Greece will not just have to make a fiscal adjustment, but it will also have to seek a fall in prices and wages – at least relative to the euro area average. This is obviously not consistent with positive economic growth rates, so that our assumption of 2% nominal growth is probably way too optimistic (and will be undershot significantly in the very short-term). The forecasts for real GDP growth in 2010 range from minus 2% (European Commission) to minus 4% (Deutsche Bank).

The Greek government had clearly hoped that the mere announcement of a backstop would change the market rates, but this has not happened, and is not likely to happen. The actual default risk is significantly higher than what is reflected in the current spread of 300 basis points plus - – which reflects an approximate 17% probability of a 17% loss (the square root of 300) in a risk-neutral setting, which itself is a heroic assumption.

I am beginning to wonder whether, given this extreme toxic situation, Greek policy makers will at one point conclude that it is in their interest to default (i.e. not quit the euro area but default on the debt while remaining inside the euro area). Given the international spread of Greek sovereign debt ownership, a financial crisis in the euro area would be almost inevitable. French, Swiss, Greek and German banks are, in this order, the largest holders of Greek sovereign debt. Here are the pertinent facts about ownership of Greek debt securities.

 

French banks:	€55bn (Société Générale, Crédit Agricole)
Swiss banks:	€ 47bn
Greek banks:	€ 40bn (14% share of the total volume)
German banks:	€ 30bn (Deutsche Bank, Commerzbank, Hypo Real Estate)

 

 

European banks have invested more than €240bn in Greek sovereign debt, and approximately 10% of all sovereign bonds in the euro area are Greek.

My expectation is that Greece will default if the interest rates remain at 6%. Germany’s tough position, which prevailed during this summit, is very likely to push Greece over the brink, but keep it inside the euro area – the worst of all conceivable worlds.

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