Friday, November 4, 2011

UPDATED: What a Greek exit from the euro might look like ...

Time lapse animation of EU membership along with info on euro area (from European Central Bank)

The latest Economist article on the the crisis suggests that Greece's euro partners should focus more on linking bailout money to structural reforms (which will eventually lead to growth) rather than austerity.

Economist (November 5th-11th 2011) "Greece's Woes"

The ratio of debt to GDP can reveal when a country is in danger of not being able to meet obligation.  Greece's ratio of debt to GDP reached 147.8% in 2010 (see link to OECD at bottom of post), and so debt repayment is clearly a problem.  However, the ratio of debt to GDP does not reveal how the debt is structured or the interest rate a country has to pay.  To get a handle on a country's ability to meet debt obligations and undertake an austerity program, it may be more useful to look at the ratio of expenditure on servicing debt to total government expenditure.

After spending a few hours trolling the websites of the IMF, the OECD, the CIA World Factbook, the ECB, Eurostats and others, the only place I could find this information was the Greek Ministry of Finance's website (see link at bottom of post). If anyone finds another readily available source for this data let me know.

According to the latest data from the a presentation by the Greek Ministry of Finance,  interest payments on government debt amounted to 6.9% of GDP in 2010.   In that same year Greece's deficit was 10.4% of GDP (according to OECD). Even if Greece didn't pay one penny of its debt, it would still have had a primary deficit over 3% of GDP in 2010 (primary deficit = total deficit - portion of deficit due to interest payments). While the primary budget will improve as Greece's economy improves, austerity programs only make economic growth harder in the near term.

Reminder for students: A deficit over 3% is not considered sustainable in the long run.  EU members who have adopted the euro are supposed to maintain a deficit to GDP ratio of 3% or less. Then again, they are also supposed to maintain a debt to GDP ratio of 60% or less. So most of the countries in the euro area are in violation of the Stability and Growth Pact anyway.

If Greece defaults, it would no longer be able to borrow and should not expect any more bailouts.  It would have to balance its budget immediately. The resulting budget would be even more austere than the one in the bailout deal. Given these facts, leaving the euro currency union doesn't sound so desirable.

Playing bluff for a better debt reduction deal might work - but is very risky.  Under the current deal, Greek government debt would be reduced by 50% in exchange for an austerity program that reduces government expenditures and/or raises taxes. Greece could argue that a larger haircut is needed. If debt was cut by 66% or 75%,  Greece would have a much better chance of reaching a sustainable 3% total deficit to GDP ratio.

When Papandreau, the prime minister of Greece, proposed a referendum on the bailout deal, he was probably not focused on wrangling a larger haircut. Rather he was attempting to force his own party and the population at large to support the bailout deal. At the moment it looks like he may have succeeded in uniting the country behind the deal, although it may cost him his job someday. He narrowly survived a vote of confidence on Friday, November 4th.

The mere mention of the referendum on the deal put the markets in a tizzy.  The following two articles tackle some of the challenges.

WSJ (11-4-2011) "Banks Conduct Greek 'Fire Drills' " by Sara Schaffer Munoz and David Enrich

WSJ (11-4-2011) "Exit Would be Mess for Athens" by Stephen Fidler

Fidler argues the element of surprise is key. Announcing a currency switch in advance gives people time to hoard euros and get euros out of Greece, making the eventual conversion much more painful.  Munoz and Enrich report that this may already be happening. Citing an anonymous European bank executive, "corporate clients usually move their earnings out of Greece every two weeks. Now they move money out of the country as often as every day".

If Greece leaves the euro, sovereign default would be inevitable, i.e. the Greek government would stop paying some or all of its debt. However, Greek companies and individuals also have many loans in euros.  For loans made in euros inside of Greece, Munoz and Enrich argue that the Greek parliament is likely to legislate a predetermined conversion rate from euros to drachmas. This rate would likely end up favoring Greek borrowers at the expense of banks from Europe and elsewhere. Hence the banking systems 'fire drills'.

It is not clear the Greek legislature would be able to impose this conversion rate on loans made in euros outside of Greece. Greek borrowers obligated to pay back debt in euros (on loans made outside of Greece) but who earn their revenue in drachmas would likely face bankruptcy as the drachma devalues again the euro. The only certainty is lots of lawsuits.

For now it looks like Greece will stay in the euro area in 2011.  However, within the next few years the haircut may be renegotiated and/or Greece might yet still leave.

Questions for class:
1. What advantages for Greece, if any, do you see from Greece exiting the euro area?
2. If Greece leaves and defaults, lots of European banks would be in trouble.
      If they are not bailed out, interbank lending would grind to a halt and a deep
      European recession  would be likely. How would a deep recession in Europe
      affect your company?
3. Ten Zillion dollar question: If Greece leaves and European governments do bail out
      their banks, what do you think might happen?

More info:

 HELLENIC REPUBLIC MINISTRY OF FINANCE: Budget 2011 (Draft Law 18 November 2010)

OECD statistics

Bank of Greece Press Release (22/03/2010)

"In 2009, as the Bank of Greece had warned, the general government deficit reached 12.9% of GDP and public debt stood at 115% of GDP. These developments triggered a series of downgradings of Greece’s credit ratings and led to a large widening in the yield spread between Greek and German government bonds – resulting in increased borrowing and debt-servicing costs for the Greek government. The increase in debt-service expenditures, in turn, increased the country’s budget deficit, made fiscal consolidation more difficult to achieve, and had serious repercussions for the real economy and the banking system. The Greek economy is caught in a vicious circle, with only one way out: the drastic reduction of the fiscal deficit and debt so that there is an immediate reversal of the current trend."

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