EXCLUSIVE: Greece debt crisis may break the Eurozone

The 11-year-old European currency union is facing its most serious threat as several countries across southern Europe – notably Greece – are at risk of failing to meet interest payments on their outstanding debt.

All have debt-to-GDP ratios far above the 60% ceiling of what is reckoned to be manageable, as well as yawning fiscal deficits.

Yet the inherent constraints of being a member of a single-currency club mean these countries cannot adopt the usual emergency measures – inflation or currency devaluation – to avoid default.

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Speaking about the problem in public, political leaders only ever mention one possible solution: the introduction of austerity measures. But the kind of austerity needed could well prove politically untenable when unemployment is already high (19% in Spain at the end of February, double the Eurozone average of 10%, according to Eurostat figures) and private sector growth is anaemic.

Moreover, austerity programmes would likely worsen debt ratios and fiscal deficits in the short term, since they cut both government investment in the economy and tax revenues. This could potentially lead to struggling governments having to pay investors higher rates to borrow money.

When austerity works

Latvia offers a useful example of a country that has implemented the early stages of a brutal austerity programme, which included in December a 15% cut in civil service salaries. This followed a two-year period in which its GDP plunged 25.5% (almost 20% in the past year alone), with the International Monetary Fund projecting another 4% drop this year. Latvia’s austerity measures are intended to reduce its fiscal deficit from an estimated 8.6% at the end of 2010 to 1.7% by the end of 2014. However, there are suspicions that such swingeing austerity measures would be seen as unacceptable among the populations of southern Europe.

The Greek government began its own austerity programme in March, with initial measures including cuts in public sector wages, a 2% increase in VAT and higher taxes on alcohol, tobacco and luxury goods. The move is designed to help cut its fiscal deficit to 10.7% of GDP from 12.7% at the end of 2009. The government wants to reduce its fiscal deficit further, to 8.7% of GDP by the end of 2010, but there are doubts whether it will be able to cut below that level without provoking social and civil unrest, a fact not lost on bond investors.

Click here for a timeline of Greece's debt crisis.

While it is clear that the Eurozone does not want such countries to default, it is equally evident that its largest member countries are unhappy paying for the over-leveraging errors of southern Europe. Germany, for example, took a strong line on any potential Greek bailout when its chancellor, Angela Merkel, finally agreed to a deal that would see the Eurozone countries lending money to Greece in the event of default, but only at market rates and in concert with the IMF.

On April 11, the European Union seemed to have made tangible progress by committing to extend €30 billion in loans to Greece at a rate of 5%, with the International Monetary Fund committing a further €15 billion. However, while confirmation that loans are available as and when Greece needs them should have given the ailing country some respite, bond investors remain unconvinced and there are growing fears Greece is entering into a debt spiral. The announcement on April 22 by Eurostat, the European Union’s official statistics agency, that it was revising upwards Greece’s fiscal deficit from 12.9% of GDP to 13.7% saw investor sentiment nosedive.

Yields on two-year Greek government bonds had blown out to 13.7% on April 27. Meanwhile five-year bond yields had spiked from a low of 5.489% on March 17 to 11.1% on April 27, a spread of more than 800 basis points over German Bunds.

Some commentators suggest the EU has underestimated the size of the loan package that could ultimately be needed, with the actual figure likely to be between €100 billion and €120 billion. So while Greece may be able to stave off disaster in the short term, a closer look at its fiscal position suggests a default is still a realistic possibility a year from now unless it can somehow push through record-breaking austerity measures.

Every which way Greece turns looks likely to lead to pain, struggle and a reasonable chance of failure. But if, instead, the country were to default on its euro debts, it would not just be Greece in danger of becoming a market pariah for several years ahead; the risk of Eurozone contagion would be considerable, especially across the remaining PIIGS countries (Portugal, Italy, Ireland, Spain). In such a situation, European sovereign bond markets would dip dramatically as many investors pulled back from the continent. And that, for the Eurozone, would be a disastrous scenario.

Not yet minted

There is an alternative outcome and it is one the Eurozone should fear every bit as much as a domino effect of sovereign defaults across southern Europe. The Greek prime minister himself hinted at it when speaking in March about the chances of EU aid for debt-stricken Greece.

“What, of course, would be a problem, would be if we continued to borrow at very high rates, beyond those that most of the European Union countries and the Eurozone countries certainly borrow at – twice, for example, the rates of Germany,” said Greek prime minister George Papandreou on March 8 during a joint press briefing with US secretary of state Hillary Clinton. “That would be unsustainable within a common currency.”

In other words, if Greece was forced to continue paying punitive interest rates on its debt, it might have to consider exiting the euro altogether.

Ever since its introduction in 1999, the euro has been heralded as doubly providential. In financial and economic terms, it has delivered stability, bringing exchange rate speculation to an end and setting a single interest rate across much of Europe. In political terms, it has tied formerly warring countries ever closer together.

But for countries like Greece the currency has become as much a straitjacket as an insurance policy. What has brought this about is that the Eurozone is not a single-speed economy, but one with an established northern base and a higher-risk, less productive south. Despite the April 11 EU announcement of reduced interest loans to Greece, evidence is mounting that the country will not be able to raise enough funds via the international bond markets to service its sovereign bond redemptions. The size of the order book on the three bond deals completed by Greece this year dropped from €25 billion for January’s five-year issue to just €6 billion on the seven-year deal sold at the end of March. And according to media reports, China and Japan, which dominate the Asian investor market that Greece is so eager to tap as an alternative to Europe, indicated in early April that their sovereign wealth funds are not interested in investing in Greek bonds because they are too risky.

In its most recent issuance, the Greek government borrowed from the market at a rate of 5.9% – as Papandreou said, almost twice the rate of Bunds. Secondary market yields were rapidly climbing towards 8% before the loan announcement; at that level Greece could only hope that the EU and IMF would keep it afloat without insisting on similar rates. And while the €45 billion package allays its immediate concerns, beyond this year the prognosis remains bleak.

“The language of EU support is contradictory,” says Uri Dadush, formerly the World Bank’s director of international trade and now director of the international economics programme at the Carnegie Endowment for International Peace. “Greece cannot afford market rates. Either lending at lower interest rates – the classic IMF package – or an outright interest subsidy or some form of restructuring is needed, whereby you reschedule the loans or aggressively haircut them. But even that doesn’t solve the problem as Greece will still have a large primary deficit, will still need to borrow and may not be able to.”

The EU may be offering below-market rates in the short term, but Greece’s economic shortfall will not end with its 2010 bond redemptions. Tied to a valuable currency, its options remain limited once this year’s aid package is used up.

Bowing out

In short, the euro has become a problem as well as a solution for a handful of countries. In a coherent monetary and economic union, the governments of the EU would make fiscal transfers to aid the worst-hit regions of the monetary zone. Likewise, the ECB would have been more insistent on countries keeping to the terms of the Growth and Stability Pact (which sets a 60% ceiling on national debt-to-GDP ratios and a 3% fiscal deficit limit). But once France and Germany had flouted the pact’s terms (in 2003), it became hard for the ECB to be rigorous in enforcing those same terms elsewhere in the union. Besides, the pact failed to prevent creative accounting: last October, the newly elected government in Greece disclosed that rather than a budget deficit for 2009 estimated earlier in the year at 6% of GDP, the actual figure was 12.7%.

During this time, the elephant in the room has been the chance that a country might actually leave the euro. The implications of such a move would be far-reaching, both for the country exiting and the remaining members of the Eurozone.

“It’s enormously expensive [to leave the Eurozone],” says Julian Wiseman, an economist who formerly worked at the Bank of England. “If your choice is death and ruin in war, sometimes all your choices are terrible. But the way the European Monetary Union is designed to lock the door it would be very difficult to speculate that countries would leave. It is so expensive, it would be very unlikely.”

Wiseman gives the counter-example of Turkey, which re-denominated its currency in 2005, dropping six zeroes. All jurisdictions regard the Turkish lira as an instrument of the Turkish state, and so look to Turkish law to define a Turkish lira. And if Turkish law defines an old lira as one millionth of a new lira, then that is how contracts under US or English law see it. Thus the Turkish re-denomination worked in all jurisdictions. But the currency of Greece is not an instrument of the Greek state.

“Let me give you what I think is the crucial question,” says Wiseman. “If you attempt to re-denominate Greek law contracts you will bankrupt much of your financial system. You will also be a diplomatic pariah. What is the price in Greek unhappiness of re-denominating your currency and bankrupting your financial system? The overall consequences of trying to leave [the Eurozone] are enormous and pretty much anything else is better.”

Dadush agrees: “If Greece doesn’t get adequate support from its European partners then it’s conceivable [that it would leave],” he says. “If this became a constitutional issue for Germany, then it might be the only viable option for Greece. It would shift the debt burden on to creditors and give it new political levers [via inflation and currency depreciation] and it would help it regain competitiveness. But it would be an absolute last resort for a country like Greece.”

Given that a country cannot transfer its external debts from euros to a new currency on a 1:1 basis and then wait for its currency to decline (and for its debt to decline with it), Greece would have to seek an alternative way to successfully extricate itself from the currency zone without its euro-denominated debts ballooning as its own currency declines.

Effect on bond markets

Europe’s sovereign bond markets have had a volatile few months and spreads in parts of southern Europe and Ireland remain wide. As for the effect of an exit of a weaker country from the Eurozone, some feel it may result in a tightening of spreads for stronger sovereign issuers.

“Countries such as Germany or France would see their bonds outperforming quite considerably versus other European issuers,” says Colin Finlayson, an investment manager in the fixed income group at Aegon Asset Management. “You’d see a flight to quality as the market looks around to see who’s next. Spain, Italy and Ireland could all suffer quite badly. At the same time, you’d see German yields fall quite significantly.”

Others see less selective contagion spreading through the European bond markets.

“Capital flight from southern Europe is likely but one can’t predict it,” says Charles Goodhart, a professor at the London School of Economics. “Markets would react by saying ‘well, Greece has gone, in a system which people said would hold for ever’. The 1992 crisis began with Italy and the UK but rapidly spread to other countries.”

Despite the intervention of the EU and the IMF in Greece’s situation, some commentators believe the sovereign debt crisis is still in its early stages.

“We’re already in a major crisis and I’m surprised you haven’t seen more rising spreads in other [European] countries,” says Carnegie’s Dadush. “We are still in the infancy of the crisis and it could become quite a bit uglier before we find a resolution. The history of every crisis I’ve seen is that when things get really bad with one or two players, it’s just a matter of time before people ask who the next one is: it happened in the Asian crisis of 1997–98 and in the recent banking crisis too.”

Some analysts blame the recent fall in the value of the euro, which depreciated 12% against the dollar from 1.512 on December 3 to 1.3296 on April 8, on sovereign debt woes in the Eurozone. 

But others downplay the impact Greek troubles are having on confidence in the euro and in the Eurozone. “People keep saying that Greece’s problems have caused the euro to weaken against the dollar,” says the director of fixed income research at a major US asset management company. “But they need to remember there is faster economic growth in the US and more confidence that short-term interest rates will go up in the US than in Europe, so it is natural for the US dollar to appreciate versus the euro. I’d also say that it is not as though we are currently trading outside the range of the past decade.”

According to this view, a Greek departure from the zone would only have a muted impact on the currency’s value. “There might be a bit of weakness in the currency that Greece has contributed to, but it is not material,” adds the director. “I still think Greece is an idiosyncratic event: it hasn’t dragged down Italy, Spain or even Ireland. The market is indicating that even if Greece were to disappear, the euro would carry on. We’re certainly not taking any precautionary action at present.”

All of which suggests that this is a storm the bond markets might weather but Greece might not. It would be easier, in fact, for countries like Spain and Italy, both of which have burdensome debts but small external debt, to leave the currency zone, since they could re-denominate domestically held debt into their new currency. Greece, on the other hand, has too many external euro debts to pull that off.

A third way

Some economists see another last-gasp solution for countries with heavy external euro debts, should the repayment burden become unmanageable. Given the financial and reputational disaster facing any country that defaults or leaves the Eurozone, a temporary two-currency system might be the least bad choice.

This option was put forward by the LSE’s Goodhart and Dimitrios Tsomocos of Oxford’s Said Business School in January. They proposed the launch of an “IOU” domestic currency that would be used for all civil service payments and domestic transactions, while keeping the euro for all international transactions (and for use by foreign tourists). It would be a non-convertible currency, its value would not be pegged and it would have a fixed shelf-life of, say, four or five years. Such a system would allow internal costs to fall without upsetting external creditors, effectively domesticating Greece’s pain so that it doesn’t become a market pariah.

“I think it may actually develop as a result of pressure,” says Goodhart. “Greece is not a sovereign country in terms of having its own currency, doesn’t have its own printing press and, because of borrowing, will find at some stage it simply doesn’t have enough euros to do everything. Then it will need a process of prioritising.”

Under the Goodhart-Tsomocos scheme, which has successful historical precedents in Argentina and (more recently) California, Greece could reopen a domestic printing press, allowing it to depreciate domestic bank notes against the euro.

“It’s not something anyone wants to do,” says Goodhart. “It will be a messy exercise with lots of difficulties. The problem is the [domestic] political and social response, as the effect of the policy would be that IOUs depreciate relative to euros, so there would be an immediate cut in wages and living standards in the public sector. Plus people would have to pay taxes in euros.”

This is, Goodhart acknowledges, a sobering prospect, but it may prove the least painful option. The key variables to watch, he argues, are wages and prices. At the moment, the status of Greece changes weekly as the EU makes one announcement and the market another.

Dadush is sceptical about such a plan. “I think it’s very far-fetched and would only happen in a Great Depression scenario when money is short,” he says. “But of course, everything is possible as a last resort.”

Euro blues

On April 27, credit market information provider CMA put the risk of a Greek default within the next five years at 43.4%. Others worry that Spain, a far bigger economy, is on the verge of collapse too, with enormous repercussions for the Eurozone. Spain, however, is a less cut-and-dried situation. On one hand, unemployment is at 19%, in February the government predicted a 2010 fiscal deficit of 9.8%, real GDP has dipped and the country is running a trade deficit. Its total external debt (private, corporate and sovereign) equates to 170% of GDP.

On the other hand, government external debt is below the 60% ECB ceiling at 55% of GDP, 18 months of adjustment have already passed and bond spreads are significantly tighter than other southern European countries. Spanish demographics are rosier than those in Germany or France and, with an open immigration policy, productivity could rise further. In fact, it is doubtful that the country should even be included in the PIIGS bracket.

“The situation is different since external debt is 75% private, which is not the case with Greece,” says Alfredo Pastor, former Spanish secretary of state for the economy and a professor at IESE, Spain’s top business school. “There is no reason to think of a sovereign default, which seems to be the Greek problem. The amount of help or internal adjustment that Greece has to undertake is not impossible but it is very large.”

For Pastor, there is no real chance of Spain leaving the Eurozone. However, the lack of fiscal centralisation in the Eurozone has complicated matters for the currency union, as have the irrational trade imbalances that afflict the continent, all of which meet in the giant German trade surplus (€12.6 billion at the end of February, up from €8 billion a month earlier).

“Spanish recovery will be slow but there’s no short-term danger of a default,” says Pastor. “Families are saving 18% of their income now so consumption is very low. But I don’t think the government can promise to implement large cuts in the immediate future as revenues are down and the housing bubble has burst. The measures are in place to reduce the deficit when growth starts to resume and that includes austerity on the spending side and further steps on VAT.”

Growth, according to Pastor, is the “big unknown” right now across the Eurozone’s higher-risk countries but, for Greece at least, it will be growth that is the difference between sustainability and default.

“If economic growth doesn’t pick up for Greece until 2012, I don’t know what will happen,” says Pastor. “If it is earlier, then a temporary bailout – probably higher than the size of the current bailout – will be introduced, but there will be a strict minimum because neither Germany nor France can be seen to bail out a country like Greece. If growth doesn’t pick up, then a quicker solution may be attempted, like a temporary euro exit. For the time being, the policy is to see how things develop.”

Pastor sees Italy as closer to Spain because it has a high domestic savings rate and has weathered large redemption crises in the past. “By and large I would not say Italy is too dangerous because most public debt is held by Italian households,” he says. “Italy has sometimes had to refinance 75% of GDP in three weeks and has never failed to do so.”

That Italy and Spain are in a far better position will come as a great relief to France, Germany and the ECB. Greece only accounts for 2% of Eurozone GDP, so a complete bailout is feasible, and even sensible, despite being politically costly for creditor countries. But Spain accounts for almost 10% and Italy closer to 15% of the currency zone’s GDP. That makes a bailout – or even support measures – unconscionable in the unlikely event that their fiscal positions deteriorate to the same extent as Greece’s has. 

“Germany will realise that Greece is its problem as much as anyone else’s,” says Dadush. “It’s a problem for their banks [German banks hold significant Greek positions] and the stability of the euro depends on dealing with it. If not, the situation will spread, affecting German exports and the viability of their banks. The same applies to all the large European countries including the UK. This becomes a global problem very quickly.”

Borrowing, after all, is a global problem too. Panning out from the Eurozone, OECD sovereign debt will reach 71% by the end of 2010, according to a report by David Roche, president of independent research outfit Independent Strategy. In the UK, the US and the Eurozone, sovereign debt is already close to the “tipping point” at which debt hampers growth – 90% of GDP – after which increases in state spending actually cut growth.

“The difficulty,” says Goodhart, “is whether the political and social systems in [PIIGS] countries can stand the shock without support from a common European fiscal policy or the ability to play the exchange rate.”

Endless talk of the troubles affecting the PIIGS may be blinding investors to the scope of Eurozone risk. “If you look at market spreads, Ireland and Portugal are closest [to Greece],” says Dadush. “Spain and Italy are some way behind. But more important than that, if the Greek problem deteriorates then all the other countries will be affected and you will get an escalating domino effect. If the problem spreads from Greece to Ireland and Portugal then it’s only a matter of time before it hits other countries.”

In 1999 the currencies of 11 European countries boarded the plane for Frankfurt, home to their new central bank. Since then, five more countries have joined. For those early arrivals, entry to the euro brought stability, improved trade flows and closer unity across borders. It was all upside.

But, for many, monetary union today is a cost as well as an asset. It now falls to all the EMU countries, and to Germany in particular, to show the market that they are serious about keeping it intact. If growth stalls and Germany errs, then Frankfurt airport may see some important departures yet.

Legal tender: the bondholders’ position

There are questions over whether an exit from the euro is covered in the legal documentation of financial market instruments, including bonds.

“We thought long and hard about whether to address the demise of the euro in our documents or prospectuses at the time the euro was introduced,” says Jeff Golden, a partner at law firm Allen & Overy. “The prevailing view has been that a country cannot unilaterally legally exit the euro, so we might just as well worry about a member country announcing it would not honour any other treaty commitment.”

Charles Proctor, a partner at UK-based Bird & Bird, who worked on a number of the early bond deals denominated in euros, says a unilateral withdrawal from the currency, without the consent of other member states, would be a clear breach of the Maastricht Treaty.

“Article 50 of the Lisbon Treaty [signed in 2007] allows a member state to withdraw from the European Union as a whole,” says Proctor. “But it does not contemplate a withdrawal from the single currency alone. It is not possible to infer a right to withdraw from the euro, since the Maastricht Treaty [signed in 1992] stated that the currency substitution would be ‘irrevocable’.”

Proctor explains there was no need to write special clauses into issuance contracts to cover the eventuality of a country leaving the Eurozone because a unilateral withdrawal would not affect the borrower’s legal duty to repay in euros.

If Greece withdrew from the Eurozone, it would have to create a new local currency and pass a new law providing for the conversion of former euro debts into the new unit, adds Proctor. “That conversion would have to be recognised by courts in Greece, but courts in London and New York would continue to enforce international bonds and enforce payment in euro, because the new Greek monetary law could not alter or detract from euro-denominated obligations governed by English or New York law.”

In other words, for Greece there is no easy way out of its euro-denominated debts.