Avoiding a Greek tragedy


SERIOUS MONEY:The EU cannot and will not allow Greece to default as the survival of the euro is at stake, writes CHARLIE FELL

SOLON, THE Athenian statesman, instigated a series of reforms soon after he assumed power in 594 BC, in an effort to rescue the ancient city state from a debilitating economic crisis. His principal reform was the Seisachtheia, or “shaking off” of economic burdens, which prohibited personal slavery as security for debts, nullified such existing debt contracts, and returned land that had been seized from struggling debtors.

He also introduced a new monetary standard that reduced coinage weights, increased the amount of coinage and prohibited debasement of the new Athenian “owl”. The coinage became a widely accepted currency throughout the Mediterranean for six centuries.

Turn the clock forward and modern-day Greece is crying out for a sage to help it avoid a potentially crippling economic crisis. Time, however, is running out, as unsustainable structural fiscal deficits combined with excessive levels of outstanding public debt bring the possibility of default closer.

The country’s fiscal deficit is on course to reach almost 13 per cent of gross domestic product (GDP) this year, 11 percentage points higher than official projections a year ago, and more than four times the EU Stability and Growth Pact’s reference value of 3 per cent.

The deficit is projected to drop to 9 per cent next year, but the proposals to achieve this are not credible as they focus on improvements in tax revenue collection rather than cuts in government spending. This means that structural deficits of more than 10 per cent of GDP are likely to persist and Greece’s public debt to GDP ratio looks certain to increase from 115 per cent of GDP to 140 per cent within two years.

Speculation that Greece may default has returned in recent weeks following the plans announced by European Central Bank (ECB) president Jean-Claude Trichet to scale back emergency lending next year.

The yield spread on Greek government bonds versus their German equivalents has moved noticeably higher, as too has the spread on five-year credit default swaps, as little vocal support or otherwise has been offered to the beleaguered government.

The European Commission and the ECB appear unwilling to reward the Greeks’ fiscal profligacy. The former concluded that effective action has not been taken to correct the deficit, while the latter has called for “courageous” decisions. It is becoming clear that the EU is reluctant to come to the rescue unless Greece meets a number of conditions that are likely to be imposed in the coming months.

Brave decisions, however, will be hard to take, as the economy’s travails have spilled on to the streets in a wave of riots.

Greece’s financial position received a further blow this week, after the decision by Fitch to lower the nation’s credit rating to BBB+, a move that is almost certain to be followed by Moody’s and Standard Poor’s.

The downgrade marks the first time that the credit rating of bonds issued by a government in the euro zone has dropped to a point at which they would not be eligible for use as collateral at the ECB once the temporary relaxation of normal criteria is withdrawn.

Capital markets responded immediately to the downgrade. Stock prices dropped 6 per cent, the yield spread on government bonds jumped to 230 basis points above their German equivalents, and five-year credit default swap spreads increased to more than 200 basis points. Current credit default swap spreads put the probability that the Greek government will default on its debt obligations over the next five years at almost one-in-five.

The notion that Greece may leave the euro zone and destabilise the monetary union is back in the spotlight. But it cannot feasibly leave the euro zone. Such a decision would require lengthy preparations and, given the expectation of a sizeable devaluation, both depositors and investors would shift funds elsewhere. The capital outflow would bankrupt the banking system and precipitate a bond market crash. Access to international financial markets would close as investors shunned Greek debt issuance. Debt-servicing costs would spiral. Furthermore, Greece would not benefit from a competitive devaluation, as its euro-zone neighbours would be certain to restrict Greek imports. There is no economic advantage to be gained through a euro exit.

The EU is pushing as hard as it can to force its most recalcitrant member to take remedial action and is clearly reluctant to provide financial assistance. However, the idea that Greece would be allowed to default is questionable, as the risk is simply too great. The crisis could easily spread to the banking systems and bond markets of other financially constrained nations, including ourselves, and the end result could well be the demise of monetary union.

This will not be allowed to happen and a rescue plan, however severe, would be put together to save the cash-strapped government. It is clear that the euro will survive.