SERIOUS MONEY:DENIAL IS the most insidious form of self-deception, and was all too apparent throughout the financial crisis that erupted in the autumn of 2007; the defence mechanism remains prevalent today as the upheaval shifts from the banking sector to sovereign credit.

The delayed and inadequate response to the Greek’s fiscal woes, which surfaced on investors’ radar screens six months ago, has precipitated financial turmoil, and recent market developments suggest that the ability to contain the crisis has been all but lost.

The words of Greek prime minister George Papandreou in recent weeks are reminiscent of Lehman Brothers’ Dick Fuld in 2008 when he assigned blame to ruthless short-sellers for the collapse in the company’s share price, and attempted to assure investors that its finances were sound just days before the investment bank filed for bankruptcy.

Papandreou attempted to blame speculators for strangling the Greek economy, yet even a glance at the country’s economic performance confirms that Athenian ills have been manufactured at home.

Greece ran a fiscal deficit of almost 14 per cent of GDP in 2009, some 12 percentage points higher than official projections 18 months ago, and is saddled with roughly €275 billion of public debt, which equates to 115 per cent of GDP.

The unsound fiscal position emerged as the Greeks failed to reduce their debt ratios from 2003 to 2008 despite strong growth, while the rapid deterioration in its public finances last year exposed an unsustainable structural deficit of more than 10 per cent of GDP.

The initial budgetary proposals designed to address the rapidly deteriorating fiscal position lacked credibility due to the omission of serious long-term reforms, and bond market vigilantes expressed dissatisfaction via higher market interest rates.

Matters came to a head in recent weeks as investors began to focus on the difficulties that the Greeks may have in rolling over the €8.5 billion in maturing debt scheduled for May 19th.

Market interest rates soared past 8 per cent as the tension mounted, and the €45 billion EU/IMF debt contingency accord at preferential rates of interest provided only temporary respite.

The plan failed to soothe investors’ nerves, and its immediate impact was overwhelmed by subsequent market developments. The rating agency Standard Poor’s downgraded Greek debt to junk status, and Eurostat revised the country’s fiscal deficit upwards by a full percentage point, casting further doubt on the reliability of data provided by the Greek authorities.

Capital markets responded immediately and the yield spread on government bonds jumped to 520 basis points above their German equivalents, and five-year credit default swap spreads increased to a record high of more than 500 basis points, which put the probability that the Greek government would default on its debt obligations over the next five years at 40 per cent.

The Hellenic republic was thrust from its state of denial and left with little option but to request the activation of the EU/IMF bail-out mechanism. The EU and the IMF finally woke up, and agreed to a revised stability package for Greece amounting to €110 billion in loans over three years at concessionary interest rates.

The Greeks will receive as much as €30 billion this year, and the first disbursement is to be made ahead of the maturing bond obligation on May 19th. In return, the Greek administration has agreed to implement further fiscal austerity measures amounting to roughly €30 billion over three years, or 12.5 per cent of last year’s GDP.

Investors greeted the latest rescue operation with less than resounding enthusiasm, and fears that the €110 billion package is insufficient and merely postpones an inevitable debt restructuring continue to dog the markets.

This is evident from movements in the yields on Greek debt across the maturity spectrum; short maturities registered a meaningful rally given the substantially reduced risk of a near-term default, but longer maturities failed to stage a meaningful recovery.

The concerns seem justified.

First, the rescue operation covers the Greek’s funding needs for up to two years, but the country could return to the market far sooner if the austerity measures do not proceed according to plan.

The proposals envisage a cumulative deficit of roughly €50 billion over the next three years, which combined with around €70 billion of maturing bond obligations, absorbs the entire loan proceeds.

Throw in the roughly €30 billion required to roll-over short-term debt and given some slippage in fiscal tightening, Greece could well be in need of help again by the end of 2011.

Second, it remains to be seen whether the Greeks have truly bought into the tough medicine that they are required to take.

The rhetoric so far has been less than convincing, and the resolve to implement measures that will ensure real GDP does not return to pre-recession levels until 2017 is lacking. Social angst is already high, and investors have every reason to be sceptical given the Greek’s track record – the country has defaulted five times since it gained independence from the Ottomans, and successive governments have failed to achieve budgetary balance since 1972 and the “Regime of the Colonels”.

Investors should be clear that the Greek rescue operation is a disguised attempt to shore up the major French and German banks that lent heavily to the ailing nation.

The probability of default is still high, and the remaining piglets – Portugal and Ireland – have reason to be nervous.

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