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This week we address an issue that puts the credibility of the euro and European institutional arrangements on the line: Greece’s sovereign debt crisis. At their January 18, 2009, meeting, eurozone finance ministers kept pressure on Greece to fulfill its commitment to cut its budget deficit below 3% of GDP by 2012. In February, the eurozone finance ministers will more fully evaluate the country's spending plans and recommend a timetable for Greece to trim its deficit, estimated at close to 13% of GDP in 2009. Because the eurozone is a monetary union with a no-bail-out clause, rather than a political or fiscal union with the associated fiscal federalism, budget cuts to contain the explosion of Greek public debt are urgently needed. In 2010, a sustainable fiscal adjustment must be delivered to restore policy credibility, market confidence and ECB/EU member-state solidarity. In RGE Analysis available to clients, we discuss possibilities for such an adjustment in greater depth.
Three coinciding events—Greece’s sharp budget deficit revisions from as low as 3.7% of GDP to 12.7% in October, the announcement of the beginning of the ECB’s exit strategies and the Dubai default—have triggered renewed risk aversion in the sovereign bond markets of developed countries. While in March spreads were broadly driven by a common systemic risk factor, the latest spike bringing Greek yields and CDS spreads to new highs is mostly a country-specific story, brought to light by a change of government and the revelation of far larger budget deficits than previously known and a severe cyclical and structural deterioration in public finances.
In tackling the deficit, Greece faces a Hobson’s Choice: whether to accept social pain with financial and economic stability, or instability. Whatever it chooses, Greece will face economic pain and difficult socio-political fallout. More aggressive spending cuts or tax hikes than initially envisaged in the stability program Greece presented in December could curb or even derail recovery, perhaps inciting social unrest. But if the debt becomes unfinanceable in the primary market or if Greece elects to exit the euro and devalue and redenominate its liabilities (a la Argentina), this could render its banking system insolvent and tip it into economic and financial isolation and decline, also with dire socio-political consequences.
While a buyers’ strike has been averted for now with Greece’s successful auction of five-year government debt at 6.2%, the additional yield investors requested was substantial. The possibility of a buyers’ strike in the primary market in the future may further test Greece’s political commitment to fiscal adjustment and economic stability, as demanded by its treaty obligations and the strictures of a currency union.
Going forward, once Greece has delivered what the EU Commission, ratings agencies and stakeholders in the markets judge to be an adequate pound of flesh, we expect the ECB to take on a more constructive stance, especially in view of the stricter collateral requirements that will be put in place by the end of 2010. The risks of not doing so would entail a judgment that Greece could, in theory, be surgically removed from the eurozone without starting a domino effect in other countries with high or escalating public debt burdens, some of which are far larger economies and hence could have an impact on the regional and global financial and economic systems. Alternatively, a sovereign upgrade to A- by two ratings agencies after the budget effort meets approval could also be part of the solution.
The endgame we expect is the extraction of a pound of flesh and a bit of a fiscal compromise that together restore debt sustainability. This will require a combination of further sharp fiscal adjustment, a la Ireland (which has committed to cut public spending in 2010 by €4 billion, or about 20% of the 2009 deficit), and a signal of support from the ECB. In response, improved signals from the ratings agencies will bring cash bond yield spreads back down to earth. Over the longer term, of course, there is no alternative to tackling the competitiveness deficit in Greece and in other member countries as well.
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