WHAT HAPPENS IF GREECE DEFAULTS?
(A scenario analysis of how it could play out)
Introduction
In recent weeks speculation has been heightened that Greece will default imminently. Since
the second bail out for Greece was agreed at the end of July, contagion has spread to Spain
and Italy and then France, as well as draining confidence from the banking system in the
Eurozone that has led to fears over the banks’ liquidity and solvency. This has prompted a
response from central banks with, firstly, the ECB reopening its securities market programme
(SMP) and buying Spanish and Italian bonds to bring the yields down and, secondly, a joint
operation by several central banks, including the US Federal Reserve and the Bank of
England, to provide dollar liquidity to the beleaguered European banks. An illustration of the
recent contagion to the banking sector in addition to the larger periphery countries is shown in
the chart below of the Intra-European bank spreads:
While these actions have brought some short term relief to markets, there remains a
paralysing fear of default within markets. The yields on Greek bonds say as much with the
yield on a bond due to mature in March of next year climbing to well over 100%! The actions
of the ECB have only been partially successful and after initially falling from over 6% to below
5%, the yields on Italian bonds, the country seen most at risk, has risen to over 5.7% again.
Acute financial stress also remains in the banking system despite the provision of liquidity by
the central banks and there have been several rumours about the solvency of some of the
French banks because of their relatively large holdings of periphery debt.
Investors are now speculating that something has to give. The policy makers have
consistently failed to deliver decisive leadership reflecting the divisions between them. Events
in the markets are now the primary factor in determining the outcome to the crisis. In chess
parlance, we are in the ‘end game’ but there are many possible outcomes of which some are
benign and some would be hugely disruptive for markets analogous to the aftermath of
Lehman’s demise 3 years ago.
The most likely trigger for the debt crisis to reach its climax would be a default by Greece.
This note considers the possible scenarios that could take place and what it would mean for
the Eurozone and world markets. Prima facie, there are 4 possible ways Greece could
default: It could have an orderly default within or by leaving the European Monetary Union
(EMU) or a disorderly default within or via an exit of the EMU. These possibilities will be
examined in turn while taking into account their respective probabilities. Before analysing the
nature of the default it is important to look at why a Greek default is, in my view, inevitable (it
is how and when that is uncertain) and why the current strategy adopted by the policy makers
is doomed to failure and whether they are likely to change it. Assessing the current situation is
as much about determining the likely course of human behaviour from the policy makers,
based on past experience, as to what should and could be done to alleviate the crisis. Much
analysis has put forward solutions that appear attractive, feasible, and, in some cases,
idealistic but are unlikely to transpire because of the inability of the authorities to take such
bold decisions. By recognising and factoring this into the analysis I believe it is possible to
give a more realistic appraisal of the likely outcome.
Why the Eurozone and EMU has not worked and Greek default is inevitable
Last week President Sarkozy of France and Chancellor Merkel of Germany met with the
Greek PM. Following the meeting they put out a joint statement that ‘Greece remains an
integral part of the Eurozone’. Given how much trouble Greece has and continues to cause to
the currency union it may appear that such a statement was one of political expediency to
reassure fretful markets. However, it goes beyond that. Merkel has also stated that ‘if the
Euro fails, Europe fails’. What she was alluding to was the amount of political and economic
capital that has been invested in the concept of a united Europe since it was founded in the
Treaty of Rome in 1957, 54 years ago. In this respect Greece is a core member of the
Eurozone. A monetary union was the natural progression and ultimate ambition of the
founders and it will not be sacrificed easily through the disorderly default of a relatively small
member.
For this reason, I believe that Eurozone politicians, especially Germany, will do their utmost to
preserve the union and the Euro currency. The formidable challenge confronting them is that
it cannot be maintained in its current form because the Eurozone was a fatally flawed concept
from the start. The ideal of a common currency for the members of the union is a convincing
one but to work efficiently it requires fiscal and political union as well as monetary union. As
has become only too apparent, there is a huge disparity between the economic performance
of the member states quite apart from the differences in language, culture, structural issues
etc. If a country such as Greece or Portugal is inherently much less competitive than
Germany, it needs an adjustment through a more competitive exchange rate; otherwise the
only way it can become competitive is by deflating its economy so there is a widespread fall in
prices and wages. Such austerity, however, can be self defeating as we are now witnessing in
the periphery countries, especially Greece, that has fallen into deep recession. Just as the
exchange rate is too high for the periphery countries it is undervalued for the stronger nations,
especially Germany that has benefited from an export boom because the Euro is significantly
lower than the Deutschemark would otherwise have been.
Therefore, the 2 most likely outcomes from the debt crisis is for Greece, and perhaps some of
the other uncompetitive periphery countries, to leave the Eurozone and restore their own
currencies to gain competitiveness or for the politicians to embrace fiscal union as a natural
corollary of monetary union. Before considering whether Greece, as the most vulnerable
periphery country, may quit the Eurozone, it is worth asking whether the Euro politicians are
likely to move towards a broader political and fiscal union.
Will the Euro policy makers change strategy and embrace fiscal union?
Although the Eurozone is a long way from full fiscal union it has progressed tentatively along
that path ever since the first Greek bailout was agreed in May 2010. The subsequent bailouts,
through the creation of the European Financial Stability Fund (EFSF) all represent pan Euro
fiscal measures. Money is being transferred to the weaker, insolvent periphery countries from
the stronger nations and as a quid pro quo the recipients have to implement strict austerity
packages that represent a loss of economic sovereignty.
The second Greek bailout in July of this year went further and has empowered the EFSF to
buy sovereign bonds in the secondary market and also help recapitalise the banking sector.
More recently some influential voices have publicly called for greater fiscal harmony. These
include representatives of the ruling coalition in Germany in direct opposition to Merkel and,
most significantly, the President of the European Commission (EC), Jose Barroso, who
floated the idea of a Eurobond last week. The chart below shows the progress towards
greater fiscal harmony (mutualisation) since the crisis began with speculation as to how it
might end if there was fiscal union:
However, developments thus far are a long way from full fiscal union and represent ad hoc
measures designed to contain the crisis rather than fundamental reform. For full and effective
fiscal union to take place there would need to be recognition that the resources of all the
members should be pooled together through the transfer of wealth from richer to poorer
countries. To enable this to function efficiently it would be necessary to set up central treasury
functions to harmonise fiscal and budgetary policy as well as a creating a mechanism for
jointly guaranteeing the debt, probably through a Eurobond, as Barroso suggested. The
Eurozone would then truly be a United States of Europe and over time, if applied correctly, it
could lead to a real monetary union supported by members that more closely aligned in their
competitiveness. Do the politicians have the will or the means to achieve this?
Unfortunately, the political hurdles to achieve full fiscal and political union are huge even if
there is now more sympathy to the idea within the Eurozone. Firstly, it would require
significant amendments to the existing treaties that would require ratification by the
legislatures of the respective members. The drafting of the new laws would encounter many
obstacles and, even if successful, would take many months, if not years, to fully implement.
Secondly, and of more immediate relevance, there is still considerable opposition to the
notion of fiscal unity, not least from Germany, the driving force in shaping new policy.
For the stronger countries such as Germany, the concept of fiscal union allows the weaker
and more profligate countries to benefit from a transfer of wealth that is unfair and, to much of
the population in the core nations, politically unacceptable. This is tantamount to moral hazard
whereby the periphery countries will be safe in the knowledge that their liabilities are
underwritten by the stronger members and there would be no incentive for them to put their
house in order. Why should the Germans and other core nations subsidise countries like
Greece that have, and continue, to run inefficient and corrupt economies? In the weaker
countries it would mean a cessation of economic sovereignty that would also be difficult to
accept domestically. As an example of the resistance to the loss of economic sovereignty, last
week the Irish government applied to the EU to amend the law so that its 12.5% corporation
tax rate could not be altered in the event of a move towards fiscal union. Ireland has always
regarded a change its low corporate tax rate as non negotiable while other countries,
especially France, believe it to be unfair in the context of an economic union. Such inflexibility
on both sides is typical of this crisis and illustrates the political impediments to progress.
Such discord will make it very difficult to reach an agreement on the nature of fiscal unity with
the governments of the respective members ultimately answerable to their electorates which,
in many cases, are strongly opposed to closer fiscal cooperation. Ultimately, there is more
loyalty on a national than on a pan-European basis. Furthermore, there are legal obstacles to
a fiscal union. Recently, the German constitutional court voted to approve Germany’s
contribution to the EFSF but only because it was a temporary measure. It prohibits the
government from entering into arrangements that involve permanent liabilities to other
governments. This will render the creation of a Eurobond illegal under the German
constitution even if the ruling party does support it, which is not the case at present.
Therefore, there are seemingly insurmountable hurdles to overcome if a dream of full fiscal
union is to be realised. Although policy makers are moving towards greater fiscal coordination the ad hoc arrangements that are being created are not sufficient to deal with the
crisis following the spread of contagion to Spain, Italy, France and the banking sector. The
authorities are moving towards fiscal union, with reluctance, in small baby steps when it
needs a giant leap forward taken with alacrity on a pre-emptive basis. The decision by the
German constitutional court shows that positions are as, if not more, entrenched than before
the second Greek bailout and so it seems reasonable to assume a benign outcome to the
debt crisis is very unlikely in the short term. On this basis, the note will now examine the
different scenarios involving a Greek default that represents a more probable outcome to the
crisis.
THE 4 SCENARIOS OF GREEK SOVEREIGN DEBT DEFAULT
Scenario 1
An orderly default while remaining in the EMU (10% probability)
This would be the ideal scenario and, with Greece’s default now inevitable, it is what the
policy makers will be discussing behind closed doors. The idea would be to provide Greece
with a sustainable debt profile by cutting the size of the debt in nominal terms and flattening
the maturity profile. However, the real challenge is to how to allow Greece to default while
preventing further contagion to other periphery countries and the banking sector.
As part of the second bailout, Greece was granted some debt relief. However, it was a
complicated deal skewed in favour of the creditors and only provided some 21% reduction on
the overall debt burden. Furthermore, it relied on voluntary private sector participation that
has not been forthcoming. The size of the Greek debt burden (over €300bn) would demand
write-offs of between 75-90% of the principal for the creditors that is normal in the event of a
‘hard’ default. Greece is forecast to have a debt/GDP ratio of about 160% at the end of 2011
that is expected to rise steadily towards 200% by 2014. The annual deficit to GDP ratio is well
above the agreed target of 7.4% at 10.5% and is now also increasing because the economy
is deep in recession (GDP is forecast to fall 5-6% in 2011 with unemployment of 16% and
rising).
One of the problems in a Greek default under the umbrella of the EU is that over 90% of debt
is governed by Greek law and it is difficult to compel participation in a debt restructuring
package without changing the local law. As we have seen with the second Greek bailout there
is already resistance by private creditors to voluntary participation. Coercive measures could
be used such as making non-tendered bonds ineligible at the ECB repo discount window but
the legal question could be a further impediment to an effective debt default deal negotiated
by the policy makers.
In any event, debt restructuring will have to make swingeing cuts to Greece’s debt burden but,
even more importantly, if the default is to be orderly, simultaneous measures will have to be
taken to limit contagion elsewhere. The recent spread of contagion to Spain and Italy has
made it much more difficult to achieve an orderly solution within the EMU. If Greece does
renege on its debts, the markets will naturally expect that the other periphery countries will be
vulnerable to default because the taboo has been broken. Italy is particularly vulnerable as it
has many of the hallmarks of the Greek economy with a high debt/GDP ratio (121%) and an
inefficient and corrupt tax system run by a government lacking in popular support. The ECB
continues to buy Italian bonds but the yields have recently climbed over 5.5% and, as the
graph below shows, the CDS are at record highs.
Source: Collins Stewart
To achieve an orderly default the politicians will have to devise a strategy that effectively ring
fences the periphery countries and implement plans to stand behind the banking sector that
would also be vulnerable on increased fears of insolvency. On the first point it will take much
more firepower than the ECB is currently displaying to stabilise the bond markets. This could
come from either the ECB conducting unsterilized purchases of bonds (i.e. full QE that
increases the money supply) or the EFSF could have its capacity raised from its existing
borrowing limit of only €440bn (of which less than €300bn is left). This could be further
enhanced by empowering the EFSF to act like a bank by leveraging its asset base that would
multiply its firepower. The table below illustrates the magnitude of the debt problem within the
periphery countries and where it is held both regionally and by institution:
The notion of full QE by the ECB will remain a last resort that will only happen if the financial
system is on the brink of breakdown. It goes totally against the philosophy of the Bank and
the recent resignation of Jurgen Stark, a member of the ECB committee, over the
controversial purchase of sterilised bonds shows how far the ECB is from doing something as
radical as QE. The ECB has stated it is only acting on an emergency basis because of the
stresses in the financial system. These include greater use of the central bank’s liquidity
windows as well as a sharp increase in the amount of deposits posted at the ECB by
commercial banks:
On the question of increasing the resources of the EFSF, this is more feasible but is not
included in the enhancements to the bailout fund as part of the second bailout. Germany
remains adamantly opposed to the idea as it will encourage moral hazard from the weaker
countries that will continue to act irresponsibly in the knowledge they are going to receive
financial help (similar to the objections over the Eurobond). To gear up the EFSF would also
require complex treaty amendments and the involvement of the ECB to refinance the EFSF’s
bond purchases that it is unlikely to agree to.
As well as agreeing measures to stabilise the bond markets of the other periphery nations,
the Euro politicians would also have to provide support to the banking sector in the event of a
Greek default. The modest write-offs of Greek debt following the second bail out highlighted
how vulnerable the Euro banking sector is to a default. Subsequently, there have been
rumours about the solvency of some French banks that are the most exposed to Greek debt
(It owes more than €29bn to French banks). The share prices of bank shares have
plummeted across Europe in the last 2 months and CDS are at record levels. This has led to
a funding crisis that the ECB with other central banks have attempted to alleviate by providing
a liquidity guarantee until the end of the year but this does not change the solvency issue of
widespread holdings of periphery bonds that have not been written down to anywhere near
market prices in the banks’ balance sheets. The following table shows the cross country
exposure and underlines that the problem would not be confined to Europe in the event of a
banking crisis:
To provide assistance to the banks the authorities in the Eurozone would have to announce
plans to recapitalise the sector via the public sector. The respective countries could announce
a recapitalisation plan similar to the successful Troubled Asset Relief Program (TARP) in the
US following the credit crisis in 2008. Certainly there appears to be more willingness to
address the problems of the banking sector than the sovereign debt of the countries, as
evidenced by the liquidity guarantees in place, and individual countries would not be
encumbered by the discord and wrangling of making multi-lateral decisions. However, a
rescue of the banking sector would retard the already faltering recovery of the Eurozone and
would also add considerably to the public debt burdens of the respective countries.
In conclusion, a stable and orderly default by Greece within the Eurozone appears
unworkable within the current framework. In particular, it will prove difficult to contain
contagion to other periphery nations without radical policy measures that the policy makers
lack the will to implement or even agree upon. As with the move towards full fiscal union, the
political obstacles are too great to envisage the quantum change that is needed to the
existing strategy in order for it to succeed.
Scenario 2
An disorderly default while remaining in the EMU (65% probability)
I believe this is the most likely outcome to the crisis. As explained above, the determination to
preserve the Euro project and currency is such that the authorities will do everything to
prevent a fragmentation of the union that would represent failure, something that is
unacceptable, as Merkel made clear in her statement: ‘’if the Euro fails, Europe fails’’.
However, the politicians do not have the cohesion or willpower to implement the fundamental
and far reaching reforms to create an orderly default (Scenario 1).
There is currently febrile speculation that Greece may default imminently because it will not
receive the 6th tranche (€8bn) from the original bailout last May. The troika (EU, IMF and
ECB) that monitors Greece’s progress in implementing its austerity measures has expressed
dissatisfaction with what has been done and threatened to withhold the payment, pending
further commitments. For instance, there has not been one privatisation to raise funds which
was seen as an integral part of the austerity programme (it is meant to raise €1.7bn through
the privatisation programme by the end of September) and no public sector workers have
been laid off in the bloated government departments. Last week the Greek government
announced a new property tax to be levied on households via the electricity bills and this has
partially placated the creditors but more needs to be done.
I still believe that a compromise will be reached and Greece will receive the funds in early
October because of the adverse consequences of not disbursing the money. This will buy 3
more months of time (the next tranche is due in December) for measures to be drawn up in
order to more effectively deal with the default when it comes. Importantly, by December the
new powers that were granted to the EFSF at the time of the second bailout should be
operational by then after being ratified by the national parliaments.
Although a deferral of a Greek default may provide some solace to markets I do not believe
that the troika will announce sufficiently bold policy measures to avert contagion. An orderly
default within the Eurozone may have been possible if contagion had not spread to Spain and
Italy but the policy makers’ prevarication has cost them dear. The key to the extent of
contagion will be what happens to Italy. Italy has a debt/GDP ratio of 121% and it is the
magnitude of its debt of roughly €1.9trillion that has unnerved markets. This means that Italy
has significant refinancing risks with about €380bn of bonds needing to be rolled over by the
end of next year (see chart below):
The Italian government has been resistant and tardy in passing new budgetary measures to
deal with its liabilities and the market has sent a clear message through the inexorable rise in
its bond yields and CDS (see graph above). The benchmark bond yield is 5.7% despite heavy
intervention by the ECB to buy Italy’s debt and is approaching the 6% level again where it is
regarded as unsustainable. As the bar chart below shows the yields of Ireland and Portugal
are already well above that level:
Source: Strategas Research
If contagion does continue to spread to Italy and beyond, the European banking system will
immediately be impacted. It is well known that under the current constitution of the Eurozone,
Italy is too big to bail out and the level of debt held in many European banks would render
them insolvent if it was written down to market value. I would expect the authorities to preempt an official default by Greece with an announcement of some plans to recapitalise the
banks in the event of a financial panic as well as plans for structural reforms to help restore
competitiveness in the periphery nations. This would be a further step towards fiscal
integration but does not represent the radical policy measures such as the creation of a
European Monetary Fund of full QE by the ECB to effectively contain the crisis.
Although there might be some short term relief on the news that the boil has been lanced,
especially if preceded by or accompanied by plans to provide more capital to the banks and
some necessary structural reforms, it would not be sufficient and prove temporary. Such a
response would be another example of the politicians being reactive and doing enough to
deal with the immediate aftermath of the next chapter of the crisis but not addressing the
longer term issues necessary to provide a sustainable solution to the Eurozone problem. For
this reason, despite the authorities’ efforts to contain the crisis, the outcome would be
disorderly.
Scenario 3
An orderly default while leaving the EMU (5%)
I regard this as the least likely scenario. Put simply, if it is unlikely that Greece can achieve an
orderly default under the aegis of the EU, then it is going to be much more difficult to do so
without the support of the troika.
An external default would happen in one of two ways. Either the troika refuses to financially
support Greece, as it is currently threatening to do, and so it runs out of money, or it decides
unilaterally to default. As discussed previously, I think it is probable that Greece will receive
the next tranche of its bailout money in October that will secure its finances until December.
However, if it once more fails to deliver on the austerity measures agreed with the troika in 3
months time a forced default via the authorities would be much more probable. If Greece was
exonerated again in December it would undermine the credibility of the policy makers as well
as encouraging moral hazard by showing that it is not necessary to comply with the conditions
of the bailout to receive the money.
If Greece were to default on a unilateral basis without the blessing of the troika it would be
because it would have collectively decided that the cost of staying within the Eurozone
exceeded the cost of withdrawing. To date, it has been rational for Greece to remain in the
union because it continues to receive financial assistance that would be denied it and the
consequences of withdrawing would be even worse for the economy than the effect of the
austerity programme. However, after almost a year and a half the population is suffering from
bailout fatigue as the economy has gone from bad to worse with rising unemployment, lower
incomes and less spending power. Popular discontent has grown and the ruling Pasok party
may be forced into an early election. This could be the trigger for a new government to be
elected with a fresh mandate that is the catalyst for Greece to withdraw from the currency
union.
What would be the consequences of unilateral default either from within or without the
Eurozone? Some commentators, such as the economist Nouriel Roubini, have argued that
Greece could have an orderly default by leaving the union. Such optimism is partly based on
the recent experiences of other countries such as Iceland in 2007 and Argentina in 2001 and
further back the revival of various economies following departure from the gold standard
between the wars. Both Iceland and Argentina, after a period of adjustment, have performed
economically better than before their respective currencies were devalued but this overlooks
the enormous short term disruption that such devaluation can cause both from a socio and
economic view. It would be much more difficult for Greece to make the adjustment because of
its current ties to the Eurozone and its currency.
An orderly transition via an external default would require perfect execution to, firstly, limit the
contagion to other periphery countries within the Eurozone and its banking sector and,
secondly, to limit the damage to the infrastructure of Greece and its people. After Argentina
defaulted the devaluation of the peso led to roaring inflation, riots on the streets (including
deaths), a domestic banking crisis and mass unemployment. It has been argued that
measures could be taken to limit the devaluation of the drachma as well as support for the
banking sector that would otherwise collapse and internal structural reforms to aid the
domestic economy. To achieve this, while at the same time implementing the radical policy
measures to contain contagion to the Eurozone and the global financial system, is wishful
thinking. If Greece defaulted markets would pronounce their verdict instantaneously whereas
one important lesson from the crisis is that policy makers move at a snails pace.
Scenario 4
An disorderly default while leaving the EMU (20% probability)
This is the scenario the markets fear the most and is the second most likely to occur. The
probability of it happening has increased with the passage of time and especially since the
contagion spread to the larger periphery countries. Furthermore, the current wrangling over
the 6th tranche of the original bailout as well approval of the second bailout has raised the
stakes in the short term.
As explained in the previous scenario, it will be very difficult to achieve an orderly default if
Greece goes it alone and returns to the drachma. The example of Argentina shows how dire
the consequences can be from a disorderly default. For Greece, it could be worse because it
is tied to the Eurozone and will have to deal with the difficulty of escaping that legacy. A
devaluation would cause the drachma to fall at least 50% against the Euro and depreciate the
value of assets currently held in Euros. The fear of default is already leading many Greek
businesses and citizens to withdraw money from Greek banks (see graph below). However,
Greece’s liabilities would still be denominated in Euros and it is likely that many businesses
would go bankrupt as a result and the banking system would fail as the default triggers a run
on the banks. With regard to Greek bonds the creditors would lose billions of Euros directly
but the effect of contagion would significantly diminish the value of their debt holdings in other
periphery countries.
Following a disorderly devaluation it is likely that the current recession would threaten to
become a depression as public sector employees did not get paid, the banking system broke
down and unemployment soared from already elevated levels. Even if Greece was able to
restore growth to its economy it would become a pariah in the international bond markets and
they would find it difficult, if not impossible, to raise the necessary funds to finance its
activities from external investors. It would also be much more difficult for Greek private
entities to raise capital.
However, the real danger from a market and international perspective is what the
ramifications of a default would be elsewhere. Significant contagion to other Eurozone
countries and the banking sector would spread, and with the level of periphery debt (including
Spain and Italy) exceeding the amount outstanding following the demise of Lehman’s in 2008
it is possible to envisage another financial crisis on that scale. The authorities, despite their
record thus far, will be well aware of this risk which is an important reason as to why I think
that default will happen within the Eurozone.
Conclusion
The defining feature of the Eurozone sovereign debt crisis has been the absence of decisive
policy action that has allowed it to develop to such an extent. In essence, the crisis is about
the irresistible force of the markets against the immovable object of politics. While domestic
political considerations continue to override the broader Eurozone economic objectives it is
likely the policy action will remain inadequate.
That said, there remains the political will to preserve the Eurozone and its currency. The
status quo can be kept going for longer than the markets and most commentators now think
and in 2013, with the creation of the European Stability Mechanism (ESM) as the successor
of the EFSF, there will be an institution that has a sovereign debt restructuring mechanism as
an integral part of its constitution. Unfortunately, markets are unlikely to be that patient and
the end game is likely to play out well before then. The above analysis suggests a disorderly
default is likely but within the confines of the existing architecture of the Eurozone. For
markets this should produce a short tem rally before contagion spreads once and forces a
more comprehensive policy response.
Ted Scott September 2011