AFTER simmering for months, the Greek sovereign-debt crisis has boiled over. The promise of a rescue by the IMF and the country’s euro-zone partners, worth €45 billion ($60 billion) or more, is no longer enough to persuade many private investors to hold Greek public bonds. Opposition to the bail-out in Germany meant that market confidence had all but vanished by April 27th, when Standard and Poor’s (S&P) slashed its rating of Greek government bonds to BB+, just below investment grade. The rating agency also lowered its rating on Portugal, to A-; a day later it downgraded Spain from AA+ to AA.
In keeping with its practice when rating bonds as junk, S&P gave an estimate of the likely “recovery rate” should the worst happen. It said bondholders were likely to get back only 30-50% of their principal were Greece to restructure its debt or to default. That prompted panic in bond markets. The yield on Greece’s ten-year bonds leapt above 11% and that on two-year bonds to almost 19% at one point on April 28th. Portugal’s borrowing rates jumped, too (see chart 1). At those rates, the racier sort of hedge fund might still be prepared to gamble on Greece paying back its debts at face value, but mainstream funds are abandoning the bonds in their droves. The speculators blamed by officials for precipitating the crisis may now be the only people willing to take a punt on Greece.
Had the rescue been swift and squabble-free, there was a chance, albeit slim, that private investors might have rolled over their existing holdings of Greek debt at tolerable interest rates. That Greece’s would-be rescuers may not after all stump up the money they promised is one of the risks that bondholders are loth to bear—though Germany may now approve its share of the bail-out by May 7th (see article). Another is that Greece will not be able to stomach the programme of budgetary and economic reform which the IMF is due to set out in early May, and on which the euro-zone rescue funds will depend.
A third concern is that even if the programme runs smoothly, the debts that Greece will continue to rack up will be too great for its feeble economy to bear. Earlier analysis by The Economist suggested that Greek government debt would rise to 149% of GDP by 2014 even if its deficit reduction went well. It assumes that Greece could sustain a brutal reduction in its primary budget deficit (ie, excluding interest costs) of 12 percentage points. Even that relied on an interest rate of 5%, roughly what euro-zone partners have agreed they will levy on Greece, on all new borrowing and on maturing debt. If interest costs are much higher, the government will have to find extra savings elsewhere. The deep cuts will only prolong Greece’s recession. Wages will have to fall if the country is to regain the cost competitiveness needed for a recovery. Both influences will push down nominal GDP for a while and make crisis management all the more difficult.
The scale of the task and the bungling of the rescue make the bond market’s capitulation seem natural. Greece needs so much money that the only thing standing between the country and default is open-ended funding from the IMF and the rest of the euro area. The €45 billion fund announced on April 11th would be enough to cover Greece’s budget deficit and repay its maturing debts (including the €8.5 billion that falls due on May 19th) for the rest of 2010. But Greece may need as much again in 2011 and still more thereafter. In an average year, Greece has to refinance around €40 billion of its debt (this year, would you believe, is a mercifully light one for redemptions). Add to that the €70 billion or so of fresh borrowing that may be needed to cover Greece’s cumulative budget deficits until 2014 and the scale of a credible rescue fund becomes clear.
Yet Greece’s would-be rescuers may feel they have little choice but to press on with the bail-out. A default that would cut the value of Greek public debt by a half or more would cripple the country’s banks. (S&P has also downgraded four of them to junk status.) It would also spark a wider financial panic in Europe. Around €213 billion-worth of Greek government bonds are held abroad. The Bank for International Settlements (BIS) estimates that foreign banks’ lending to Greece’s government, banks and private sector was €164 billion at the end of last year. How much of this is public debt is unclear. But if half of the foreign holdings of government bonds are held by banks, and if each country’s banks owns those bonds in proportion to their total holdings of Greek assets, then perhaps €76 billion is held by euro-zone banks (see table 2).
Euro-zone countries might be tempted to let Greece default, force non-bank investors to take a hit, and use the funds earmarked to rescue Greece to fortify their banks instead. That would cost perhaps €53 billion if, as S&P fears, a restructuring of Greek debt resulted in losses of as much as 70%. That may look small next to a rescue fund. But if Greece defaulted it would still rely on its EU partners to fund its budget deficit, which will take time to shrink from the 13.6% of GDP it reached last year. It seems there are no longer any options for Greece that will not cost its partners a lot.
The risk of contagion
Other countries may now need a helping hand, too. The hope that Greece’s problems could be contained now seems faint. There is growing anxiety about the poor state of public finances in Portugal, Ireland, Italy and Spain. Each has some combination of big budget deficits and high public debt, though none is as financially stretched as Greece. But their deeper problem stems from a decade when wage growth ran far ahead of productivity gains. Stuck in the euro, they can no longer cure that malady by devaluation. The only remedies are a period of wage restraint combined with structural reforms aimed at boosting productivity. These will take time, as well as political will, to put in place. The danger is that restless bond investors will not wait.
Portugal is first in the markets’ sights. Its ten-year bond yield rose to 5.7% on April 28th, the highest for more than a decade, in the wake of the S&P downgrades and the anxiety about the size and timing of the Greek bail-out. A week earlier its yields were below 5%. Portugal could be forgiven for feeling picked on. Although its budget deficit last year was an alarming 9.3% of GDP, that was lower than Greece’s. Its public debt, at 77% of GDP last year, is less scary too. That is, in part, the result of a programme to slash the deficit in the years before the global financial crisis struck, and gives Portugal’s government a credibility that Greece lacks. On April 28th its prime minister, José Sócrates, said he and the opposition had reached agreement on speeding up an austerity programme.
Yet Portugal shares three weaknesses with Greece. First, its economy is small (smaller, indeed, than Greece’s), accounting for 2% of euro-area GDP. It offers investors very little diversification. Those who want safe claims in euros can simply lend to Germany or France, and save themselves any worries about Portugal’s economy and public finances.
A second weakness is competitiveness. Greece at least had a boom after it joined the euro in 2001. Portugal seemed to exhaust the benefits of the euro before the currency was born. It grew healthily in the late 1990s as its interest rates fell to converge on Germany’s in the run-up to the euro’s creation. But it has never recovered convincingly from the downturn that followed. GDP grew by an annual average of less than 1% between 2001 and 2008; productivity growth was weak. Nominal wage growth of 3% a year further undermined competitiveness.
Portugal has got by on a drip-feed of foreign capital. Its current-account deficit averaged 9% of GDP in 2001-08. The cumulative impact of those deficits is behind the third weakness it shares with Greece: the foreign debts that its firms, households and government have run up. The IMF reckons that Portugal’s net international debt (what residents owe to foreigners, less the foreign assets they own) was 96% of GDP in 2008, an even higher ratio than Greece’s (see chart 3).
A good chunk of the gross debt is held by foreign banks: The BIS puts the figure at €198 billion at the end of last year, around 120% of GDP (see table 4). The bulk of this has been borrowed by homeowners and businesses. The debt has to be rolled over from time to time, which makes Portugal, like Greece, vulnerable to a sudden change in sentiment. As with Greece, the bulk of public debt is held abroad and the country’s low saving rate means it too depends on foreign buyers of fresh debt.
Could contagion spread further? Spain looks most at risk. Its dependence on foreign finance is on a par with Greece’s. Spain’s public-debt burden, at 53% of GDP last year, means its fiscal position is among the least worrying of all rich countries’ (though an eye-watering deficit means that burden is rising fast). The country’s biggest task is to convince foreign investors that its economy will revive without further infusions of credit. Though Italy has a big public-debt burden, it can hope to rely on domestic savers to buy its government bonds. Its net foreign debts and current-account deficit are fairly small by rich-country standards. Much of the Irish assets held by foreigners are factories and offices, rather than bonds and loans, so Ireland is less prone to a sudden stop of overseas finance. It also has a good record of putting its public finances right.
Do the rumblings in Greece signal a wider retreat by investors from sovereign debt? Defensive Eurocrats point out that the public finances of the euro area as a whole are no worse than America’s. The IMF reckons that America’s net public debt will be 70% of GDP this year, against a euro-zone average of 68%. But the zone is not a single fiscal entity and investors are wary of countries whose finances or growth prospects are worse than average.
America has the great advantage of issuing the world’s reserve currency. In crises, scared investors rush into American Treasuries, which are prized for their liquidity. That is why Treasury yields fell this week as Greece’s soared. That hunger for American assets has lifted the dollar against the euro (and the yen, sterling and the Swiss franc) since the start of the year. That at least is some comfort for members of the euro zone. When countries accounting for more than a third of its GDP are struggling in export markets, that is exactly what they need.
