Greece: awaiting the inevitable

The credit default swap market is pricing in a 65% probability of a default within the next five years.

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Last week the strains of the eurozone were all too apparent as attention turned back to Greece. The bond markets gave a particularly bleak verdict, with two-year bond yields exceeding 25% while the spread of ten-year bonds over German Bunds reached 16%. Meanwhile, the credit default swap market is pricing in a 65% probability of a default within the next five years.

The EU/IMF programme called for Greece to return to the bond markets in 2012 with long-term debt issuance of EUR 25bn. But current market pricing suggests investors are not impressed with what they see. The fiscal deficit targets were missed in 2010, with the actual shortfall of 10.5% of GDP well above the original deficit target of 8%. The primary balance (which excludes the cost of servicing existing debt) was double the target at 4.9% of GDP. As a result, gross debt has ballooned to 143% of GDP and prospects to meet the 2012 target of a primary budget surplus look forlorn.

Public debt is set to rise further to 160% of GDP by 2012, if not before, and it is unlikely that the Greek government can gain access to funding at interest rates that are not usurious. At current bond yields of 15.5%, and assuming a trend growth rate of 2% and an inflation rate of, say, 1% (reflecting that the periphery would have to deflate relative to the rest of the region to regain competitiveness), then to stabilise this debt burden at 160% of GDP would require a primary budget surplus of close to 20% of GDP. This would be unsustainable. But even if Greek bond yields could be reduced to Spanish levels (of 5.5%), the required primary surplus would still be close to a demanding 4% per annum. Even at this level we suspect that the political will to endure so many years of austerity would not be there.

The choice for Greece is therefore unappealing: ongoing official transfers from other eurozone governments at concessionary rates of interest, or some form of restructuring (which looks to be the most likely outcome). The worry is that any pain from a Greek restructuring or default would not be limited to Greece, with approximately two thirds of Greek public debt held by foreigners. The size of any haircut to stabilise debt ratios would have to be sizeable, with BarCap calculating that a reduction in the debt / GDP ratio to 60% by 2050, with the primary surplus at 4% of GDP from 2015, would require a haircut of 45% – enough to wipe out about three quarters of Greek banks’ capital, while causing considerable damage to French and German banks that hold sizeable amounts of Greek bonds

The key issue is when any resolution will occur. An early resolution would remove the uncertainty, but it would hurt Greek and other eurozone banks, thereby adding to the likely recapitalisation costs. A delay, however, could find the other periphery countries being dragged into this crisis, perhaps including Spain. Expect a series of rolling crises in Europe, with the euro being the lightning rod for the region’s economic stress.

David Shairp May 2011

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