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Dec 11, 2009 | 12:01 GMT

8 mins read

Greece: A Looming Default?

JEAN-CHRISTOPHE VERHAEGEN/AFP/Getty Images
Summary
Greece's credit rating was downgraded from A- to BBB+ by Fitch Ratings on Dec. 8, due to concerns over the country's debt levels. A number of other eurozone nations, however, are facing fiscal situations nearly as difficult as Athens', and the European Union may decide to make an example of Greece to encourage other high-spending nations to cut their debt levels.
Financial rating agency Fitch Ratings downgraded Greece's long-term foreign currency and local currency issuer credit ratings to BBB+ from A- on Dec. 8, citing concerns about the country's rising budget deficit. This is the first time since Greece joined the eurozone that it has been downgraded below an "A" grade rating. Meanwhile, rating agency Standard & Poor's warned Dec. 7 that Greek banks faced the highest long-term economic risks in Europe. Economic problems in Greece are causing investors to worry that the entire eurozone could become destabilized. Indeed, one day following the Greek cut, Standard & Poor's cut Spain's debt outlook from AAA to AA+. The growing Greek budget deficit and total government debt will be a subject of discussion at the European Central Bank's (ECB) Governing Council meeting on Dec. 17. Faced with the possibility that it will be made an example of by the European Union as a way of sending a message to other big spenders in the EU like Ireland, Italy, Portugal and Spain, Athens is staring at difficult budgetary cuts for 2010.

Roots of the Crisis

Greece is considered one of Europe's most notorious overspenders. Even prior to the current crisis, it was fighting high budget deficits, primarily caused by high social spending, a symptom of the country's ever-present social tensions. The government's liabilities on the pension system and through ownership of unprofitable enterprises, such as Olympia Airways, have been difficult to jettison due to the threat of unrest, which flares up whenever Athens tries to rein in spending. Total government spending on social programs represented almost 20 percent of gross domestic product (GDP) in 2008, the highest percentage in Europe and one that has risen almost every year since 1997, when it was 13.9 percent of GDP. This is higher than even Italy (17.7 percent of GDP) and France (17.5 percent of GDP), the two traditional big spenders in Europe. Because of the large public debt and the increasing deficit, the government has often turned to methods such as fudging statistical reporting to the EU in order to avoid disciplinary measures from Brussels. The ouster of center-right Prime Minister Costas Karamanlis by his leftist rivals, the Panhellenic Socialist Movement (PASOK) in early October continues the cycle of wild swings in Greek politics. PASOK has pledged to not cut any social spending for the poor and instead increase taxes on the rich, as well as crack down on tax evasion (a notorious problem in Greece) to reduce the budget deficit. Despite an expected decline in GDP for 2010, PASOK is forecasting an extremely unlikely 9 percent gain in revenues — which means that in all likelihood the current budget imbroglio is only the beginning.

Greek Banking Troubles

In the background of the country's perennial spending problems are the troubled Greek banks. STRATFOR cautioned about the Greek banking system at the onset of the current global financial crisis. As the Baltic states and ex-communist Central European states entered the European Union, Austrian, Italian and Swedish banks looked for new markets where they would have an advantage over their larger German, French, British and Swiss counterparts. They found that advantage in their former geopolitical spheres of influence, with the Austrians and Italians entering the Balkans and Central Europe, and the Swedes entering the Baltics. European banks offered foreign-denominated currency loans — mainly in euros and Swiss francs — that carried with them lower interest rates than domestic currency loans. Because they were the latecomers to this game, Greek banks had to be particularly aggressive, using ever-lower interest rates to attract clients and undercut the more resource-rich Italian and Austrian lenders. Greek banks also had to rely much more heavily on foreign-denominated currency loans because their domestic deposits were much smaller than those of Austrian and Italian banks (a strategy similar to the disastrous banking methodology employed by Icelandic banks. Greek exposure, particularly to the Balkans, is therefore troubling for the overall economy. The fear is that, unlike the larger Italian and Austrian banks, Greek banks will not be able to refinance loans or absorb losses of affiliates abroad. Greek banks have thus far drawn around 40 billion euros of cheap credit from the ECB, out of a total of around 665 billion euros extended to all eurozone banks. This represents between 6 and 7 percent of total ECB outstanding liquidity, much higher than the Greek share of EU economy (2.5 percent), and puts Greek banks second only to the Irish in terms of dependence on ECB emergency liquidity. Due to the overall effects of the crisis, the yield spreads between Greek and German bonds (considered the safest government debt in the eurozone) have widened to 246 basis points on Dec. 9 (from 75 basis points in September 2008 before the current economic crisis struck).

The Road Ahead

The road ahead is not going to be easy for Greece. There are a number of options, but all are bad. First, the Greeks could "simply" balance their budget. To do this they would need to slash their government spending by over half. That sort of cut would easily send unemployment above 20 percent for a sustained period of time. At a minimum this would set the country afire in a storm of protests and result in a series of revolving-door governments. This may sound normal for Greece, but the political and social chaos of the past is the country's baseline. Just imagine what it would look like under austerity measures. Second, Greece could leave the eurozone. Membership in the eurozone requires surrendering control over one's currency. Leaving it would allow Greece to print currency to pay off the debt, triggering inflation which would eat away at the remaining debt's value. Such a move would also devalue the Greek currency, giving Greece a trade advantage globally. Such measures were commonplace in European countries more powerful than Greece in the time before the euro. The downsides, however, make this a startlingly unattractive option. Greece would suddenly find it next to impossible to raise funds. Many are willing to invest in Greece's euro-denominated debt, but very few would be willing to invest in the drachma-denominated debt of a loan-dodger. Greece could well find itself broke, cut off from capital markets, and spiraling into hyperinflation. And even that is assuming that the rest of its former euro colleagues don't take its decision to jump ship personally. Third, while STRATFOR doesn't see this option as viable, Greece could simply walk away from the debt and default. Such an action would sever Greece from capital markets — including simple things like trade financing even within the European Union. It would lay a very sturdy foundation for the utter destruction of Greece as a modern economy. STRATFOR only sees discussion of this option as a means of pressuring other European states to bail Greece out. After all, a Greek default would instantly translate into much higher borrowing costs for other eurozone states — most notably Ireland, Portugal, Spain, Italy, and France, roughly in that order. The only way these states could then recover financially would be to face the same gamut of choices Greece is currently facing. As all are more socially stable than Greece, most would likely raise taxes, and the result would be lower growth, higher interest rates and lower inter-European trade. If the EU can do something to avoid a Greek default, they'll do it. Which leaves this final option — some sort of external assistance. Unlike many other states that have sought assistance, the International Monetary Fund (IMF) is not a likely source of significant help. In addition to the austerity measures it would demand being extremely unpopular, the non-European members on the IMF's board are unlikely to look kindly on bailing out a member of the eurozone. That leaves an internal European bailout. Here the obstacle is Germany. The Germans feel that they have already bailed out all of Europe — twice (once by absorbing East Germany without a cent of assistance from the rest of the Continent, a second time in absorbing so many small and weak economies into the eurozone which Germany underwrites). If Germany is to sign off on a Greek bailout, therefore, it will only be under terms which give EU institutions an unprecedented ability to regulate Greek finances. Since Athens has already signed away monetary policy in order to accede to the eurozone, all that is left is budgetary control. The question is how the left-wing government of new Prime Minister George Papandreou will handle the inevitable social pressures that will accompany any attempts at budgetary cuts, especially ones being dictated by Berlin. His predecessor, Karamanlis, faced these same pressures during the December 2008 rioting, and ultimately buckled under the pressure. The one year anniversary of the December 2008 rioting was marked by unrest in Athens, foreshadowing the potential for more social angst in Greece in 2010.

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