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Greek Rumblings

By Shashikant Singh | 7/18/2011 5:01 PM Monday

As was largely expected, the Greek Parliament agreed to some stringent austerity measures, securing the next tranche of 12 billion Euros out of the 110 billion Euros in aid that were granted last year. After little more than a year when Greece was on the verge of sovereign default, it once again stood at the same place with little or no improvement in its fiscal position.

The country’s budget deficit exceeded the interim target set last year, increasing by 13 per cent on a yearly basis for five-months ending May 2011 compared to the corresponding period. The deficit increased to 10.28 billion Euros against 9.1 billion Euros recorded a year earlier, when in fact the goal was to bring it down to 9.07 billion Euros.

The reasons for this might actually be the stringent austerity measures forced by the EU and the IMF as a precondition for availing the bailout facility. Revenues also declined by 7.1 per cent to 18.36 billion Euros in the same period.

As a part of the austerity measures, Greece cut public sector wages by 15 per cent and pensions by 10 per cent, and hiked the value added tax by four percentage points and excise taxes by 30 per cent. So much for a country of that size to come out of a sovereign debt crisis!

However the question is, how important is Greece to the global or for that matter to the European economy? Does the country really matter to the future of the global economy? How much of the recent measures (both domestic and international) are really going to help the country to overcome its current crisis? The most crucial question is, what is the likely impact of this crisis on the Euro itself?

The total size of the Greek economy is less than one per cent of the world economy, and the debt issued by it is even smaller than that figure. There seems to be no apparent reason why any default by Greece should shake the global economy. Nonetheless, the problem lies with the organisations that are holding these debts and the repercussions on them in case of a default. According to the Bank of International Settlements (BIS), at the end of 2010 German and French banks had a significant exposure of 9.2 per cent, and 20 per cent of their total peripheral European exposure tied to Greece. The figure would have been higher had Greece not received the bailout pack-age from the EU and the IMF. The bailout helped in reducing the private sector holdings of Greek debt.

It is important to note here that when other investors withdrew, banks were pushed into raising their government bond holdings. Now these bonds form the core of the Bank’s capital against which they lend. Even if we take a capital adequacy ratio of 20 per cent, these banks are lending five times of this capital. Any restructuring (read haircut) or default will simply aggravate the situation.  This is only the tip of the iceberg with respect to the financial implications of any default by Greece.

The point we are missing here is the amount of Credit Default Swaps (CDS) or other hedging strategies that foreign holders of Greek debt have used in order to protect themselves, as well as European Central Bank’s (ECB) big exposure to Greece through its lending to Greek banks. The second leg of CDS is not limited only to European banks but encompasses banks from countries like USA and Japan. This complicates the matter. making it a global phenomenon rather than a local one limited to Greece.  Thus, any default by Greece holds the threat of triggering a situation similar to that witnessed post the Lehman Brothers’ episode, when banks stopped lending credit to each other. This is the reason why ECB went ahead and violated Article 125 of the EU treaty that prohibits the bail-out of financially distressed countries. 

This brings us to the next question of how far the current measures will go in resolving the underlying problem of excessive debt. It is quite clear that in order to avoid a default, Greece should either restructure its debt or receive more loans to service its debt. The former option is out of question because it will significantly affect the entire banking system of Europe as a result of the reasons discussed above. Even if banks agree to restructure the debt, they will scarcely be able to ignore other European countries like Portugal and Ireland which are equally distressed and might demand the same treatment for their bonds—thus creating a situation that is neither desirable nor warranted.

 

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