Why is Greece close to defaulting on its sovereign debt (government bonds)? Why cannot Greece use the monetary policy tools that traditionally states used to ease their debt burden, and what are some of these tools?
Even before the time they entered the EU, Greece has been on a spending spree on infrastructure, services and public sector wages. As Greeks reduced their tax payments, the vast gap between government income and expenditures was filled in by borrowing billions of dollars from other banks and nations. This enormous public deficit was exposed post the 2008 banking crisis and currently, with a 160% debt to GDP ratio, Greece is nowhere near able to pay off its debt. With the downgrade of Greek bonds to junk status no one is also willing to lend Greece and being on primary deficit it is further unable to meet its expenses without external monetary support.
Some of the monetary tools that governments use in such a situation are devaluation of currency, increasing the interest rates, controlling reserve requirements or printing new currency. Greece had been deploying many of these tools before its integration into the Euro. However, under the Maastricht criteria applicable to all EU members, all the EU states need to keep their inflation rates within stipulated limits and need to have a control over their government deficit and debt. In addition they need to follow the exchange rate mechanism under European Monetary System (EMS) and also need to keep a check on their long term interest rates. Since Greece is a part of the Euro it does not have enough flexibility with these policies to be able to come out of its debt crisis.
http://en.wikipedia.org/wiki/Maastricht_Treaty
The Greek economy is small relative to the economy of other states in the EU – why would a Greek default significantly impact (i) the economy of other EU states; (ii) the stability of the Eurozone; (iii) the world economy?
Even though Greece has a relatively small economy, a Greek default can lead to a contagion the effect of which will be felt throughout the EU and also the world at large. It would send the yields on Portuguese, Irish and Italian bonds spiraling upwards and Portugal might have an incentive of defaulting as well. Subsequently the confidence in these countries will drop leading to a bank run and a severe credit crunch and EU will need to provide capital to the banking system for which there would be no collateral.
Such events would lead investors, and the world, to lose confidence in EU and hence growth can be hampered in the near future which can also lead to a drop in the euro. With the global financial system just out of a financial crisis, this contagion will be akin to rubbing salt on the wound that hasn’t even begun to heal yet and it would probably put Europe in a recession and would stall short term growth throughout the world.
Great efforts are expended to restructure the Greek debt so that it does not trigger CDSs written on Greek bonds. Who holds these CDSs?
The net value of CDS written on Greek debt is small as compared to the total debt. For instance, with a $300 billion of restructuring and $100 billion of wipeout, the outstanding CDS contracts net just about $3.2 billion ($70 billion overall).
These CDS are held by private entities that have invested in Greek debt over the years. Although this information is not publicly available, it is known that major European banks such as DB and BNP Paribas as well as some American banks such as JP Morgan, Citibank and Goldman Sachs hold Greek debt and have hedged it with CDS.
Recognizing that the situation evolves from day to day, what are the arrangements related to the Greek debt restructuring that are contemplated currently?
Of course Greece defaulted for non payment of the dues it owed on 20th March. Thankfully, to my utter surprise, it failed to shake the markets in a way I had imagined leaving it with just a nudge, maybe that was also the market's volatility itself. However, to ensure that financial markets are now immune to the fate of Greece a series of hard steps were taken and accepted, in some cases against the will of many. Here I lay down those steps and their magnitude.
There have already been four rounds of austerity packages involving about 100bn Euros in loan and a round of austerity measures being implemented by the government. Currently the Greece creditors have agreed to a 53% haircut on the Greece debt and EU has raised about $172 billion for support the remaining debt of Greece. Debt swap for coupon bonds (50% of face value as compared to original) have been initiated with a coupon of 3.7% bringing the total voluntary write-down to around 70%. Although it seems that even this huge bailout will not be enough and ECB reckons that Greece would need another 254bn Euro to meet its targets.
Under the terms of this bailout Greece is required to undergo reforms aimed at reducing its debt to 120% of GDP by 2020 from 170% currently. These include severe austerity measures as well as a 22% wage cut across the working population and a 35% for those under 25.
But this bailout has quite some risk associated to it especially because of the elections that are about to take place in Greece in April. The debt restructuring package is extremely demanding on the citizens and it is not surprise that there have been widespread demonstrations, sometimes violent, against it. This can be a crucial campaign agenda for politicians who can promise a renegotiation of the terms which casts uncertainty over Greek default. On the other hand the deal has been struck with the private sector representative, the IIF and needs the support of each of the private debt holder to go through which is a major process in itself. Now this debt restructuring has been accepted by a higher majority of the private creditors as against the alternative of losing their entire investment and face the ugly process of recovery from a default.
http://blogs.wsj.com/marketbeat/2012/02/07/whats-the-latest-on-greece/?KEYWORDS=greece+default
http://online.wsj.com/video/where-next-for-greece/DE35FF36-8253-4E67-90B8-637E849D7F7F.html
http://dealbook.nytimes.com/2012/02/21/greek-crisis-raises-new-fears-over-credit-default-swaps/
http://news.goldseek.com/UnionSecurities/1328198400.php
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