The Greek bailout flame-out - by Stephanie Flanders*

 

Stephanie Flanders | 17:46 UK time, Tuesday, 4 May 2010  

The Greek support package has not yet failed. But you can hardly call it a success. Investors have little more confidence in Greek debt than they had last week.

And - it seems - little confidence in the eurozone either. The euro today sank to a one year low, and markets shuddered across Europe.

Why? Apparently, even bond market vigilantes think you can ask a government to do too much.





The interest rate on two-year Greek debt has gone up nearly three percentage points since this morning. Worse, from a eurozone standpoint, Portuguese bond yields have risen sharply as well, though in Spain it's been the stock market rather than bond prices that have been taking the strain.

Assuming the support package goes through the various national parliaments, the huge new pot of official money should mean that Greece doesn't have to worry about borrowing from the markets for quite a while - these high interest rates need not affect it. But the likes of Portugal don't (yet) have that safety net.

To see what a disappointment this must be for the European authorities, consider quite how much precedent and procedure has been thrown overboard in the past few days.

Between them, eurozone governments have promised to lend Greece 80bn euros - despite a "no bail out clause" in the Maastricht treaty that was designed precisely with countries like Greece in mind.

The IMF is also on the peg for 30bn euros, even though that is more than 30 times Greece's quota at the IMF, and the most they have ever previously made available was 15 times quota.

And, also hugely significant, the European Central Bank (ECB) has agreed that European banks can put up any Greek government debt as collateral for cheap liquidity - despite the fact that the ECB's president had previously insisted there could be no change applying to one country alone.

But there are times when spelling out exactly how a country is going to be rescued only goes to remind everyone how much of a jam they are now in.

Even hard-nosed investors look at the austerity that comes with this programme and wonder how on earth a democratic government is going to stay the course. This isn't a short sharp shock, it's the macroeconomic equivalent of many years' hard labour.

Greece has to cut its budget deficit by 11% of GDP in three years - and most of that time its economy will be getting smaller, not bigger.

The Greek government was forecasting that growth would return in 2011 - and the budget deficit would fall to less than 6% of GDP. As the IMF has correctly identified, those two numbers were mutually incompatible for Greece.

The IMF-eurozone programme forecasts the economy will shrink by 2.6% next year, and borrowing will still be close to 8% of GDP, only falling below 3% of GDP in 2014.

But realistic is not the same as plausible. Looking at the programme, many economists expect that sooner or later, the Greek government will falter in meeting its commitments.

The IMF would then have to decide whether to suspend the programme and push the country into default - as it did, in effect, with Argentina. The eurozone governments would have to decide whether to let Greece renegotiate its debts after all.

Sovereign CDS spreads for Greece - a rough guide to market expectations of a default - are now over 730 basis points, higher than yesterday, or the end of last week (though somewhat below their peak of 824 points a week ago.)

Spreads for Spain and Portugal have risen by 30-40 basis points. Officials were probably hoping to see them go down.

There will be more to say on this in coming days - particularly on the ramifications for the balance sheets of European banks and of the ECB, where a good part of this crisis may now be played out.

But here's one interesting point to note about today: the interest rate on German government debt fell once again. You might say - what's so surprising about that? The answer is that it's not a surprise, but it does tell you that bond investors do not think that, in the end, Germany will put European integration ahead of its own monetary stability.

How so? This weekend, the eurozone - Germany at the forefront - effectively said they would underwrite Greek sovereign debt. This is how the distinguished European economist, Charles Wyplosz, sees the potential endgame as and when the contagion spreads to Portugal, Spain, and beyond:

"What has been offered to Greece cannot be refused to other eurozone governments. So, one more time, a (dwindling) group of deficit-stricken countries will have to provide money to increasingly large debtors. In fact, this process means that ultimately there is no national debt anymore, at least for the next few years. In effect, in the market eyes, there will then be just one eurozone debt. Could markets run on all eurozone public debts? Once again, no one would expect all eurozone governments to be forced to default but markets can and do panic and self-fulfilling crises can occur wherever there is vulnerability. Just imagine that, one by one, each eurozone country falls in the same trap as Greece. Eventually, Germany could be last one. Could it underwrite all the other public debts, on top of its already own respectable one? Current estimates set the overall eurozone public debt level at 90% of GDP in 2012. This is reassuringly lower than Greece's 135%, but it is about the same as Portugal's and it represents 330% of the German GDP."

Unsurprisingly, the markets are not pricing in this scenario quite yet. German debt is still considered a safe haven within the eurozone, even though it's Germany that could end up paying all the bills. Either investors cannot think this far ahead, or they think - probably rightly - that German voters would jump ship long before.

BBC News

http://www.bbc.co.uk/blogs/thereporters/stephanieflanders/