The Euro and Greek bailouts: making thing better or worse?

University Degree Business and Administrative studies

Greece bailouts: making thing better or worse?

The 110bn euro bailout package approved for Greece in 2010 was believed to be able to help the worst euro crisis in its 11 years history. However, the outcome was the opposite and it leaded to the second bailout this year.

Greece had spent beyond its means in the past decade. The Greek government’s spending was more than its taxation income. Therefore, the government had to run the budget deficit and borrowed heavily. The public spending had mounted and the public sector wages went up almost double during the past 10 years. As shown in figure1, in year 2009, the Greece’s debt deficit was 115.1% to its GDP and the debt deficit was 13.6% to its GDP. The Greece’s debt was one of the highest among euro zone’s countries. The debt was 300bn euro and had to pay off more than 50bn euro in 20101. The high level of debt means the lenders become more cautious to let Greece borrow more money or would require high premium if they have to do so.

Figure1: How country debts and budgets compare in 2009

The figure 2 illustrates the probability of the countries that would not be able pay back the debt in year 2009 and 2010. The country that had the highest chance of default is Greece which was more than 50% of the probability.

The likeliness of default was so high that S&P downgraded Greece debt to junk level. Therefore, Greece was seen as a very risky country to invest in. From these reasons above, Greece had to ask for the bailout in 2010 for the first time. Euro zone members and the IMF have agreed three year bailout package of 110bn-euro to rescue Greece's embattled economy2. The euro provided 80bn euro and the IMF would also provided 30bn euro2. In return, Greece had to make a major austerity cut plan. The plan objective is to slashed 30bn euro from the country’s plan over next three years as well as public deficit must be monitored and controlled at below 3 percent of GDP by 20143. (As shown in figure 1, it was at 13.6% in year 2009.) The austerity plan measures consisted of the public sector workers’ involvement in cutting public sector staffs’ bonus, limiting annual holiday and freezing salary and bonus increment for at least three years. Additional measures are increasing VAT from 21% to 23%, raising 10% of taxes on fuel, alcohol and tobacco, and taxing illegal construction2. Thus, not only public sector but also private sector had been suffering from these measures.

Greece’s performance from the austerity program has actually been quite impressive. Originally, Greek’s 2010 gross GPD was expected to fall by 4% but the actual number was 4.5%4. The 2011 gross GDP was forecast to be 2.6%, but according to March review, it was changed to be 3%4 which was actually the better number. Initially, the 2010 government deficit was expected to be 8.1% of GDP but the actual number was 9.6%4. The 2011 government deficit was forecast to be 7.6% of GDP, but it has changed to 7.5% after the new revision4.

Figure3: Forecasts of Greek GDP growth, current account deficit, gross debt and bonds

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Figure3: Forecasts of Greek GDP growth, current account deficit, gross debt and bonds

However, the Greece’s performance is still not good enough. First, Greece’s debt level is still very high. As demonstrated in figure 3, the gross debt ratio in 2012 was forecast to be 149% of GDP which should be hit the highest level. But according to IMF new revision in March this year, it was changed to be 159% which was significantly higher than the past forecast. Second, the current account deficit was still aggravated. As shown in figure 3, the current account deficit in 2014 was forecast to be 2.8% of GDP. But according to IMF new revision in March this year, the changed forecast was up to 5.5%. It is important to bear in mind that this deficit portion cannot be finance during the austerity plan. Third, the economy is still in the crisis, confirming that Greece is still in the middle of recession. According to the Bank of Greece’s announcement, Greek economy in this is forecast to shrink further down by 3% this year5. The unemployment rate also rose up to 16.6% in May in this6. Forth, it is not only the financial problem, but also the political problem. Recent figures show that the “elite” and “court” have over 600bn euro in saving accounts in Switzerland7. It is believed by many Greeks that the money comes from corruption. Consequently, it is also hard to trust the same group of politicians who dragged the country into this trouble to pull the country out of trouble.

From the above reasons, Greece has to ask for the second bailout in 2011 as the target has missed both in term of budget deficit and revenue. The second bailout is $153bn in which the rescue comes from the euro zone countries and the IMF. Out of this $153bn, $70bn will be contributed by banks and private lenders8. The mechanism is to roll over the bonds but also change them into new ones that have lower interest rate and/or selling them back to Greece with cut price. In return, Greece has to slash more spending after the lenders discover that the original austerity program was no longer sufficient. A gap of 5.5bn euro in the four-year program needs to be close and about 600m euro has to be raised by the end of this year to keep budget target on track8.

However, it is difficult for public-sector union to easily agree on the austerity plan because they know that as long as they keep protesting, the foreign debtors and euro members will continue giving them the bailout. Therefore, there is no reason to scarify while knowing that the rescue will always come.

The subsequent bailout in 2011 will not help resolving the situation. On the other hand, it would make Greece go deeper into the dead spiral. The lenders just try to give more debt to solve Greece’s problem while the root cause of Greece is having too much debt. Eventually, Greece will have to pay all these anyway but with the higher cost. The budget control system, the high taxation rate and all measures from the austerity plan painfully cut down the economic growth. No lender would be willing to give Greece more financing while the country is still facing the high debt level and the inactive economic model. If no one trusts Greece in its ability to repay the debt, the bailout is simply not the right idea. Without creditors’ support in the future, the chance of default will be high. The matter is just about the time. If Greece defaults in the future, not today, the debt level would be very much higher comparing with the no bailout scenario. The damage would be very much severe than today.

The reason that EU and IMF still give the bailout to Greece is probably because they want to help its own banks by buying more time. In this way, the lender countries will have more time to prepare themselves before Greece is actually default. Everyone will have time to gradually write off their sovereign debt without additional capital injection from states. Alternatively, they can try to sell the debt to the public sector, avoiding the damage to their balance sheet. Otherwise, the situation can be so called Lehman Brothers Bankruptcy of Euro since it will cause the widespread of financial problem throughout euro zone. Their sovereign debt might default with devastating results and the euro zone will be destabilized.

The Euro currency is also under pressure because of the anxiety about contagion if Greece defaults. The widespread of domino effect will firstly impact the weak countries. Under this current situation, it is believed that PIIGS countries (Portugal, Ireland, Italy and Spain) would be the first ones that hit by the domino effect. Consequently, the fear is also exacerbated by rating agencies. The rating agencies might downgrade the countries that have potential of debt default. Consequently, the downgrading might cause the sovereign debt crisis because the downgraded countries would not be able to find the funding, or have to fund with unusual high interest rate. Any types of private sector’s participation in a bailout even with no haircut condition would be viewed as a “selective default”9. So far, there is no country in the euro zone has been rated in this level. (Selective default refers to the bond that has been changed the conditions such as the repayment period or the interest rate. It completely downgrades to the “default” rating. It usually happens when the borrowing country or company does not repay the whole amount of the bond9.) Many banks and financial institution that hold Greek’s bond would also have a rigorous effect on this matter, and as a result, the shareholders would also get affect. The shareholders in this case are ordinary people and small investors, thus it means that the impact will broaden throughout every country in the euro zone, and might be also the other parts of the world. The domino effect and the downgrading have direct impacts to euro countries as a whole as well as euro currency. The euro currency will be easily collapse if Greece and the other euro countries defaults it debts.

As it is explained that the bailout does not make the situation better, the other scenarios for Greece are abandon the euro, default and debt restructuring.

Greece abandons the euro is a way that suggested by some commentators. However, it is difficult to see that the abandon could happen without immediate collapse on the banking system and European Central Bank (ECB). If Greece were to exit the euro, it has to change back to their own currency, drachma, and then devalue it. It might have to devalue as high as 50% of the current value against the euro10. In this way, Greece would face many major consequences. The banks will need substantial amount of fund to recapitalize. Its debt will transform to foreign currency debt. The import cost will be raised. Even the personal debt such as credit card debt and mortgage debt will be more expensive for the repayment in drachma. This will cause higher inflation which will impact the fundamental cost of living for Greek. Using drachma instead of euro means that the currency will be less trustworthy and thus less international support. There is no doubt that Greece has to resolve its problem alone. But it does not mean that Greece will be the only party who has trouble from leaving euro. The ECB and the creditors which many of them are the euro zone countries will also suffer because they will have to write off a huge portion of the irrecoverable debts. According to the Financial Ministry official of German, the write off amount can be as much as 40bn at least10. Consequently, it would ultimately impact the confidence of euro currency.

German and French financial institutions are thought to hold up to 70% of Greece debt10. These two countries would be immediately hit by the default. For reasons of self-interest, the euro, especially German; the main contributor for the bailout, is likely to go any lengths to stop Greece defaulting.

Debt restructuring seems to be the best choice under the limitations. Like the other alternatives, debt restructuring has its pros and cons. But the pros seem to outweigh its cons and the other alternatives. Under this way, the catastrophic run on country’s banking system and the damage on the economic will be less comparing with the abandonment and the default. The Greek sovereign debt is hold by Greek major banks for 40% and a large number foreign private bank for 60%11. By debt restructuring, the lenders would have to accept a haircut. The size of the haircut could be between 20% and 50%12. After the haircut, the ECB and every creditor also must agree on the debt rehabilitation plan as well as the debt restructuring package. This means that Greece has to present its new austerity plan and the creditors have to issue the new debts to Greece in the amount of remaining portion after the haircut, with the longer maturity period and lower interest. Both Greece and bondholders, of which includes euro countries such as German and France, have to scarified, but it is for good because it is one time and done. Compared with the bailout, there may still be the chance of third and forth times bailout request, and eventually it would lead to the default event anyway. Debt restructuring would somehow raise interest rate for future new bonds issued by Greece and other troubled euro countries. Therefore, the discipline of implementing austerity plan has to still be strictly monitored in order to avoid the future potential of default.

Even though Greece bailout is not mutually agreed by the commentators and analysts, it is mutually agreed by the euro countries. The best scenario to be expected is the bailout succeeds. But it does not mean that there would be no worries in the longer term. The PIIGS potential of default and the success in the austerity plane are the major factors to determine the stability of the euro and its single currency policy. The future outcome is not too far to wait and see.

References

Greece’s economic woes. (2011, May 2). Retrieved August 13, 2011 from
Eurozone approves massive Greece bailout. (2010, May 2). Retrieved August 24, 2011 from
Greek strikers hit Athens streets over austerity plan. (2010, May 4). Retrieved August 24, 2011 from
Martin Wolf (2011, June 21). Time for common sense on Greece. Retrieved August 13, 2011 from
Greek economy to further shrink in 2011: central bank. (2011, February 16). Retrieved August 25, 2011 from c_ 13733658.htm
Dimitris Kontogiannis (2011, August 12). Greek economy shrinks again. Retrieved August 13, 2011 from
Michael Schuman (2011, June 21). Why another Greek bailout is a stupid idea. Retrieved August 13, 2011 from
Kerin Hope and Peter Spiegel (2011, June 24). Greece agrees to more austerity cuts. Retrieved August 13, 2011 from
Greece to get new bailout 2011. (2011, July 21). Retrieved August 13, 2011 from
Jacob Wolinsky (2011, May 11). Should Greece Abandon The Euro? Retrieved August 20, 2011 from
George Irvin (2011, June 24). Greece must restructure its debt or face a messy default. Retrieved August 20, 2011 from greece.euro. bailout.debt_1_debt-restructuring-eurozone-greece?_s=PM:OPINION
Robert Plummer (2010, April 28). Greece crisis: Is there an exit? Retrieved August 13, 2011 from

The Euro and Greek bailouts: making thing better or worse?

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