The turmoil related to Eurozone debt entered a new phase last week, driven by a growing recognition that Greece is likely to default, according to QNB Capital.
Greece has long run a structural fiscal deficit to finance public employment and social security, building up a large sovereign debt. When the current government came to office in October 2009, it became apparent that prior governments had manipulated financial and economic data to fit within EU limits. As a result, the deficit was much worse than previously thought. Furthermore, the Greek economy was hit particularly hard by the global recession, shrinking by 2% in 2009 and 4.5% in 2010.
Rating agencies downgraded Greece’s sovereign debt to junk status in 2010, and consequently the bond yields demanded by investors rose sharply, increasing the cost of refinancing debt.
In May 2010, the EU and IMF pledged €110bn in bailout loans over three years at 5% interest, a significant discount on market rates. This was on the condition that the government would implement austerity measures to cut its deficit.
The Greek crisis heightened sovereign debt concerns in Ireland and Portugal, which also received large bailouts in 2010.
In July 2011, the Greek bailout package was expanded and made more generous by lowering the interest rate to 3.5% and increasing the repayment period.
At the same time, contagion appeared to be spreading to two much larger economies—Italy and Spain. The European Central Bank (ECB) intervened by purchasing Italian and Spanish bonds, which drowve down yields.
Juergen Stark, the ECB’s chief economist, opposed the bond-buying program and announced on September 9th that he would retire. His move mirrors wider discontent in Germany that the country is shouldering the burden of Southern European overspending.
However, the EU initiatives are merely delaying measures, according to QNB Capital. As Greece continues to run deficits, its debt stock will keep rising. Furthermore, Greek GDP is expected to shrink further this year. As a result, Greek debt is projected by Eurostat to rise to 166% of GDP by the end of 2012, up from 111% in 2008, and continue rising thereafter. Concerns are growing about whether it will ever be able to fully repay the massive debt.
If Greece fails to meet its budget cutting targets, EU bailout loan instalments may not be provided, forcing it to pay market rates for debt refinancing and accelerating the crisis.
All of this points to a default, which the market seems to be expecting. The yield on two year Greek debt rose to a dramatic 70% on September 12th, more than doubling in a month. Moreover, the cost of insuring Greek debt through credit default swaps implied a 24% chance of default within a year, according to Moody’s (Qatar by contrast has only a 0.13% risk), and 61% chance within five years. There have been recent indications that Germany is preparing contingency plans to support its banks in case of a default.
The choice may be between a chaotic default, including Greece withdrawing from the Eurozone, or a more orderly restructuring that is planned with private creditors and the EU to minimise the pain all around. The EU-Greek relationship will need to strengthen to enable the former scenario.
The sharp falls in European bank shares last week, particularly in France and Germany, were linked to their high exposure to Greek debt, as well as more general concerns about the state of the economy. The euro has fallen sharply against the dollar as investors sell euro assets.
QNB Capital notes that the implications for the Gulf are mixed. On the negative side, a Greek default could spark a fresh credit crunch in European banks, increasing the cost of financing globally, including for projects in the Gulf. Also, if the crisis further knocks the already weak economic growth, then oil prices could fall.
More positively, a weaker Euro would reduce the cost of imports to the Gulf, which sources much of its capital and consumer goods from Europe. Also, low asset prices may provide buying opportunities for GCC private and sovereign investors, as they did in 2009.