Greek debt: Europe's struggle with a tricky mess

There is no shortage of theories on the potential impact of a Greek sovereign debt default.

It ranges from doomsday prophesies of a financial Armageddon bringing down institutions and sovereigns in Europe with ripple effects felt across the world to a medium-intensity credit event that at worst would warrant some balance sheet repairs for a few banks.

But the truth lies somewhere in between. While the collapse of the global financial system in the wake of a sovereign default in Europe is over-exaggerated, dismissing it as some sort of minor credit event could prove to be a gross underestimation of the gravity of the situation.

"Failure to undertake decisive action could rapidly spread the tensions to the core of the euro area and result in large global spillovers," the International Monetary Fund warned on June 20.

The world is no longer a stranger to crises of such magnitude. Following the financial crisis in 2008 when big banks began to crumble sovereigns came to their rescue. The key difference in terms of the current crisis is that sovereigns themselves are under pressure.

"The magnitude of the Greek crisis and the debt issues faced by some other European countries such as Portugal, Italy, Ireland and Spain is enormous. But the EU as an entity has the ability and the will to prevent the crisis spreading across the continent," Guy Monson, chairman of the Investment Policy Committee of Bank Sarasin, told Gulf News in an interview.

Divided on strategy

But events last week point towards the absolute lack of collective political will on the part of EU members. The EU bureaucracy and the political leadership of core Europe are still debating how best they can impart fiscal discipline to delinquents from the periphery.

On June 19, Eurozone finance ministers decided to delay making a final decision on a €12 billion (Dh62.81 billion) loan to Greece. They said the country must introduce harsh austerity measures first if it is to get the latest installment of its €110 billion bailout package. Greece needs the loan by the middle of next month to avoid defaulting on its debt.

To make matters worse, Greece is facing huge domestic political pressures to reject the EU-led fiscal tightening plan. The government survived a key confidence vote last Tuesday as the main opposition abstained from voting. The next biggest challenge before Prime Minister George Papandreou is to implement radical remedy of deep spending cuts and sale of public debt to reduce the fiscal burden.

For hardnosed Eurocrats, the logic is plain and simple: ‘You take concrete steps on cutting the spending; we will open the funding tap.'

"My message to the Greek people is that if the government acts, Europe will deliver," EU President Jose Manuel Barroso said last Wednesday.

That is easier said than done. For the beleaguered Greek government, the task begins from persuading the governing Socialist Party lawmakers to pass a bill that would save or raise about $40 billion (Dh146.90 billion) by 2015, equivalent to 12 per cent of Greece's gross domestic product, through wage cuts and tax increases.

Papandreou's government came to the brink of collapse last week as protesters rioted on the streets of Athens.

EU's point of no return

"We see Greece's problems as just too big for the country to absorb even with the aid of Eurozone togetherness. The rioting on the streets of Athens shows that the population remains worried about the pain that will need to be taken to right the economy within the rigidities of the Eurozone," said Gary Dugan, chief investment officer, private banking, Emirates NBD.

Analysts believe that a Greek sovereign default is unthinkable for Europe and all its institutions. "The core has to hold the periphery together. And I expect it will be done at any cost," said Monson.

The consequences of Greek default will not be just limited to the holders of about €340 billion of Greek sovereign debt, but also for holders of hundreds of billions of euros of Greek commercial debt and tens of billions of euros of derivative contracts linked to Greek debts.

If Greece defaults, speculators will turn their attention to other vulnerable nations, driving their bond prices down and their borrowing costs up. The perceived risk of lending to Ireland and Portugal could trigger vast additional losses on hundreds of billions of euros of loans to those states and their respective banks.

Bigger problem

Analysts say the bigger problem would be if jittery investors drove up yields on Spanish and Italian bonds to the point where it became hard for those countries to roll over their debts, triggering further defaults. Spanish and Italian 10-year bonds yield around 5.5 per cent and 4.8 per cent respectively, compared to equivalent German bonds at 3 per cent.

Additionally a default could bring down many banks across Europe warranting massive bailouts, probably some of them larger than the bailouts of 2008-09. And finally, the European Central Bank, the largest holder of Greek, Portuguese and Irish sovereign debt will face bankruptcy requiring bailout from Eurozone countries.

Thus in the end game any default from peripheral Europe will be too expensive for the core European nations like Germany and France and they will have no choice but to prevent such an event in their own best interest.

How the fairytale became a horror story

The Greek government went on a spending spree after it adopted the euro. It has a sovereign debt of $480 billion (Dh1.76 trillion). As it could not cope with the global financial crisis, it was given €110 billion of bailout loans to help it get through the crisis.

So why not release the next €12 billion tranche?

The idea behind the bailout was to give Greece time to sort out its economy so that the cost for it to borrow money commercially would come down. That has not yet happened. The ratings agency S&P recently decided that Greece was the least credit-worthy country it monitors.