Greece: Enter the Reaper

The Greek economy is past the point of no-return. Greek bonds are quoted at 30 cents on the dollar, and they are poised to go lower. Trading volumes are very thin. Many institutional players already sold down their positions, while others refuse to take any additional losses until they see the final outcome. The Greek economy is also collapsing. The €109 billion rescue package that was agreed a few months ago assumed that the Greek economy would decline 3% y/y in 2011, but it will probably contract more than 5% y/y. In other words, Athens will miss its tax revenue targets by a wide margin. One of the country’s main problems is the loss of competitiveness. Despite the gut-wrenching recession, the Greek economy is expected to post a current account deficit of more than 9% of GDP this year. The situation has been compounding for a long time. Since 2000, the German deflator rose an accumulated 11%, while the Greek deflator surged 34%. This is why the country has such a large external gap. This also suggests that the new Greek currency will need to devalue at least 24% against the euro in order to regain competitiveness against the largest exporter of the Eurozone. Given that maxi-devaluations are usually associated with large increases in pass-through inflation, the Greek devaluation would probably need to overshoot by almost twice as much. This means that the size of the Greek economy would probably decline by half to about $140 billion. Consequently, the country’s debt to GDP ratio would jump to over 250%. Therefore, in order to reduce the debt load to a more manageable range of 50% of GDP, Athens would need to give a haircut of about 65%. The problem is that the Greek government owes official creditors, such as the IMF, EU and ECB, approximately $180 billion. Official creditors are considered to be senior, and they will not accept any reduction in principal. Some of the losses may be offset by assets that official creditors held in reserve for future disbursement. Nevertheless, unofficial creditors will be left with very little.

It is for this reason that many of the European countries, such as Germany, Austria and Finland, started hardening their position against the Greeks. There is a sense that there is no real commitment on the parts of Athens to come to grips with the crisis. No assets have been privatized and many of the reforms are pushed into the future. There is a realization that Greece is insolvent, and the disbursement of the additional €8 billion that Athens desperately needs by the middle of October appears grim. There is a sense that throwing more money down the Greek rabbit hole is only postponing the inevitable. Europe is better off using whatever funds it can garner to recapitalize the banks that will be hit by the default. BNP is at the top of the list, with an exposure of €5 billion. This is followed by Dexia and Commerzbank which have €3.5 billion and €3 billion, respectively. Most the rest is scattered throughout the Eurozone, which will create major problems for the region. The volatility associated with the crisis already produced unintended consequences. The $2.3 billion loss incurred by UBS was partially the result of the massive increase in market volatility. Most of the largest hedge funds are also underwater due to the same reason. Many European banks are being forced to lighten balance sheets by dumping positions in the U.S. and emerging markets, thus leading to a spread of the contagion.

The other concern is the impact that the Greek default will have on the other peripheral countries. It is true that some countries, such as Ireland and Spain, are trying to get their economic houses in order. Ireland underwent a gruelling adjustment and the Spanish are trying to privatize assets. The Italians and Portuguese are making less headway. Nevertheless, these economies are multiples of Greece, and the impact on the European banking system would be devastating. Many investors will be dumping peripheral positions in fear that the crisis could spread further abroad. This is why Europe is much better off allowing Greece to default, and pooling its resources to backstop the rest of the Eurozone. Not only is the future of the European banking sector at stake, but the prospects for the unified currency bloc. Come what may, some very hard decisions need to be made regarding the future of the continent. The governments must look for ways to improve fiscal oversight and coordination, as well as harmonize bank supervision. The Europeans tried all that was possible to stave off the inevitable, but now it will be difficult to escape the swing of the reaper’s scythe.