Friday, October 7, 2011

What Will Happen When Greece Defaults?

Greece will likely not be able to pay back the full value of its debt, due to the fact that Greek debt to GDP is 140%. Many market commentators are stating that a Greece default will not cause a significant move in the markets ("Greece is only 3% of EU GDP" or "A full meltdown is very unlikely but the market must price in this very unlikely event")

These commentaries do not perform a cause and effect analysis -- meaning, what would occur in the case of a Greek default, if one takes into account the impact on banking institutions, and national economic activity, in a step by step, sequential analysis? Such an analysis shows that significant problems occur with a Greek default for the EU and world economy and markets.

If Greece defaults, then the value of its bonds will drop by 50-80%. Note that the average sovereign default since 1980 according to Moody's has seen net losses of between 50-60%, but Greece is has significantly more debt than the average default, so losses would likely be higher.

Greek Banks would be insolvent:

This default in turn would cause the major banks of Greece (which in turn hold Greek sovereign debt) to go bankrupt. As the Greek government cannot guarantee the deposits of the Greek banks, the deposits of these institutions would be wiped out.

Significant Declines in Greek GDP:

What would happen to Greece's gdp? Many large banks go bankrupt in Russia in 1998 (although not in Argentina to the same extent in 2002-2003, as Argentina limited the amount of funds deposit holders could withdraw) as Russia defaulted on its debt in that year. Russia's GDP fell approximately 50% from 1992 to 1996, then recovered somewhat from 1996 to 1998 but then declined a further 15% fro 1998 to 2000. Argentina's gdp declined approximately 15% from 2002 to 2004. Both countries began to recover when their currency declined significantly and the export market (as both Russia and Argentina are major commodity exporters) picked up.

Greece's GDP would likely fall more than 15%. The world economy is more fragile currently, so a recovery in two years may not occur, through an export led recovery, so the slump would likely last for several years. The issue of leaving the Euro would have to be addressed -- instituting a new currency in a very difficult economic environment would be problematic.

Other Southern EU Banks at Risk:

Deposits in other southern European Union countries would be at risk, in so far that account holders in Italy, Portugal, Spain and Ireland would see Greek banks default, then attempt to transfer their deposits to safe havens, whether northern European banks. Italian, Portuguese, Irish and Spanish banks would be at risk from direct losses from holdings of Greek bonds (total outstanding Greek debt is over $400Bn, held mainly by European banks). As the southern EU governments are already highly levered, it is not likely that they would have the ability to raise funds to bank stop losses in their banking systems.

Southern EU Countries GDP at risk of significant decline:

Southern EU banking insolvency would be a significant risk, which could drive declines in Southern EU gdp.

French and German banks with exposure to Greek debt would be at risk:

Deutsche Bank and the major French banks have significant exposure to Greek debt, which would mean significant losses at these banks, and likely a need for government assistance. As both France and Germany have debt to GDP ratios in the 80% range, further payments to their banks would likely move their respective debt to GDP levels to close to 90%, which is the cut-off range (according to Harvard economics professors Kenneth Rogoff and Carmen Reinhart) for markets funding debt to GDP without significant issues (although this 90% cut off grade has received some criticism as being too arbitrary, however 90% likely does not leave too much room for further debt financed growth or assistance).

Certain Hedge funds will likely go insolvent and will likely have to liquidate, driving stock values down:

In the October 2008 crash, according to the book "The Quants" many large quantitative and macro hedge funds which were levered had to panic sell in order to meet investor redemptions. With the unprecedented volatility in the markets from a Greek debt, some larger hedge funds would have to liquidate, driving asset prices down.

Mutual Funds would see higher redemptions, causing selling to drive the market down:

Most mutual funds have been bullish through this crisis and have encouraged their investors to hold through the long term. Mutual funds had record low levels of cash in July and many have seen significant declines in equity values since that time. Further the average mutual fund investor is likely an aging baby boomer who is nearing retirement. All these factors point to higher redemptions.

Pension Fund Values would decline, leading to unrest:

Pension funds as a whole are more heavily invested in equities, due to the fact that they can assume a higher rate of return on equities (more in the range of 8-9%) verses bonds (in the range of 4-6%). The projected value of the pension plan is highly dependent on the projected return on plan assets. With panicked selling, pension plans would see the value of their assets decline significantly.

Safe Haven Assets would increase in value:

Safe haven assets are likely the US dollar, the Swiss Franc, potentially precious metals (however precious metals are held by hedge funds, which would likely liquidate in the short term).

Government Bailouts of Banking Institutions would be even more unpopular with the public, worsening the banking crisis.

The public of many countries is already upset with the banking bailouts of 2008 and 2009, and would not be in any mood for continued bailouts. This would complicate efforts to shore up bank balance sheets, making the banking crisis worse than otherwise would be. As banking crises have a "cumulative" character - the farther they are allowed to fester, the more the public panics and withdraws funds, potentially causing and worsening a bank run -- the unpopularity of bailouts can only worsen events for the banking system.

Recovery for Southern Europe would be more protracted, due to a weaker than normal world economy and therefore export market:

Both the United States and China are currently slowing -- China is attempting (successfully) to slow housing and infrastructure spending, however this means that commodity demand from China is slowing. This, in turn, impacts the major regions more dependent on commodity export: Latin America, the Middle East, Russia, Australia. This means that the EU will have a more difficult time utilizing exports to dig itself out of crisis.

What can be done to avoid a Greek Default?

As this analysis shows that a Greek default would be extremely problematic for the EU and world economy as well as stock markets, the question is, what can be done to avoid a Greek Default?

Either the EU, or another institution such as the IMF, should come in and guarantee Greek debt so that banks are assured of receiving 90%+ of their full value of their bonds. If the full value of Greek bonds are more or less assured, the chain of events described above will not occur.

However, likely the sovereign debt of the other Southern EU states, Italy, Spain, Portugal as well as Ireland needs to be backstopped as well in order to stop potential defaults of these countries, which in turn would cause banking crises moving to economic to market crises.

What would be the amount of funds needed to guarantee Greek and Southern EU debt?

Something in the range of 50-80% of Greek Debt would be needed to fully backstop this debt, meaning funding in the range of $200Bn to $360Bn. This is likely at the highest range for France and Germany combined to fund. Germany's debt to GDP is 80%, and German GDP is $3.33 Trillion, meaning that Germany can afford $333Bn before it moves to 90% debt to GDP (the danger zone, according to Rogoff and Reinhart). France's debt to GDP is also approximately 80%, and France's GDP is approximately $2.65 Trillion, meaning France could contribute $265Bn before reaching 90% debt to gdp.

Both France and Germany would therefore be seriously strained to provide a backstop to Greek debt, and the UK (also at 80% debt to GDP) is not in the Eurozone, and would likely significantly resist paying for Greek debt. Other countries with relatively low debt to gdp such as Finland (48% debt to GDP) only have smaller GDP levels (Finland's GDP is approximately $222Bn). Of course, Southern EU countries such as Spain and Italy cannot provide funding to Greece, in so far that their debt to GDP levels are already too high and the markets would likely not support these countries issuing more debt.

The problem is that not only Greek debt needs to be guaranteed, but also Italy, Spanish, Portuguese and Irish debt needs to be guaranteed. Italy currently has a debt to gdp of 119% with total debt outstanding in the $2.5Trillion range. In order to get this debt down to a manageable 80%, total funds would be needed of approximately $700Bn. All in all, the total backstop for Europe to guarantee all its "in danger" countries would likely be over $1Trillion.

Overall, it appears unlikely that France and Germany or a combination of other European countries can backstop $1trillion.

Can the IMF provide funding to Europe?

The current lending capacity of the IMF is approximately $400Bn -- so the lending capacity of the IMF would have to be increased. To get to $1Trillion, the United States (which contributes 17% to the overall IMF funding capacity) would have to increase $106Bn, which is possible, but politically unlikely. Other countries, such as Japan (which contributes 6% to the IMF budget) would have a difficult time raising funds to contribute to a vastly increased IMF lending capacity. Overall it appears the IMF will have a very difficult time guaranteeing EU debt alone.

Can a combination of IMF and the EU Guarantee Southern EU Soveriegn Debt?

This is possible, but would require the IMF taking the lead, as it is difficult to see how the northern EU states and France could guarantee more than $400Bn, while over $1 Trillion would likely be needed. An increased funding capacity to $500-$700Bn for the IMF is more possible -- meaning additional funding by $200 to $300Bn. This would require close cooperation between the IMF and the EU, which appears very difficult currently, politically. But financially, it is possible although difficult.

Conclusion: Greek Default and Southern EU Sovereign Defaults Very Possible -- if not likely -- without joint EU -IMF Bailouts

Currently as of the beginning of October, it does not look as if there is the political will to get the EU and IMF coordinating on a combined, increased bailout package, which would require significant additional funding (read: additional taxes) for the EU from France and Germany and increased funding for the IMF (read additional taxes for IMF member countries). The likelihood of this occurring is very difficult to say, but cannot be considered "the most likely outcome" meaning that the probability is higher for less than a needed guarantee for southern EU debt materializing in the future.


Media Mentions said...

Now as is the case with many a political issue, nothing is ever black and white, regardless of what some politicians will have us believe. But of course in this case i’m referring specifically to Greece and it’s looming default. I have recently found a short article on pressdisplay that I think sheds its fare share of insight into the situation. In any case, here’s the page if you’re interested ( and hope you find it as handy as I have in deciphering some of the country’s current issues. Cheers!

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