Will Greece still default?
We have some good news and some bad news. The good news is that the immediate crisis facing Greece has been averted, with two packages worth close to €170 billion from its European partners and the IMF. Politicians – admittedly under severe pressure – finally managed to put together wide ranging measures: loans, debt buy backs, private sector support. The bad news is that this is not enough. The harsh reality is that Greece built up government debts of €340bn, about 160% of GDP. The early assessment is that the package would lower that ratio by some 25%, helpful certainly but not the radical solution that will finally be required. Governments are still treating the crisis in Europe as one of liquidity, the need to supply sufficient finance to the right organisation at the right time, and not one of solvency, debts cannot ever be repaid. We see recent events as a temporary solution – better than many expected– but only a palliative. In due course, investors will again ask: “will an EMU member default, if so when and if so what happens to the currency and the banking system?"
Before answering such questions, it is vital to define the word ‘default’ carefully. Such words are bandied about too much; is it voluntary or involuntary, orderly or disorderly? One way forward is to consider three different sorts of ‘default’. The first is a temporary one – the credit rating agencies could announce a short-term selective default for a few weeks or months, before renewing a credit rating on the basis of the new arrangements. Similar happened to Uruguay back in 2003. Indeed it is expected Greece experiences this shortly.
The second default would be a major rescheduling of debt to put it on a sustainable path. When will it happen? When the banks are strong enough! We have long argued that it cannot occur until the vast majority of banks, especially in France and Germany, can cope with serious losses. The latest bank stress tests showed this cannot happen this year – perhaps next then.
The third form of default is the most worrying, a disorderly one, whereby a country becomes unable to adhere to the austerity measures within its EU/IMF programme, resulting in a political and banking crisis. The negative effects of such a ‘default’ on the currency and banking system would be large, as global investors pull out of Euro assets. More important, though, would be the extent of second-round effects, which in turn would depend on how successful the ECB, and the other Euro-zone institutions, would be in ring-fencing the problems surrounding Greece. The ECB, for example, could initiate its own form of QE, while G7 currency intervention is possible.
Short term, markets reacted positively to the latest EU announcements. A lot of bad news had been priced in! Looking forward, our analysis suggests that most European banks would be able to cope with the first or second types of ‘default’, but not the third – and that explains why EU politicians must continue to work hard towards putting stronger systems in place.
Andrew Milligan, Head of Global Strategy, Standard Life Investments