Why is the possibility of Greek debt default so important?

Portugal, Ireland, Italy, Greece and Spain are countries of the euro zone that have sovereign debt problems. These countries are often referred to as the PIIGS in matters concerning the debt crisis across the euro zone. In order to tackle the mounting debt these countries need to reduce spending and increase taxes. However, their economies are either experiencing dull growth or are contracting. As a result debt continues to climb as the cost of borrowing rises because these countries become less likely to repay their debt.

In a survey undertaken by international investors in May of 2011, 85% of the participants expect Greece to default on its debt this year (Kennedy 2011). The Greek government has committed to slash spending in an agreement with the European Central Bank (ECB) and the International Monetary Fund (IMF). In return they will receive a package devised together by euro zone nations worth 110 billion Euros given to them over a period of 5 years. However, the bail-out package is just another set of loans put together by euro zone nations. Greece is forced to slash spending in an already contracting economy and its basically borrowing further (from the 110 billion Euro package) to pay off its existing debt. With plans to significantly reduce spending it is unable to pay of its debt by itself. According to Sanati (2011), the deal with the ECB and IMF is just prolonging an inevitable default.

When the default does occur, Greece will be worst hit. Greeces private sector banks hold up to 20% of the sovereign debt. The default would result in write-downs or write-offs of the debt value held by those banks leading to huge losses. These banks would then be on the verge of collapsing, unable to lend money and thus there would be no money in the economy. The government is unable to inject money into the economy because it cant borrow from the private sector and it is unable to borrow from other nations private banks because it is too risky. This will inevitably result in another bail-out package from the ECB and IMF.

The issue that the euro zone nations are up in arms about is they cant escape from the contagion. German and French banks are the largest holders of Greek bonds. A large portion of Greek debt is held by European banks. They hold 96% of the total foreign Greek government bonds held worth US $52 billion. German and French banks together hold up to

73% of the European ownership of Greek bonds, with German and French banks holding $US 22.7 billion and $US 15 billion respectively. The default will force the owners of the debt to take haircuts which in essence is writing down or writing off the value of the debt held. The banks may incur such significant losses that they themselves may tumble or require their own government to bail them out. Already the speculation over the Greek debt default has lead to a potential downgrade in credit ratings of large European banks that hold Greek debt. In June three French banks, BNP Paribas, Societe Generale and Credit Agricole were issued a credit downgrade warning by Moodys investor Service because they have huge exposure to Greek debt, together they hold $US 65 billion in public and private debt (Sanati 2011 and Schoen 2011).

Combining the other members of the PIIGS with a Greek debt default will intensify the contagion effect on the euro zone. After Greece, the countries next in line who are expected to default are Portugal and Ireland. According to Sanati the biggest fear of a Greek default, though, isnt the default itself, but the message that it would send to other countries struggling to pay off their debts. Sanati states that these countries are already experiencing strict spending cuts to pay off their debt, a Greek default will cause restlessness among the people who are then likely to pressure the government into taking the same road to a default. Spain is the major holder of Portugals debt, holding $US 80 billion in debt (Nicolaci da Costa 2011). Germany and France will be further devastated through the downfall of Portugal which would potentially lead to the downfall of Spain. Germany and France are also the largest European holders of Spanish debt. As mentioned in Nicolaci da Costas article, data from the Bank for International Settlements (BIS) shows that French banks hold double the amount of Spanish debt than Greek debt which is approximately $US 140 billion. From the same data German banks are significantly more exposed to Spanish debt than Greek debt. They hold six times as much Spanish debt than Greek debt valued at $US 180 billion. If Greece was not so intertwined with the euro zone economies, especially the PIIGS, a default would be much easier to handle and it would not have such a severe impact.

The interconnectedness of the global financial system means that not only would Europe be effected, the consequence of the default would be spread around the world. The Greek default would trigger credit default swap (CDS) claims from those who own Greek government bonds. The financial institutions that issued the CDS to those who bought the bonds would be

forced to pay up the face value of them placing a huge amount of stress on them and potentially causing them to go bust.

The global financial system is so tightly bonded together through the transferral of risk through the selling of debt, CDSs, and collateral. Schoen of msnbc (2011) is certain that the debt crisis will spread to the US. He makes note that large French banks sell their debt to U.S. money market funds in order to raise capital. The U.S. has $US 200 billion exposure to debt crisis in Greece, Portugal and Ireland through transactions between US and European financial institutions.

It appears that the Greek debt default will have a similar outcome on the world economy as Lehman brothers did when it triggered the downfall in 2008. Just like the previous global financial crisis was triggered by subprime mortgages, the next one would be triggered by subprime sovereign borrowing (Schoen 2011). Hutchinson from Money Morning (2011) makes note that while the debt of Greece is lower than it was for Lehman brothers when it filed for bankruptcy its problems were only rooted back into the 2003-07 financial bubble, Greece, on the other hand, roots back deeper to 1981 when it joined the EU. The deeper the roots of the problem which have developed over a long period of time mean that the consequences will be more powerful and will have a longer residual effect on Greece and those nations effects.

With strict spending cuts and higher taxes in place to finance the debt in Greece, the people are frustrated and have lashed out on the government. It will take a long time to bring the now 160% GDP deficit (Hopkins et al 2011) to a required state of 10% of GDP surplus to get it back on its feet. Unemployment has sharply risen, GDP is expected to decrease by 3.5% this year and the deficit cant stop escalating, growing 12.9% over almost half a year in 2011 (Sanati 2011). When Greece entered the EU and adopted the Euro it experienced superficial growth through large government spending and there was also lax enforcement of tax. Greeces living standards grew without the people lifting a finger. The people now have to face the problems and absorb the loss. Hutchinson (Money Morning 2011) states that its people need to suffer a decline in living standards of about 30% to 40%, so that the countrys output is sufficient to repay its debts.

Not only is the people of Greece unhappy about absorbing the losses of the debt problems but the 15 euro-zone nations that have collectively funded the bailout packages are experiencing a similar challenge. These bailouts have been funded by tax payers and it is inevitable that they will not be fully repaid. Tax payers from these countries will also be up in arm. Forelle (2011) who writes from the Wall Street Journal points out that the losses would be deeply resented in Germany, Finland, and the Netherlands because they were the countries who were forced into the deal and were already concerned about it. The citizens of Greece have not finished showing their displeasure to the government. The unrest has the potential to bring down the government. It is also likely that the unrest will spread further into other eurozone countries and it could possibly mirror the riots that took place in London in August of 2011.

References

Marketplace videos 2010, PIIGS, video recording, viewed 4 September 2011, <http://www.youtube.com/watch?v=-loLBrlnnxQ&feature=related>.

American Public Media 2008, Untangling credit default swaps, video recording, viewed 2 September 2011, < http://www.youtube.com/watch?v=DdEI6PkGZK8>.

Sanati, C. 2011, End of the line: What a Greek default means, CNN Money, viewed 26 August 2011, < http://finance.fortune.cnn.com/2011/06/17/end-of-the-line-what-a-greekdefault-means/>.

Forelle, C. 2011, Greek debt default would be painful, The Australian, Sydney, viewed 26 August 2011, < http://www.theaustralian.com.au/business-old/news/greek-debt-haircut-faceshurdles/story-e6frg90x-1226040886085>.

Kennedy, S. 2011, Greece defaulting on debts anticipated by 85 in global poll of investors, Bloomberg, May 13, Viewed 4 September 2011, <http://www.bloomberg.com/news/201105-13/greece-defaulting-on-debts-anticipated-by-85-in-global-poll-of-investors.html>