26 June 2011

Why Greece Will Likely Default

Few people wish to see Greece defaulting on its debt obligations.

Greece will probably avoid a default now, but it will likely default eventually.  It is only a matter of time.

When a country has difficulties in meeting its debt obligations, it will typically try to negotiate with its creditors to accept a reduction in the principal amount or in the interest payable and/or a postponement of repayment of principal or payment of interest.

Restructuring the existing debt is not enough to nurse a country back to health because restructuring alone does not generate cash flows needed to service the restructured debt.  So the country devalues its currency in order to stimulate exports and encourage inward tourism and inward capital inflows.

Let's take a look at Greece.

Greece is a member of the European monetary union.  The other members of the European monetary union do not want Greece to default because they are afraid of the consequences to the euro, their banks and their economies.

Together with the IMF, they will try to rescue Greece.  They have to be very careful because restructuring Greece's existing debt may trigger a default.

They will provide financial assistance to allow Greece to meet its immediate debt obligations.

How will Greece meet its debt obligations in the future?

As a member of the European monetary union, Greece does not have its own currency that it can unilaterally devalue.

Worse is that one of the conditions of the financial assistance is that Greece must introduce fiscal austerity measures (increasing taxes and reducing spending) and privatise government-owned enterprises.

Fiscal austerity will bring about hardship to the middle and lower income groups.

Fiscal austerity programmes will likely bring about economic slowdown, further reducing tax collection and Greece's ability to meet its debt obligations.

Privatising government-owned enterprises may result in upfront cash flow to the government, but it will be at the expense of future cash flow.  It may prove to be difficult to find buyers for assets that are located in Greece and are dependent on the Greek economy to generate and maintain a reasonable level of revenue.

Who will suffer?

The Greek people, certainly.  The common people.

The (mainly German and French) banks and (mainly European) private investors which hold Greek government bonds.  If the capital base of these banks is severely diminished, their ability to continue their ordinary business of lending may be impaired.  The economies of the European Union will be affected.

Other banks may stop transacting with the banks that hold, or are believed to hold, significant levels of Greek government bonds, because no one really knows how badly affected the counterparties are.  The domino effect takes over.

If not handled properly, the contagion may spread to the rest of the world.

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Updates

12 July 2011

Dutch finance minister Jan Kees de Jager said that Eurozone finance ministers were open to the possibility of allowing a selective debt default by Greece.

Any proposal that penalises existing investors which do not participate — for example by threatening a hard default or by changing the tax or legal status of the residual bonds — may result in a selective or restricted default.  This in turn may trigger insurance claims on Greek government debt.


21 July 2011

Dutch finance minister Jan Kees de Jager said that neither France nor Germany would prevent Greece from partly defaulting on its debt.

European Central Bank, which had strongly opposed a Greek default, may accept a default.

Member countries of the Euro area announced a rescue package for Greece, comprising €109 billion in official financing and €37 billion from the private sector to roll over maturing debt.


22 July 2011

Fitch Ratings Inc. said that the rescue package package for Greece would put the country in restricted default.


25 July 2011

Moody's Investors Service cut Greece's foreign and local currency bond ratings from Caa1 to Ca, just one notch above what is considered default.

It warned that the rescue package implied a temporary sovereign default.  The likelihood of a distressed debt exchange and a default on Greek government bonds was virtually 100 per cent.

It warned that Greece still faced medium-term solvency challenges and there were significant risks in implementing the required reforms.  From its experience, countries that defaulted often defaulted again.

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