Friday, January 22, 2010

How Serious Is Greek Debt Crisis?

Worries over the big budget deficit in Greece have steadily escalated in recent weeks, causing the yield spread between Greek and German bonds to exceed 300 basis points (3 percentage points). But how serious is this crisis really?

The truth about the issue is that Greece's public finances are indeed in a bad shape, but that it is not likely that Greece will default or exit the euro.

One part of the problem is that Greek statistics have proven unusually unreliable. All government statistics should be taken with a grain of salt, but Greek statistics are particularly unreliable-particularly with regard to public finances.

Case in point is the 2009 budget deficit which according to the new government was much greater than what the previous government reported it to be. And this is not the first time that such irregularities existed. The fact that statistics are unreliable makes the problem much worse since the uncertainty will in itself create an extra risk premium on Greek bonds.

Assuming that the current statistics for 2009 are reliable (and that seems likely. And it is more likely that the current government might even exaggerate the deficit to make their predecessors look worse than it is that they would want to underestimate the deficit they inherited) the situation is indeed bad with a deficit of over 12% of GDP and a debt of 109% of GDP. That is not uniquely bad as there are countries (for example the U.K.) that have a bigger deficit or a bigger debt (for example Japan), but unlike the U.K. and Japan, Greece doesn't have the ability to print money, making it potentially vulnerable for a formal default. It is much more difficult and dangerous to be fiscally irresponsible if you lack your own currency and the ability to print it (or if the government debt is denominated in a foreign currency), something which both Greece and California have experienced.

Furthermore, the worries about Greek debt risks being a self-fulfilling prophecy. The more markets worry about it the higher will yields go something which in turn will cause the deficit to increase further (because of higher interest cost), something which will raise yields further and so on in a vicious circle.

Given the magnitude of the yield increases in some days, it seems likely that we are not just talking about investors selling their holdings but also of hedge funds and others selling Greek debt short.

So there is indeed a possibility of default-but it is not a very likely possibility. Speculative attacks of this kind are usually short-lived and the Greek government does seem committed to fiscal austerity measures. While the current panic will increase interest costs, it will also increase the determination of its politicians to reduce the deficit and increase public support for such measures. In the past when the price for doing so was low, it was difficult to convince the Greeks of the dangers of deficit spending, but now the rules have changed.

And ditching the euro in order and bringing back the drachma to enable the politicians to inflate way out of trouble is highly unlikely. First of all because it would be inconsistent with the rules of EU membership and secondly because Greek debt is denominated in euros. If the drachma was reintroduced it would almost surely drop in value dramatically against the euro, increasing the burden of euro denominated debt dramatically, worsening the debt crisis.

With all this in mind, it seems clear that Greek bonds are significantly undervalued from a fundamental point of view. The current yield spread against German bonds imply (for 10-year securities) a 100% certainty of a 30% default (that the Greek government will only pay back 70% of the nominal value), assuming 0% risk of any kind of default on German bonds. Or alternatively that there is a 30% risk that the Greek government will repudiate its entire public debt, something which would be unprecedented for a civilized country (With the exceptions of for example the newly created Soviet Union repudiating the debts of the Russian Empire, it has almost never happened anywhere). While the risk of some kind of partial default is clearly higher for Greek bonds than for German bonds (justifying a smaller yield spread), it is not anywhere near that much higher.