EU: Contagion fears


The Greek debt crisis has intensified dramatically in recent days, raising concerns about contagion within the euro area. Greek sovereign debt has been downgraded, yields on Greek government bonds have soared, and estimates of the cost of a joint EU/IMF bail-out are increasing. Sovereign ratings for Spain and Portugal have also been downgraded. The risk of outright default by Greece has increased substantially. The turmoil should ease once European governments approve a support package allowing Greece to refinance €8.5bn (US$11bn) worth of bonds maturing on May 19th. If, as is being widely reported, this package offers multi-year support, it should further help to calm markets by limiting the need for Greece to refinance maturing debt. But investors will continue to be wary of any signs that the package will fall apart. Fiscal problems in Greece or other countries now seem likely to cause renewed bursts of turmoil over the next year.

The ultimate question for Greece is whether it will have sufficient external support to avoid a default until the delayed effects of fiscal consolidation show up in budget deficit numbers. The government has already announced plans to tighten fiscal policy by 6.5% of GDP this year, using measures such as large tax hikes, public-sector wage cuts and (less reliable) plans to combat tax evasion. Further measures to improve the fiscal position over the next three years are being negotiated between Greece, the EU and the IMF, following Greece’s formal request for financial support on April 23rd. This massive tightening will drastically weaken the Greek economy, hitting tax revenues and thus undermining the government’s immediate prospects of bringing down the fiscal deficit. Only once Greece has passed through this tunnel will efforts to reduce the public debt show more visible progress.

The concern for investors is that by then it will be too late to avoid default, as the public debt and thus debt-servicing costs would have already risen to unmanageable levels. For this reason markets are pricing in a high chance of a debt restructuring. The spread between Greek 10-year government bond yields and their German counterparts, an important indicator for perceptions of default risk, rose to 852 basis points on April 28th, up almost 200 basis points from the previous day and much higher than the average of a little above 300 for the first three months of the year. Concerns about solvency also triggered a downgrade of Greek government debt by Standard & Poor’s (S&P), a credit ratings agency, by three notches to BB+, the highest junk-bond rating.

The rating downgrade, if followed by similar moves at other major rating agencies, could have direct implications for Greek financing costs. The European Central Bank (ECB) allows commercial banks to supply government debt as collateral for the ECB’s main refinancing operations, but it requires the debt to be rated as investment-grade. If the investment-grade status is lost, banks would not be able to use Greek government debt as collateral with the ECB. They would have to move their money into other securities, which, in turn, would prompt a further sell-off in Greek debt, pushing yields still higher.

Euro zone wrangling

Another reason for the surge in Greek bond spreads has been the market perception that European governments have lacked urgency in developing a package of financial aid. In particular, the German government has been keen to postpone approval of any bail-out until after a key state election on May 9th, as the German population is widely opposed to supporting Greece and the federal government fears a voter backlash. However, in the face of the latest deterioration in market confidence, the German parliament is likely to vote on the package on May 3rd. This vote is likely to get broad support, clearing a major stumbling block to a rescue for Greece and thus providing relief for the markets.

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Market uncertainty also reflects the rapidly changing state of bail-out discussions. Initially the support package, approved on April 11th, was expected to amount to €45bn, consisting of €30bn from euro area governments and an additional €15bn from the IMF. Judging by reports from German parliamentarians, negotiations are now discussing a total rescue package of €100bn-120bn. This could be sufficient to avoid the need for Greece to return to capital markets for two to three years. Even if the actual package turns out to be substantially lower than this amount, it should be seen as encouraging that the IMF is preparing the ground for prolonged support for Greece. This will make it easier for Greece to get through the period during which fiscal tightening will depress the economy (and thus government revenues). The fact that policymakers are talking about support beyond the current year rather than ignoring the need for further support may calm markets.

Euro area governments have strong incentives to prevent a default. Apart from the electioneering in Germany, their wavering mainly reflects a concern to signal that fiscal profligacy will not be an option for other euro area governments. Those governments with more fragile public finances would see their borrowing costs soar, as a Greek default would make clear that they could not rely on outside support. Even governments with relatively strong public finances, such as Germany and France, would be hit by the need to absorb the shock to their own banks. Some €85bn (out of a total of €200bn) in Greek government debt is held by non-Greek euro area banks, with France having the largest share. A restructuring would lead to a renewed dramatic surge in risk aversion that could freeze inter-bank markets much as the Lehman collapse did in mid-September 2008.

The concern is that other countries’ dependence on Greece avoiding default could encourage the Greek government—which faces protests at home because of its austerity programme—to bargain for less stringent conditions for financial support or to be half-hearted in its implementation of agreed consolidation measures. Any such brinkmanship could then lead to an unravelling of the support package. This, however, seems unlikely, at least for the present, since the Greek prime minister, George Papandreou, seems determined to try to restore Greece’s reputation within the EU and internationally.

The bigger picture

So far, spreads over German bonds for other euro area governments have risen much more modestly than for their Greek counterparts. Some of the increase in recent days has been due to a decline in German bond yields, as a result of Germany’s safe-haven status. Still, spreads for Portugal have risen from an average of 120 basis points in March to 283 points as of April 28th, and spreads for Ireland have increased from 140 points to 226 in the same period. The balance-sheet pressures facing these countries, for now, appear less formidable than those for Greece. But if markets start challenging the assumption that the situation can be controlled, yields could raise financing costs to unsustainable levels.

The concerns are also shifting to bigger euro member states, with a focus on Spain. Spreads for Spanish bonds have barely increased, but the challenges facing the country are substantial. The housing crash in Spain is still going on, and the fall-out will continue to undermine the financial sector, GDP growth and public revenues. A serious fiscal crisis in Spain remains unlikely, but there is a high risk of market pressures forcing Spain to tighten fiscal policy more aggressively, which would further weaken the recovery.

While the US has benefited from substantial safe-haven inflows as a result of the Greek crisis, its own fiscal situation will remain under close scrutiny. The public finances of the UK and Japan will also remain a serious concern. As a consequence, even assuming that the Greek crisis eases after a package of support is agreed, fiscal pressures will remain a major concern for the world economy. Renewed turmoil triggered by any one of these countries is more likely than a shift to smooth sailing.

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