Will Greece Default?

Greece appears to be saved for now, but will they default? Some experts argue that it is only a matter of timing. They are not at all out of the woods. Who is next? Is Portugal next in line? Spain, Italy and Ireland are on the radar as well. If it were just Greece, the problem wouldn’t be so bad.

From the Financial Times:

The European Union finally agrees a bail-out, and the much-predicted rally of Greek bonds turns into a rout. A week later, spreads on Greek bonds had reached their highest levels since the outbreak of the crisis. The financial markets have recognised that, bail-out or no bail-out, Greece is in effect broke.

The bail-out prevents a default this year, but makes no difference whatsoever to the likelihood of a subsequent default. Just do the maths: Greece has a debt-to-gross domestic product ratio of 125 per cent. Greece needs to raise around €50bn ($68bn, £44bn) in finance for each of the next five years to roll over existing debt and pay interest. That adds up to approximately €250bn, or about 100 per cent of Greek annual GDP.

To avoid long-run insolvency, Greece will need to find a way to stabilise the debt-to-GDP ratio. This would in turn require a multi-annual deficit reduction plan and a programme of structural reforms to raise the potential growth rate. The Greek government has so far presented a one-year plan to cut the deficit from 13 per cent of GDP to about 8.5 per cent. While this sounds ambitious, it is not very credible, as it is based heavily on tax increases, with no structural reforms.

But even if the Greek government were to present a credible long-term stability plan, the risk of default would remain high. This means that some form of debt restructuring is unavoidable. Restructuring is a form of default, except that it is by agreement. It could imply a haircut – an agreed reduction in the value of the outstanding cashflows for bond holders. The Brady bonds of the late 1980s, named after Nicholas Brady, a former US Treasury secretary, worked on a similar principle. An alternative to restructuring would be a debt rescheduling, whereby short and medium-term debt is converted into long-term debt. This would push the significant debt rollover costs to well beyond the adjustment period.