Wednesday, April 28, 2010

Some details on the Greek situation (UPDATE-1)

Spreads for Portugal, Spain and Greece are jumping up relative to a week ago. Except for Greece, the situation is not terrible, but there is growing evidence of the risk of contagion is very real as evidenced by the jump in Portugal and Spain's borrowing rates. The graphs are for today and last week, respectively.
  • Greek GDP was approximately EUR 237B in 2009
  • Greek deficit was approximately EUR 32.3B, or 13.6% of GDP
  • Debt service costs based on at-issue yields of outstanding government bonds (Bloomberg: Crop GGB Corp) is EUR 11.7B
  • Therefore, the debt service is approximately 1/3 of the deficit.
  • Public sector spending accounts for 40% of GDP
  • Imports are in 2009 were EUR 47B and imports EUR 15.7B (source)
The haircut scenario:
  • What is this trying to accomplish?
    Reduce the debt burden on Greece so it can continue to operate.
  • After the haircuts will Greece start reducing net debt outstanding?
    No. Their structural deficit is twice the size of their debt service. Assuming a 50% haircut, Greece would still pay over EUR 5.8B a year in debt service, or 2.4% of GDP.
  • OK, So what's the point?
    The idea is to get Greece to the point where it's GDP is growing faster than it's total debt, reducing outstanding debt as a percentage of GDP. Without this, they would just be heading right back in the same direction.
Let's look at some of the problems with this plan. We commonly define GDP as:
GDP = Consumption + Investment + Government Spending + NetExports
  • Increasing government spending is out of the question. The government is already running a deficit which they are trying to reduce and the restricted access to capital markets makes going further into debt to stimulate the economy a non-starter. If anything, this number will be shrinking.
  • Furloughs, layoffs, wage cuts or benefit cuts would do nothing to increase consumption.
  • To increase NetExports you would need to reduce imports, increase exports or both. When a country devalues their currency, imports instantly become more expensive and exports more competitive, therefore instantly goosing this number. Greece, however, doesn't have this option because it is part of the Euro, so the answer is to reduce wages. Judging by the pictures of the protesters I've seen, I would expect significant resistance.
  • To increase Investment, businesses would have to start spending to increase in capacity. An increase in capacity spending would need to see increased aggregate demand.
Increasing retirement ages would decrease pension expenditures, but increase labor costs for government employees. With an already elevated unemployment rate (~9.8%), increasing the labor force does nothing except increase idle capacity. Because of the stickiness of wages in a highly-unionized labor force, the added capacity is unlikely to exert enough pressure to significantly reduce wages and increase utilization.
    As you can see, without the option of devaluation, stimulating GDP will not be easy. Without significant wage cuts or fiscal stimulus, the economy runs the very real risk of stalling and falling into a deeper recession. The Greeks have a real problem in their hands, and I see no straight-forward solutions. The more I look at the numbers, the more exiting the Euro seems like a good strategy.

    A Euro exit
    More than debt and associated debt-service, Greece's problem is it's financial obligations. They spend more than they collect and eliminating their debt is not going to change that. If the people refuse to accept cuts in nominal terms, they are going to have to accept cuts in real terms. Default is not going to magically fix this. If anything, the restricted access to capital markets would put even more pressure on the government to balance it's budget as borrowing to cover short-falls ceases being an option. If workers refuse to be flexible, inflating away obligations is the only choice if Greece wishes to get back to growth, and they can't do that without leaving the Euro unless the ECB debases the Euro, which is a topic for another post.

    UPDATE-1:  Peter Bookvar over at The Big Picture has this to say:
    There is talk that the package for Greece will total 120b euros over 3 years which would be much bigger than initially said a few weeks ago.
    EUR 120B is definitely enough money to delay default by 2, maybe 3 years. At 30B a year, it would be enough to cover all funding of the deficit, although there is that small matter of the 17B,still due this year, the 30B due next year and the 31B due in 2012 in combined short and long-term bonds coming due. (Bloomberg: GGB / GTB). The issue, once again, is that you'll just end up with a more highly-leveraged Greece. Without GDP growth or deficit reduction, this is just delaying the problem and making sure the fallout will be greater when it does hit.

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