UNIVERSITY OF BIRMINGHAM

THE GREEK DEBT CRISIS 1048774

Word count 6449

ABSTRACT Although Greece is relatively a small economy compared to behemoths like the United States and China, its debt crisis is one that has captured the attention of the world, with political leaders scrambling to find a solution. This paper is divided into five sections with the first section offering an introduction to what a sovereign debt crisis is and how the situation in Greece erupted into a fullblown one. Section two analyses the lax enforcement of the stability and growth pact, fiscal imbalances, and the lack of clarity from EU leaders to support Greece as the main causes of the debt crisis. The actions taken so far to deal with the crisis in the form of austerity measures, bailout funds and private bondholders debt swap is examined in the third part of the paper. The merit of alternative measures namely a default and an exit from the European Monetary Union is subsequently debated in the fourth section. Finally the paper ends with a conclusion summarizing the essay and a description of what problems remain unresolved.

TABLE OF CONTENTS
1. INTRODUCTION TO THE GREEK DEBT CRISIS 1.1 Sovereign debt crisis 1.2 Transition to a full blown crisis 2. MAIN CAUSES OF THE CRISIS 2.1 Fiscal imbalances 2.2 Lax enforcement of the Stability and Growth pact (SGP) 2.3 Lack of clarity from EU leaders to support Greece 3. ACTIONS TAKEN TO DEAL WITH THE CRISIS 3.1 Bailout funds 3.2 Austerity measures 3.3 Private Sector Involvement (PSI) 4. ALTERNATIVE ANTIDOTES TO THE CRISIS? 4.1 Default within the EMU 4.2 Exit from the EMU 5. CONCLUSION References Appendix 3 3 3 5 5 8 9 10 10 12 17 20 20 22 24

1.

INTRODUCTION TO THE GREEK DEBT CRISIS

This chapter explains what a sovereign debt crisis is, the root cause of it and analyzes how the situation in Greece erupted into a full-blown crisis. 1.1 Sovereign Debt crisis.

A Sovereign debt crisis refers to a period where there is a dramatic rise in the interest rates creditors demand from a Government due to the fear of a default. If bondholders begin to fear a country might become insolvent the interest rates demanded of that country would surge in order to compensate for the higher risk of default. Sovereigns unlike companies cannot be liquated and there are no courts available which can enforce payments on its contracts such as transferring assets to creditors. (Bianca De Paoli, 2006). The inability of creditors to seize assets of an insolvent nation makes sovereign debt highly sensitive to any hint of a potential default. Hence the greater the risk of default the higher the yield bondholders will demand on a government bond.

1.2

Transition to a full-blown crisis.

With reference to public finance theory, a countrys debt becomes explosive if its bond yields exceed its growth rate in the absence of a primary surplus, as debt accumulates faster than GDP grows. During the early part of the millennium Greece enjoyed robust growth, averaging 4.1% between 2000 and 20061, with its real debt burden fairly stable bar fluctuations around the 100% debt to GDP ratio mark2. However beginning in 2007 with the onset of the global financial crisis Greeces growth rate began to decline, falling from 5.5% in 2006 to 3% in 2007 and eventually a contraction of 0.2% in 20083. With the rate of growth in tax revenues declining and no subsequent cut in the pace of increase in Government expenditure4 Greeces primary deficit rose from 0.7% of GDP in 2005 to 10.6% in 2009

Eurostat See table at the end of this section for exact figures 3 Eurostat 4 This point is expanded upon in section 2.1 titled Fiscal Imbalances
1 2

causing Greeces real debt burden to increase by 27.7% over this period, from 101.2% of GDP to 129.3%5. As investors distrust in the ability of Greeces economy to grow and its willingness to impose austerity measures grew6 so did Greek bond yields7 until it became unsustainable for Greece to auction bonds in the capital markets8 causing it to result to bailout loans from the Troika to finance itself. A present day unorthodox situation is Japan which currently has a debt to GDP ratio of 220%9 yet its bonds (JGBs) yield 1.04%10 on the secondary bond market while Greece with a real debt burden of 165% has a yield of 68.08% on its bonds11. The key reason for this phenomenon is Japanese Government bonds unlike Greek Government bonds have a larger steady inflow of funds into them from domestic households and corporate sector due to the Japanese domestic publics home biasedness and aversion to foreign exchange risks12

140 120 100 80

Billions
60 40 20 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Government Revenue Government Expenditure

Source: Eurostat

Eurostat A new government came into power in October 2009 and announced the previous incumbent had underestimated the deficit figure for the year by 50% 7 The yield on 10 Year Greek bonds rose from 2.26% in Oct 09 to 8.4% in May 10 Bank of Greece 8 Greece still auctions Treasury bills 9 IMF 10 Bloomberg 11 Bank of Greece 12 Waikei R. Lam, Kiichi TokuokaAssessing the risks to the Japanese Government Bond market
5 6

2.

MAIN CAUSES OF THE CRISIS.

In this chapter I analyze the slowdown in the Greek economy, a lack of clarity from EU leaders to support Greece, and a lax enforcement of the stability and growth pact as the main causes of the Greek debt crisis.

2.1

Fiscal Imbalances.

A countrys real debt burden cannot grow without limit unless it will end up insolvent, without economic growth it must run a primary surplus to stabilize its debt yet simply running a primary surplus might not be sufficient enough if its debt service costs are high and as such a large primary surplus might be required13. i.e. Debt = G T + rD-1

13

De grauwe P. 2000 economics of monetary union 4th edition oxford press

A country can however stabilize its debts even with it running deficits given its growth rate exceeds the interest rate on its debts14. (D/Y) = (G T)/Y + (r-g) D-1/Y The formula above calculates the required primary balance to attain a specific change in the real debt burden figure, to keep it unchanged a country must run a primary budget surplus equal to its debt servicing costs. If its primary balance is above the required surplus its real debt burden begins to fall, furthermore, the higher the interest rate the bigger the required surplus to keep the real debt burden constant. Using public finance theory to calculate the required primary balance needed to stabilize Greek debt between 2002 and 2010 it emerges that the only time Greeces real debt burden fell was in 2003 15 when its actual primary balance, a deficit of 0.7% of GDP exceeded what was required of it, a deficit of 0.9% of GDP. However from 2004 Greece has consistently missed the required primary balance16 to stabilize its debt resulting in its debt to GDP ratio rising from 97.4% in 2003 to 113% in 2007. The pace of the increase in Greeces real debt burden began to rise substantially from 200717 as the slowdown in growth was not counterbalanced by a contraction in the rate of increase in government expenditure, in 2008 and 2009 the difference between the percentage change in government expenditure and the percentage change in government revenue was 6.6% and 12.8% respectively, resulting in Greeces primary deficits rising from 2% of GDP in 2007 to 10.6% in 2009. As Greeces primary deficits began to worsen so did Greek bond yields begin to rise18 resulting in Greeces deficits and real debt burden skyrocketing19.

YEAR Govt. Expenditure (% of GDP) Govt. Revenue (% of GDP) % Govt. Expenditure % Govt. Revenue

2002 45.09 40.25 6.48 5.39

2003 44.74 39.02 9.25 6.74

2004 45.52 38.10 9.32 4.89

2005 44.60 38.96 2.09 6.57

2006 45.21 39.18 9.69 8.81

2007 47.61 40.81 12.32 11.08

2008 50.60 40.69 11.11 4.23

2009 53.81 38.02 5.76 -7.06

2010 50.24 39.48 -8.36 1.91

Source: Eurostat

De grauwe P. 2000 economics of monetary union 4th edition oxford press It fell from 101.7% of GDP in 2002 to 97.4% in 2003 16 See exact figures in the table below 17 Rising 34.9% between 2007 and 2010 compared with 8.7% between 2004 and 2007 18 27% between 2006 and 2009 Eurostat 19 See table below for exact figures
14 15

YEAR Growth (%) Interest Payment (% of GDP) Primary balance to stabilize debt* (% of GDP) Actual primary balance (% of GDP) Debt Burden (% of GDP) Deficits (% of GDP) Inflation (%) Yields (%) Gross debt ( billions) GDP ( billions)

2002 3.4 5.6

2003 5.9 5

2004 4.4 4.8

2005 2.3 4.6

2006 5.5 4.6

2007 3 4.8

2008 -0.2 5.1

2009 -3.3 5.1

2010 -3.5 5.8

2.2 0.7 101.7 4.8 3.9 5.12 159.2 156.6

-0.9 -0.7 97.4 5.6 3.4 4.26 168.0 172.4

0.4 -2.6 98.8 7.5 3 4.25 183.1 185.2

2.3 -0.7 101.2 5.2 3.4 3.58 195.4 193.0

-0.9 -1.4 107.3 5.7 3.3 4.07 224.2 208.8

1.8 -2.0 107.4 6.5 2.9 4.5 239.3 222.7

5.3 -4.8 113 9.8 4.2 4.8 263.1 232.9

8.4 -10.6 129.3 15.8 1.4 5.17 299.5 231.6

^ -5.0 144.9 10.6 4.7 ^ 329.3 227.3

Source: Eurostat *Calculated using Public finance theory formula ^ Unavailable data

28/1/12 160 140 120 100

GREEK DEBT IN % OF GDP

160 140 120 100

80 60 97 98 99 00 NET PUBLIC DEBT RATIO 01 02 03 04 05 06 07 08 09 10 11 12

80 60

GREEK BALANCE IN % OF GDP

-5

-5

-10

-10

-15

-15

-20 97 98 99 00 PUBLIC SECTOR BALANCE 01 02 03 04 05 06 07 08 09 10 11 12

-20

Source: Thomson Reuters Datastream

2.2 LAX ENFORCEMENT OF THE STABILITY AND GROWTH PACT (SGP) The stability and growth pact was a framework for the coordination of fiscal policy in the European Monetary Union (EMU). Its main idea was to promote fiscal stability in the EMU by promoting sound fiscal policies in member states and it required all member countries to have a national real debt burden of no more than 60% of GDP and a deficit ceiling of 3% of GDP. Germany and France were the two main supporters for the adoption of the SGP, herein lays the irony; it was in fact Germany and France who both limited its effectiveness. The SGP sought to impose a 0.5% of GDP financial sanctions on countries which failed to adhere to its fiscal rules. However between 2002 and 2004 Germany and France breached the 3% deficit limit, both countries suffered from rising unemployment and slow economic growth and were reluctant to cut spending as they feared it might worsen the state of their economies. Using their economic might they lobbied the European and Financial affairs council to reform the rules under the premise the original rules were too strict and difficult to enforce. Although the 3% and 60% rules were maintained, stringent rules in the past were loosened such as deadlines for countries to converge to the 3% deficit level being extended if a State was deemed to 8

have taken action but not meeting the target due to economic events. The definition of a severe economic downturn was also watered down to allow countries run deficits and avoid sanctions by taking refuge under the exceptional and temporary clause20. In 2002 and 2005, prior to the reforms, Portugal and Greece were respectively threatened with financial sanctions due to their deficit to GDP ratios exceeding the 3% criterion; these threats of sanctions caused both countries to adjust their finances with Portugal cutting its deficits from 4.3% of GDP in 2001 to 2.9% in 2002 and Greece cutting its from 7.5% in 2004 to 5.2% in 2005. The reforms to the SGP were made to make it more understanding of economic factors and circumstances but consequently made it redundant by making the enforcement of the SGP more discretionary than rule based. After the reforms countries breaching the 3% deficit to GDP ratio were allowed to continue with no threat of financial sanctions, if the implementation of the financial sanctions were imposed as originally designed it would have served as a deterrent to Greece running excessive deficits.
COUNTRY 2000 2001 2002 2003 2004 2005 2006 Greece 3.7 4.5 4.8 5.6 7.5 5.2 5.7 Portugal 2.9 4.3 2.9 3 3.4 5.9 4.1

Units: Deficits % of GDP Source: Eurostat

2.3 LACK OF CLARITY FROM EU LEADERS TO SUPPORT GREECE The state of Greeces public finances has left it teetering on the edge of default, with the only thing keeping it solvent being bailout loans from the Troika. The bailouts are disbursed in tranches with each tranche being released subject to Greece meeting conditionality set by the Troika. In November 2011 an overdue tranche of 8bn to Greece was suspended following a Greek call for a referendum to approve a second bailout of 130bn which had been previously agreed with the Troika, highlighting the lack of unity between Greece and the Troika. In addition to the delay in releasing the bailout tranche there were calls by European officials insisting any new bailout funds be specifically earmarked to pay off remaining holders of Greek debt. Under the proposed plan an escrow account would be created to accept new bailout funding directly rather than paying it to Greece21. The rationale behind this plan is that the new fund would ensure bondholders are paid off in the process avoiding a default while also providing the Troika with the ability to withhold additional cash required for the Greek government to operate if they do not

20 21

This is a clause which allows countries to run temporary deficits under exceptional conditions Financial Times 2010 New Greek bailout to prioritise debt holders

implement reforms. Although valid in its aim the plan consequently exposes EU officials lack of credence in Greeces resolve to impose fiscal discipline and combat the crisis, suggesting Greece is on a path to default. There is a taint of hypocrisy in the sense that Eurozone officials do not want to impose new powers on the ECB to assist Greece when in the past they were willing to reform the SGP in order to help both Germany and France navigate their own economic slumps. By not reforming to include full employment into its mandate, the ECB has a conflict of interest between trying to keep inflation at 2% and performing a monetary expansion to stimulate aggregate demand in the short run22 which could provide temporary relief to Greece while it performs economic adjustments such as labor market reforms. Newly restructured bonds from the PSI debt swap programme23 are currently significantly discounted in the secondary bond market displaying investors belief in a further restructuring or default. Bonds with an 11 year maturity currently trade at 26.5 cents in the euro, with an 18.6% yield compared with a coupon of 3.65%, while the 30 year bonds currently trade at 23.1 cents in the euro with 13.5% yields24.

3. ACTIONS TAKEN TO DEAL WITH THE CRISIS. Three critical steps have been taken to alleviate Greeces debt crisis. In this chapter I discuss the bailout funds set up for Greece to access financing, the ongoing austerity programme, and finally the bond write off agreed between Greece and its private creditors. 3.1 Bailout Funds The Troika, a tripartite committee composed of EMU25 countries, the IMF and the ECB fund Greeces bailouts through bilateral loans26 with the contributions from EMU countries calculated on the basis of a countrys GDP, as Germany and France are the two biggest economies in the EMU they contribute the most and consequently their opinions carry the most clout. Greeces first bailout was a 110bn package from the Troika with the EMU countries contributing 80bn and the IMF 30bn. A second bailout to further support Greece was later agreed in February 2012 of which the EMU countries and IMF provide 117bn and 13bn

Monetary expansion cannot provide long term real gains in GDP due to the long run neutrality of money Discussed extensively in Section 3.3 of this paper 24 Wall Street Journal 2012 New Greek bonds same old doubts 25 European Monetary Union 26 The ECB does not fund Greeces bailout loans directly but it does buy Greek bonds on the secondary market and provides loans to the Greek Banks
22 23

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respectively27. The second bailout package includes the creation of an escrow to always hold three months worth of debt repayments until Greeces constitution is amended to make debt payments a top priority in government spending, it also includes a permanent team of EU monitors in Greece to ensure it conforms to the austerity measures conditional of the bailout package28. The bailout packages are sufficient enough to cover Greeces financing needs; its gross public debt is currently 356bn29 which is relatively small compared to other member states such as Italy whose debts total approximately 2.3tn30. In addition to the funds available from the Troika there is the European Financial Stability Fund (EFSF), the EFSF is a special purpose entity financed by loans issued on the bond market and guaranteed by Eurozone member states it was created to provide temporary financial assistance to member states if needed and the EFSF has a capital guarantee of 726bn with a lending capacity of 440bn31. Although big enough, debate exists regarding the interest rate charged on the bailout loans. Michael Musa in his paper titled Beware of Greeks bearing debts (2010) commented So long as the official support that Greece receives is the form of loans that must be repaid with interest that at least compensates official creditors for their own cost of funds there is no true bailout of Greek citizens. However with analysis of the real bond yields of countries providing the bailout loans coupled with examination of the real yields they stand to gain from the bailout loans it emerges not all creditors cover their real cost of funding the bailout with the ability to cover costs highly dependent on floating variables such as inflation and nominal bond yields. In the tables accompanying this section I provide analysis of the real profit various creditors stand to make on the bailout loans under different scenarios. As of writing, the interest rates on the bailout loans to Greece have been fixed at 4.5% from 2012 to 2015 and 3.5% after 201532.With the yields on the bailout loans fixed creditors with low inflation and low nominal bond yields stand to cover their costs of funding while countries without that luxury do not in fact cover their real cost of funding. The outcome of creditors real profits (Real profit is calculated as Real interest rate on bailout loans Real bond yields of creditor) on the bailout loans are subject to minor variations in the endogenous variables used in the calculations of a creditors real profit. For instance, in an optimistic scenario where inflation is constant at the ECBs 2% target and nominal bond yields fall 5% from their current positions Finland stands to make a real profit on its bailout loans of 4.05% between 2012 and 2015, and 3.05% from 2015 onwards. If the scenario was altered to a case where inflation is constant as
Europa.eu Financial Times 2012 Brussels told of need to reinforce monitors in Greece 29 European Commission The Economic adjustment programme for Greece 5th review, March 2012 30 Economist intelligence unit 31 www.efsf.europa.eu 32 Europa.eu
27 28

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they are today33 and nominal bond yields rise by 5% from current levels34 the gains to Finland would be 2.04% between 2012 and 2015 and 1.04% from 2015. Likewise the macroeconomic scenario also dictates whether a country covers its cost of funding or not. If inflation and nominal bond yields remain constant as they are today over the duration of the bailout loans Belgium will make a real profit of 0.8% on its loans between 2012 and 2015, and a loss of 3.5% from 2015 onwards. However in a sanguine case where inflation is constant at 2% and nominal bond yields are down 5% from current levels Belgium stands to make a 1.47% real profit on its loans between 2012 and 2015 while making 0.47% from 2015 to maturity. Tables in the appendix show the real profit and losses different countries stand to reap under various scenarios.

3.2 Austerity measures The Troika dispenses Greeces bailout funds subject to Greece implementing austerity measures conditional in the rescue package. The first bailout was dispensed in six tranches and although the second bailout was initially agreed in October 2011 conflict subsequently erupted between Greece and the Troika regarding the conditions of the bailout, Greece regarded the required cuts as too severe and went as far as the then Prime Minister George Papandreou calling for a referendum to seek national approval of the bailout package35, nonetheless the 2nd bailout was fully agreed upon in February 201236. Although the proposal for a referendum was later retracted it further damaged the relationship between the Troika and Greece, in so much as the European commission stating publicly The budgetary policy by the Greek authorities did not comply with the councils recommendations and seems insufficient to address Greeces fiscal imbalances in a sustainable manner37. In spite of massive social unrest and public opposition Greece has nonetheless proceeded to adopt a number of austerity measures to rectify its dismal fiscal position and also meet the conditions imposed on it by the bailout packages. Some of the measures include a 7% cut in the salaries of public and private employees, decentralization of companies, welfare and pension cuts, a 10% cut in public sector bonuses, 30% cut in Christmas, Easter and leave of absence bonuses, a rise of VAT from 4.5% to 23%, an increase in income taxes for everyone with an

3.3% in Finland ECB 2.46% in Finland ECB 35 BBC Greek crisis: Papandreou promises referendum on EU deal 36 Financial Times 2012EU agrees second Greek bailout 37 Europa.eu GREECE: Commission assessment in relation to the commission recommendation for a council decision under Article 104(8) of the Treaty
33 34

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annual income over 8000, rises in petrol alcohol and cigarettes taxes and the increase of the retirement age for public sector workers from 61 to 6538. Several factors have stalled Greeces progress towards the targets of its austerity programme, political instability, social unrest and more fundamentally a deep recession (6.9% in 2011). Negative business and household sentiment, high unemployment levels, decline in investment, deceleration in demand for Greek exports and difficulties in accessing credit contributed to weak private consumption and subsequently lead to the deep recession in Greece in 201139.

Source: European Commission

38 39

Europa.eu European Commission The Economic adjustment programme for Greece 5 th review, March 2012

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Units: Thousands of Millions (Billions)

Greeces deficit is estimated to have reduced from 10.5% of GDP in 2010 to 9.25% in 2011 with the decline resulting from an increase in the revenue to GDP ratio by 1.5% while the primary expenditure ratio as a percentage of GDP fell by 1 percentage point40. Withstanding an increase in interest expenditure by more than 1% between 2010 and 2011 the improvement in Greeces primary deficit was almost 2%, to have achieved this it is estimated Greece undertook austerity measures amounting to 7.75% of GDP. This amount of measures is significantly higher than the resulting reduction in deficits suggesting that the recession in Greece is serving to counteract its austerity programme through the downward pressure on the tax revenue available to the Government. Greeces return to sustainable debt levels depends heavily on the macroeconomic conditions that materialize; in this part of the essay consideration is given to the sustainability of Greek debt based on a baseline scenario and the effect deviations from this scenario will have on Greeces real debt burden.

40

European Commission The Economic adjustment programme for Greece 5 th review, March 2012

14

Source: European Commission

Source: European Commission Units: % of GDP 15

Under the baseline forecasts a reduction in the debt to GDP ratio will occur in 2012 as a result of the debt PSI swap programme but will rise again in 2012 due to the ongoing recession and the still low primary surplus. Only in 2014 will the fiscal adjustment effort, a return to growth and the privatization proceeds cause Greeces debt to begin to progressively decline from 164% of GDP in 201341. The alternative scenarios in the graph above illustrate the wide spectrum of outcomes which may arise as a result of minor variations in policy choices and macroeconomic developments; they show in particular that subtle variations in growth can have a substantial impact on Greeces debt burden. If the annual nominal growth rate is consistently higher than in the baseline scenario by 1% Greeces debt burden in 2020 would be 105%, in contrast weaker growth rates of 1% per year below the baseline scenario will result in the debt to GDP ratio being 129% in 2020. To illustrate the impact of different fiscal adjustment programmes the debt was projected assuming primary surpluses of 1.5% and 2.5% of GDP over the whole period. Under a scenario where Greeces primary surplus does not exceed 1.5% of GDP its debt reduction would be temporary as its debt burden would begin to increase as soon as the gains of privatization disappear. On the other hand under a scenario where the primary surplus is constant at 2.5% of GDP the debt ratio will be 131% of GDP in 2020 and about 120% in 2030. In a case where the privatization of state assets is unsuccessful with proceeds not exceeding 10bn, in 2020 the real debt burden still declines if the other parameters in the baseline scenario are attained, however the debt burden would remain above 130% of GDP by 202042. These projections display how critical strong growth and a large primary surplus are in reducing Greeces real debt burden and although austerity is needed to improve Greeces competitiveness and ensure a large primary surplus the ones currently being imposed on Greece are too abrupt and are providing a substantial negative shock to the Greek economy, Greeces real debt burden will increase if growth is further stifled by the Troika imposing rapid austerity measures. Asked whether Greece under the scenarios of the second bailout could reach sustainable debt levels by the end of the decade, Wolfgang Schauble the German finance minister responded Naturally they come with, as Mark Twain said, a significant amount of uncertainty43.

41 42 43

European Commission The Economic adjustment programme for Greece 5 th review, March 2012 European Commission The Economic adjustment programme for Greece 5 th review, March 2012 Financial Times 2012 Greek accounting cannot hide the urgency for growth

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3.3 Private sector involvement (PSI) Private bondholders initially owned 205bn worth of Greek debt44 and following negotiations with Greece agreed to a voluntary bond swap in which their holdings of existing Greek bonds were exchanged for new bonds issued by Greece. The new bonds have a face value equal to 31.5% of the face amount of the debt exchanged, medium to long term maturities, 2% annual coupon payments till 2015, 3% from 2015 to 2021 and 4.3% thereafter. In addition to the new bonds investors are given 2 year EFSF bonds worth 15% of the face amount of debt exchanged45. The PSI programme wiped out 110bn of Greeces gross debt, approximately 1/3 of it. While the PSI programme has succeeded in reducing Greeces real debt burden in the short run it could discourage investors from investing in Greek bonds when Greece does eventually attempt to return to the bond market for financing with two key reasons existing which may cause this disinterest. The first is the potential for a perceived subordination of private bondholder claims to that of the official sector46 due to the ECBs exemption from partaking in losses on its Greek debt holdings through having its holdings exchanged for new bonds which are not subject to restructurings47. As of January 6 2012 it was estimated the ECB held 36bn of Greek debt48, if the ECB had participated in the restructuring with this amount of Greek debt in its portfolio Greeces debts could have been reduced by an additional 25bn. The way in which the PSI debt swap programme was implemented may also marginalize investors further away from future Greek bond auctions. By inserting a collective action clause into Greek governed bonds which forced unwilling participants to participate in the PSI programme the Greek government made the nature of the debt swap coercive and consequently investors may be reluctant to lend to Greece in the future fearing they may be powerless in outcomes which involve their interests. In the short to medium run the PSI programme also has the potential to negatively impact the Greek financial sector by adding more downside risks to Greek banks who are already challenged with a protracted recession and low credit standing of the Greek economy as a whole49 with nonperforming loans in Greek banks balance sheets have continued to increase reaching 15% at the end of September 2011, up from 13.25% in June of the same year50. The Greek banking sectors
Greek ministry of Finance Greek ministry of Finance 46 National governments and Supranational entities 47 Bloomberg 2012 ECB said to swap Greek bonds for new debt to avoid enforced losses 48 Bloomberg.com 2012 Germany backs ECB in rejecting Lagardes call to take losses on Greek debt 49 European Commission The Economic adjustment programme for Greece 5 th review, March 2012 50 European Commission The Economic adjustment programme for Greece 5 th review, March 2012
44 45

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balance sheet also contracted by 8.7% in 2011 with credit to the domestic economy falling by 3.8% and demand deposits decreasing by 18% over the same period, causing the loan to deposit ratio of most Greek banks rising51. It was estimated by the European commission that the Greek banking sectors portfolio of Greek sovereign debt stood at about 43bn before the PSI programme52, if accurate the PSI resulted in a loss of 29.45bn, 6.3% of the total assets of the Greek banking sector53. While the capital loss arising from the PSI programme coupled with the dismal state of the banking sectors business climate has the potential to cause bank runs it is unlikely given the availability of loans from the ECB through its Emergency Liquidity Assistance scheme. However funds from the ECB only provide temporary relief and if Greek banks do not return to self-sustainability and ECB funding costs in the future become unbearable it may lead to a financial crisis in Greece.

PERIOD % Growth in Bank deposits

Jan11 -0.3

Feb11 -3.8

Mar11 -6.4

Apr11 -9.1

May11 -9.3

Jun11 -6.4

Jul11 -6.4

Aug11 -10.4

Sep11 -17.8

Oct11 -18.8

Nov11 -19.9

Dec11 -20.1

Jan12 -20.5

Source: ECB Units: % change

European Commission The Economic adjustment programme for Greece 5 th review, March 2012 European Commission The Economic adjustment programme for Greece 5 th review, March 2012 53 Bank of Greece
51 52

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Greek Banking Sector Soundness indicators

Greek Sovereign and Greek Bank bond Ratings

Greek banks borrowing from the euro system via monetary policy

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4. ALTERNATIVE ANTIDOTES TO THE CRISIS? With conflict existing between Greece and the Troika regarding the severity of the required austerity measures, merits of alternative methods namely a default and an exit from the EMU are analysed as in this segment.

4.1 Default within the EMU. Concerns regarding Greeces commitment in implementing the proposed austerity measures have grown as time has worn on, even leading to Germany seeking for Greece to cede sovereignty over tax and spending decisions to a Eurozone budget commissioner for it to secure the second 130bn bailout54. Both Greece and the EU political leaders officially reject any suggestions of a Greek default with both sides having different incentives in avoiding a default. EU leaders are keen to avoid a default due to the fear of contagion and moral hazard in the Eurozone as there is the perceived notion that a Greek default would pose systemic risks to European financial a la Lehman Brothers, but contrary to popular belief this is not necessarily the case. Prior to the ECB buying periphery debt on the secondary market foreign banks and institutions possessed 140bn of Greek bonds on their balance sheets, accounting for 12% of the Tier1 capital of German banks, 6% of French banks, 14% of Belgian banks and 9% of Portuguese banks55. Some of these bonds have presumably been transferred to the balance sheet of the ECB through its Securities Market programme as the ECB is now estimated to own between 35bn to 40bn worth of Greek bonds (Financial times) and also, following the PSI programme and the triggering of payments on Greek Credit Default Swaps there has been no negative shock to the European financial sector and as such I believe the risks of contagion are not as great as feared. Moral hazard is another reason EU officials oppose a default, fear exist that if Greece defaults on its debt then nations with high debt burdens will also default which could cause a financial turmoil in Europe. However this is not certain as losing market access for a prolonged period provides a deterrent to other countries defaulting.

54 55

Financial Times 2012 Call for EU to control Greek budget Blundell-Wignall,A. and P. Slovik 2010 The EU stress tests and sovereign debt exposures

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Greece still needs austerity measures whether it chooses to default or not, the difference however is the severity of the austerity which needs to be implemented. At the end of 2011 Greece cut its primary deficit to 2.9% of GDP56, as such if Greece manages to eliminate this primary deficit it could afford to default on its debts as it would not need to borrow to finance itself, in contrast however a larger austerity programme is needed to attain a primary surplus which can cover both government expenditures and service Greeces existing debt. Nonetheless default carries with it the consequence of being locked out from capital markets for a prolonged period57 and as such Greece would need to sustain a primary surplus for an extended period if it defaults. Another obstacle which may hinder Greece from defaulting is political coercion from other EU countries as the official sector is now Greeces largest creditor, forecasted by the European Commission to account for 2/3 of Greeces total debt by 2014.58 Growth rates after a default vary among different countries, Argentina experienced an increase in its 5 year annual average growth, rising from 2.5% in the 5years pre default to 4.5% post default, on the other-hand Cameroon experienced a slowdown in its five year annual growth dropping from 4.3% pre default to 2.7% post default59. As such a default does not automatically lead to an increase in growth; it does however provide a clean slate for the economy to rebuild. While the forecast for Greeces GDP in the event of a default is beyond the scope of this paper a default will slow the contraction in the economy caused by the Troika imposed austerity programme.

European Commission The Economic adjustment programme for Greece 5 th review, March 2012 Argentina has been unable to access financing from the capital markets since its default in 2001 58 European Commission The Economic adjustment programme for Greece 5 th review, March 2012 59 Economist 2011 Sovereign defaults and GDP
56 57

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4.2 Exit from the EMU. The main cost of joining a monetary union is the loss of monetary sovereignty. If Greece exits the EMU it could perform a monetary expansion which would stimulate aggregate demand in the short run albeit at the cost of inflation in the long run due to the long run neutrality of money. The lack of fiscal transfers and low labor mobility in the EU condemns Greece to a slow painful economic adjustment process through wage cuts and job cuts in order for it to become competitive and return to potential output. A historically similar case to Greeces current crisis is the Argentine debt crisis in 2001, in addition to accumulating debt which became unbearable to repay it also had its currency pegged at a rate of 1 to 1 with the US dollar60. As Argentinas deficits widened to 2.5% of GDP and its external debt surpassed 50% of GDP it became locked out of bond markets as rating agencies placed Argentina on a credit watch, leading it to resort to borrowing from international lenders namely the IMF, World Bank and the US treasury, which lent to Argentina below market rates. The IMF in return for the loans advised Argentina to impose austerity measures to balance its budget and combat the debt crisis and the Argentine government obliged. The austerity programme much like is currently happening in Greece caused a negative shock to the Argentine economy with unemployment rising 12% year over year between 2000 and 2001 along with GDP contracting 4.4% over this period61. In December 2001 Argentina defaulted on part of its external debt and in January 2002 abandoned the fixed 1 to 1 peso dollar peg which had existed for 10 years to damper inflation. The peso suffered huge depreciations which in turn prompted inflation; the immediate effect was a rise in unemployment by 16.8% and a fall in GDP of 10% in 200262. However since its default and devaluation Argentine unemployment rate has declined from 22.4% in 2002 to 6.7% in 201163 along with real GDP growth of 94% over this period64 notably through import substitution as local producers have improved competitiveness relative to their international counterparts as a result of the devaluation.

The peg was implemented to try and control Argentine inflation in the 1990s IMF 62 IMF 63 IMF 64 Doubts exist in the validity of the reported inflation figures by the Argentine government Tim Worstall: Argentina as a model for Greek default, Forbes 2001
60 61

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Whether Greece can accrue similar gains by exiting the EMU depends on ones opinion regarding the neutrality of money65, it goes beyond the scope of this paper to examine this theory. However, if the theory is invalid then Greece stands to benefit similarly to Argentina from a devaluation, on the other-hand if the theory holds then the gains accrued by Argentina through its devaluation will be wiped out in the long run as households adjust their wage demands and as such will be irrelevant to its real GDP whether Greece chooses to exit the EMU or not.

P. Davidson Keynes serious monetary theory: The IMF Chief economist Oliver Blanchard has said All the models we have seen impose the neutrality of money as a maintained assumption, this is very much a matter of faith based on theoretical considerations rather than empirical evidence
65

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5. CONCLUSION In this paper I have attempted to analyze the Greek debt crisis from its causes to the steps being taken and also alternative methods to resolve the crisis. My aim in this section is to give a summary on the crisis and the possible ways forward. The Greek debt crisis is not a unique phenomenon; it came about from disregard for economics. Greece over extended itself with leverage beyond its real inter-temporal budget constraint and it requires contractionary fiscal policies to stabilize its debt. Theoretically wage cuts and job cuts are needed to impose the economic adjustments but in reality labor as economic agents will always be opposed to this as their utility is directly proportional to consumption66. Prior to joining the Euro Greece was experiencing an increase in competitiveness but this trend was reversed from 2001 after entry into the EMU67. However following years of continued growth well in excess of the average in the EMU, unit labor costs are declining in Greece with wages falling by around 5% in the year leading up to the 3rd quarter of 201168 boosting exports by 11.6%69, this was nevertheless insufficient to halt its recession as exports account for 21% of GDP70. A large import substitution is needed to improve Greeces trade balance and its economy however this is yet to happen as Greek imports in 2011 only fell by 1.9%71. As Greece is in a single market the ability to restrict imports with trade barriers is significantly constrained meaning further labour market measures need to be taken to reduce costs and improve competitiveness. In light of my analysis of the crisis I believe a further extension on the maturity of Greek bonds held outside its banking sector (to avoid further damaging their balance sheets) would help slow the austerity induced recession as the burden of interest payments would be lessened, this coupled with labor market reforms could help Greece return to growth.

Until the law of diminishing marginal utility sets in See chart at the end of this section 68 European Commission The Economic adjustment programme for Greece 5 th review, March 2012 69 Hellenic Statistical authority Commercial transactions of Greece December 2011 70 World Bank 71 Hellenic Statistical authority Commercial transactions of Greece December 2011
66 67

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REFERENCES

Bank of Greece BBC Greek crisis: Papandreou promises referendum on EU deal Bloomberg.com Germany backs ECB in rejecting Lagardes call to take losses on Greek debt Bloomberg.com ECB said to swap Greek bonds for new debt to avoid enforced losses Blundell-Wignall,A. and P. Slovik 2010 The EU stress tests and sovereign debt exposures Economist 2011 Sovereign defaults and GDP Economist intelligence unit Europa.eu Europa.eu GREECE: Commission assessment in relation to the commission recommendation for a council decision under Article 104(8) of the Treaty European Commission The Economic adjustment programme for Greece 5th review, March 2012 Eurostat Financial Times New Greek bailout to prioritise debt holders 2010 Financial Times Brussels told of need to reinforce monitors in Greece 2012 Financial Times Call for EU to control Greek budget 2012 Financial Times Greek accounting cannot hide the urgency for growth 2012 Greek ministry of Finance Hellenic Statistical authority Commercial transactions of Greece December 2011 IMF P. Davidson Keynes serious monetary theory 2010 Thomson Reuters DataStream Tim Worstall: Argentina as a model for Greek default, Forbes 2001 Waikei R. Lam, Kiichi TokuokaAssessing the risks to the Japanese Government Bond market Wall Street Journal 2012 New Greek bonds same old doubts www.efsf.europa.eu

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APPENDIX Calculations made using data from Eurostat.

COUNTRY AUSTRIA BELGIUM FINLAND FRANCE GERMANY ITALY LUXEMBOURG NETHERLANDS SLOVAKIA SLOVENIA SPAIN

INFLATION 3.60 3.50 3.30 2.30 2.50 2.90 3.70 2.50 4.10 2.10 3.10

NOMINAL BOND YIELDS 3.00 3.70 2.34 3.02 1.85 5.55 2.03 2.24 4.98 5.73 5.11

REAL BOND YIELDS -0.60 0.20 -0.96 0.72 -0.65 2.65 -1.67 -0.26 0.88 3.63 2.01

REAL YIELDS ON BAILOUT LOAN (20122015) 0.90 1.00 1.20 2.20 2.00 1.60 0.80 2.00 0.40 2.40 1.40 REAL YIELDS ON BAILOUT LOAN (20122015) 0.90 1.00 1.20 2.20 2.00 1.60 0.80 2.00 0.40 2.40 1.40

REAL YIELDS ON BAILOUT LOAN (2015MATURITY) -0.10 0.00 0.20 1.20 1.00 0.60 -0.20 1.00 -0.60 1.40 0.40

REAL PROFIT ON BAILOUT LOAN (20122015) 1.50 0.80 2.16 1.48 2.65 -1.05 2.47 2.26 -0.48 -1.23 -0.61 REAL PROFIT ON BAILOUT LOAN (20122015) 1.35 0.62 2.04 1.33 2.56 -1.33 2.37 2.15 -0.73 -1.52 -0.87

REAL PROFIT ON BAILOUT LOAN (2015MATURITY) -3.70 -3.50 -3.10 -1.10 -1.50 -2.30 -3.90 -1.50 -4.70 -0.70 -2.70

COUNTRY AUSTRIA BELGIUM FINLAND FRANCE GERMANY ITALY LUXEMBOURG NETHERLANDS SLOVAKIA SLOVENIA SPAIN

INFLATION 3.60 3.50 3.30 2.30 2.50 2.90 3.70 2.50 4.10 2.10 3.10

NOMINAL BOND YIELDS (UP 5%) 3.15 3.89 2.46 3.17 1.94 5.83 2.13 2.35 5.23 6.02 5.37

REAL BOND YIELDS -0.45 0.39 -0.84 0.87 -0.56 2.93 -1.57 -0.15 1.13 3.92 2.27

REAL YIELDS ON BAILOUT LOAN (2015MATURITY) -0.10 0.00 0.20 1.20 1.00 0.60 -0.20 1.00 -0.60 1.40 0.40

REAL PROFIT ON BAILOUT LOAN (2015MATURITY) 0.35 -0.39 1.04 0.33 1.56 -2.33 1.37 1.15 -1.73 -2.52 -1.87

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COUNTRY AUSTRIA BELGIUM FINLAND FRANCE GERMANY ITALY LUXEMBOURG NETHERLANDS SLOVAKIA SLOVENIA SPAIN

INFLATION 3.60 3.50 3.30 2.30 2.50 2.90 3.70 2.50 4.10 2.10 3.10

NOMINAL BOND YIELDS (DOWN 5%) 2.85 3.52 2.22 2.87 1.76 5.27 1.93 2.13 4.73 5.44 4.85

REAL BOND YIELDS -0.75 0.02 -1.08 0.57 -0.74 2.37 -1.77 -0.37 0.63 3.34 1.75

REAL YIELDS ON BAILOUT LOAN (20122015) 0.90 1.00 1.20 2.20 2.00 1.60 0.80 2.00 0.40 2.40 1.40 REAL YIELDS ON BAILOUT LOAN (20122015) 3.50 2.80 4.16 3.48 4.65 0.95 4.47 4.26 1.52 0.77 1.39

REAL YIELDS ON BAILOUT LOAN (2015MATURITY) -0.10 0.00 0.20 1.20 1.00 0.60 -0.20 1.00 -0.60 1.40 0.40

REAL PROFIT ON BAILOUT LOAN (20122015) 1.65 0.99 2.28 1.63 2.74 -0.77 2.57 2.37 -0.23 -0.94 -0.35 REAL PROFIT ON BAILOUT LOAN (20122015) 2.50 1.10 3.82 2.46 4.80 -2.60 4.44 4.02 -1.46 -2.96 -1.72

REAL PROFIT ON BAILOUT LOAN (2015MATURITY) 0.65 -0.02 1.28 0.63 1.74 -1.77 1.57 1.37 -1.23 -1.94 -1.35

COUNTRY AUSTRIA BELGIUM FINLAND FRANCE GERMANY ITALY LUXEMBOURG NETHERLANDS SLOVAKIA SLOVENIA SPAIN

INFLATION 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00

NOMINAL BOND YIELDS 3.00 3.70 2.34 3.02 1.85 5.55 2.03 2.24 4.98 5.73 5.11

REAL BOND YIELDS 1.00 1.70 0.34 1.02 -0.15 3.55 0.03 0.24 2.98 3.73 3.11

REAL YIELDS ON BAILOUT LOAN (2015MATURITY) 2.50 1.80 3.16 2.48 3.65 -0.05 3.47 3.26 0.52 -0.23 0.39

REAL PROFIT ON BAILOUT LOAN (2015MATURITY) 1.50 0.10 2.82 1.46 3.80 -3.60 3.44 3.02 -2.46 -3.96 -2.72

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COUNTRY AUSTRIA BELGIUM FINLAND FRANCE GERMANY ITALY LUXEMBOURG NETHERLANDS SLOVAKIA SLOVENIA SPAIN

INFLATION 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0

NOMINAL BOND YIELDS (UP 5%) 3.15 3.89 2.46 3.17 1.94 5.83 2.13 2.35 5.23 6.02 5.37

REAL BOND YIELDS 1.15 1.89 0.46 1.17 -0.06 3.83 0.13 0.35 3.23 4.02 3.37

REAL YIELDS ON BAILOUT LOAN (20122015) 3.35 2.62 4.04 3.33 4.56 0.67 4.37 4.15 1.27 0.48 1.13

REAL YIELDS ON BAILOUT LOAN (2015MATURITY) 2.35 1.62 3.04 2.33 3.56 -0.33 3.37 3.15 0.27 -0.52 0.13

REAL PROFIT ON BAILOUT LOAN (20122015) 2.20 0.73 3.59 2.16 4.62 -3.16 4.24 3.80 -1.96 -3.53 -2.23

REAL PROFIT ON BAILOUT LOAN (2015MATURITY) 1.20 -0.27 2.59 1.16 3.62 -4.16 3.24 2.80 -2.96 -4.53 -3.23

COUNTRY AUSTRIA BELGIUM FINLAND FRANCE GERMANY ITALY LUXEMBOURG NETHERLANDS SLOVAKIA SLOVENIA SPAIN

INFLATION 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0

NOMINAL BOND YIELDS (DOWN 5%) 2.85 3.52 2.22 2.87 1.76 5.27 1.93 2.13 4.73 5.44 4.85

REAL BOND YIELDS 0.85 1.52 0.22 0.87 -0.24 3.27 -0.07 0.13 2.73 3.44 2.85

REAL YIELDS ON BAILOUT LOAN (20122015) 3.65 2.99 4.28 3.63 4.74 1.23 4.57 4.37 1.77 1.06 1.65

REAL YIELDS ON BAILOUT LOAN (2015MATURITY) 2.65 1.99 3.28 2.63 3.74 0.23 3.57 3.37 0.77 0.06 0.65

REAL PROFIT ON BAILOUT LOAN (20122015) 2.80 1.47 4.05 2.76 4.99 -2.05 4.64 4.24 -0.96 -2.39 -1.21

REAL PROFIT ON BAILOUT LOAN (2015MATURITY) 1.80 0.47 3.05 1.76 3.99 -3.05 3.64 3.24 -1.96 -3.39 -2.21

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