Europe’s sovereign debt problems are a reminder that the global financial crisis that the collapse of Lehman Brothers triggered in 2008 is far from over. However, unlike the US, whose financial and fiscal woes have consistently made the headlines, Europe’s problems have tended to jump on and off the financial markets’ radar screens. The latest warning signals come from Greece, which faced a debt crisis in May 2010 and was subsequently bailed out by a consortium of other Eurozone members and the International Monetary Fund (IMF) that also put a long-term assistance package in place. However, like all rescue packages, fund disbursal was made contingent on commitment to extreme austerity and consolidation. Greece appears to have reneged on some of these commitments and its current problems stem from the fact that the consortium could hold back a tranche of ¤13.4 billion that are due in June. This could result in Greece defaulting on its obligations in the subsequent months. Besides, its bailout package stipulates some amount of market borrowings by the Greek government to finance its fisc. In 2011, it needs to raise about ¤11 billion and ¤40 billion in 2012. With yields on its 10-year sovereign debt benchmark paper at a crippling 17 per cent, the markets feel Greece will find it impossible to access the market. The bottom line is that there could be a series of defaults by Greece.
Greece might be a relatively small economy, accounting for about 2 per cent of Eurozone’s GDP. Its sovereign debt stock at about ¤330 billion might not be minuscule, but is not of overwhelming size. The problem is that (unlike Argentina which went through a similar crisis in 2001 and whose debt was held largely by local banks) Greek sovereign paper is held by banks across Europe. If there is an outright default by Greece, the markets will factor in the possibility of other economies like Ireland following suit. The entire market for sovereign bonds of the fiscally stressed Eurozone members could then collapse, dragging banks down with it. So it may be less costly to bail Greece out than to let it default and then bail the banks out instead. In the near term, the EU-IMF needs to stump up the cash next month and also signal to the markets that some of its more immediate funding needs could effectively be taken off-market. However, periodic infusions of cash will not resolve Greece’s fundamental insolvency issue. Debt restructuring could offer a more permanent, sustainable solution. This could be a combination of extension of the maturity profile of debt and a “haircut” on the outstanding obligations. This could create more breathing space for Greece and pull down its debt-to-GDP ratio to more manageable levels. Restructuring will hurt Greece’s creditors, largely European banks.
The very whiff of such an exercise could trigger a liquidity crisis in Europe’s inter-bank markets since banks, unsure of their counterparties’ exposure to restructured debt, could stop lending to each other fearing default. This could snowball into another full-blown financial crisis especially if markets begin to factor in the prospect of other fiscally stretched economies taking a cue from Greece and restructuring their debt. Thus, both the timing of its announcement and the way it is handled will determine whether its impact on the markets will be a mere ripple or a full-blown tsunami. It might just be prudent to give the markets some time to prepare for restructuring and announce it in early 2012. Besides, a liquidity back-stop from the European Central Bank is imperative as is financial assistance on the lines of US’ troubled assets reconstruction programme (TARP) for banks that are hit hard by restructuring. These policies could somewhat soften the blow but it is unlikely that they can stave off another wave of risk aversion among investors. That is bound to take a toll on all “risky” assets in the months to come.