Financial markets continue to be driven entirely by developments in the Eurozone. Greece remains on the markets’ radar screen with global investors fearing a worst-case scenario of possible “disorderly default”. But why does Greece matter so much? After all its contribution to global and Eurozone GDP is virtually insignificant. The answer lies in the exposure that financial institutions have to Greek sovereign debt and the impact the default could have on the global financial system. The first round impact of a Greek default is well known. European banks that have a direct exposure to Greek debt will most likely face significant losses in their bond portfolios.
The bigger risk is of the second round impact of a contagion developing in the global financial system, particularly of it quickly crossing the Atlantic. This explains US Treasury Secretary Tim Geithner’s much-publicised agony over the lack of a quick resolution in Europe. The US financial system stands to come under stress for two reasons. There is a substantial amount of credit default swaps (CDS) that US banks had written to provide insurance against default to the holders of bonds from Greece and other fiscally-stressed states like Ireland and Portugal. Data released from the Bank for International Settlements (BIS) reveal that US financial institutions have close to $100 billion in CDS exposure to the debt of fiscally-challenged states and around $40 billion to Greece alone. Second, US money market funds have significant exposure to European financial institutions of around $360 billion (with $200 billion in exposure to French paper itself) and could face significant strain in the event of a Greek default.
The main problem with Greece is that its debt dynamics are unsustainable. Even if Greece were to stick to the prescribed austerity measures according to the bail-out agreements, its total public debt-to-GDP ratio will stabilise at 155-160 per cent in 2013. To make its debt burden easier and possible to bear, Greece will have to renege on its debt-service commitments at some point to trim its public debt levels. Markets realise this and are looking for a credible solution that will ensure minimal losses to the financial sector. Unfortunately, European policy-makers are yet to chalk out an appropriate solution.
However, the bit of good news is that the respective Parliament houses of most of the European member nations passed the second Greek bail-out programme. That effectively means that Greece will stay off the market for a year but private bond-holders will have to accept a haircut. The bad news is that while the bail-out package might help Greece, it will prove inadequate to tackle the scale of problems of the Eurozone as a whole. For one thing, the new aid programme does not address a fundamental conundrum. The demand for austerity that underpins any commitment for a bail-out will hurt growth, compromise revenue and make the task of fiscal consolidation more difficult. Greece’s GDP, incidentally, contracted by a staggering 7.3 per cent in the second quarter of 2011.
One way in which European policy-makers can dilute the Greece-related strain is to increase the size of the current European Financial Stability Fund (EFSF) that is used to bail-out or provide assistance to fiscally-challenged states. The current size of 440 billion euros is simply not big enough. By increasing the size and more specifically announcing a recapitalisation programme for the European banking sector that is saddled with sovereign debt, EU policy-makers will be able to remove an important source of anxiety. Thus, they might just be able to allow selective default by Greece but stem the contagion to an extent. Besides, an increase in size of the rescue fund could also be used to provide an important liquidity backstop for the sovereign bonds for other fiscally-challenged states that, because of Greece, have seen bottom fall out of their markets. The idea is to get the markets to view Greece as a one-off basket case that does not represent the problems of the entire European periphery.
However, EU policy-makers still seem to be guided by their dogmas. Germany seems to be dead against a plan to leverage the EFSF to increase its size. On the other hand, the European Parliament announced that member nations should stick to budget deficits of around three per cent of GDP and a maximum debt level of 60 per cent of GDP and get to these levels by 2015. It might have been more prudent to announce measures to give fiscally-challenged states a little more leeway before enforcing stronger austerity rules on them.
Meanwhile, the rupee had come under intense selling pressure that resulted in portfolio outflows and tightness in the European money markets that made rolling over short-term debt difficult. However, a combination of RBI intervention, changing sentiment in the NDF market and exporter selling ensured that rupee did not break the critical 50 barrier to the dollar. While concerns about the European banking sector are likely to result in further rupee volatility in the immediate future, the 50-barrier might prove to be an important resistance level. Only an unanticipated shock could result in a break of this level.
The writers are with HDFC Bank. These views are personal
