Greek Default Could Spur Europe-Wide Contagion

Jun 21, 2011
Originally published on May 23, 2012 11:43 am

Greece's day of reckoning is very nearly at hand.

Bright anger has spilled onto the street, as the country tries to dig its way out of an economic crisis. Prime Minister George Papandreou's government survived a key confidence vote, which he had called to help him pass deeply unpopular austerity measures. European Union ministers have threatened to cut off billions in bailout money if Greek legislators don't pass wage cuts and other painful austerity steps.

Greece needs that $17 billion infusion from the EU and the International Monetary Fund by mid-July or it risks going into default — the eurozone's first. Experts say the country's options are limited and that default could produce something resembling panic.

"You would see a run on the banks, I think," said Lee Buchheit, a partner at Cleary Gottlieb Steen & Hamilton who advised Uruguay during a similar economic crisis.

Economists say bank lending could grind to a halt and that Greece — or perhaps the whole EU — could be thrust into a double-dip recession.

For all the scrambling, there's little surprise that Greece stands on the precipice of financial collapse. Athens turned to the IMF last year for a line of credit to pay bondholders, and the country has been in default more often than not during the past two centuries. In fact, what could be considered the first sovereign debt default took place in Greece in the fourth century B.C. when municipalities in the Attic Maritime Association missed payments to the Delos Temple, according to the IMF.

The Aegean nation is hardly alone. Notably, Russia defaulted during the "ruble crisis" of 1998, and since then, a dozen other countries have either missed or come close to missing payments to foreign bondholders — Pakistan, Indonesia, Ecuador and Moldova more than once.

Greece Is No Uruguay

The process of recovery can be painful, and some countries come back from the brink sooner than others.

Uruguay, which nearly defaulted in 2003, became a "classic case of a country that did the right thing," Buchheit said.

Before it missed any payments, Uruguay went to its creditors and worked out a plan to extend the terms of its loans for a few years, an adjustment known as reprofiling. Within a few weeks, the country was back on firmer financial ground.

"Officials in Uruguay said, 'Look, read the numbers and you will see that we run out of gas very soon unless we can move this debt stock down the road,' " Buchheit said.

But Greece is no Uruguay. For one thing, Uruguay, like other countries, devalued its currency as a way to recover its competitiveness and export revenues. A cheap currency makes goods produced in a country easy for other nations to buy.

"The Greeks can't do that because they're in the EU monetary union," Buchheit said. Non-EU countries can just print more money, but Greece doesn't have sole control over the euro printing press.

To make exports cheaper, Greece would have to lower wages, reduce pensions and strip away subsidies — deeply unpopular moves that have resulted in social unrest and austerity strikes. But even if Greece finds the political will for such severe cuts, it won't come soon enough to guarantee that Athens won't miss a payment on its sovereign debt.

Experts say Greece essentially has three options: a full-on default in which the country misses a payment to creditors; a structured default a la Uruguay, where terms of loans are extended; or yet another bailout that allows Athens to keep paying on its obligations on the current terms.

Fears Of Contagion

Most economists think the bailout option is the only realistic scenario if the EU is to avoid a contagion effect that could further weaken strapped eurozone economies such as Italy, Ireland, Portugal or Spain.

A default or even a restructuring of Greece's debt could spook investors and cause them to stop lending to those other suspect countries, said Jacob Kirkegaard, a former Danish government official and senior staff member at the Peterson Institute for International Economics.

That, in turn, would drive up the cost of borrowing for those economies. "The higher cost of borrowing leads to more austerity, slower rates of growth and perhaps even a double-dip recession," he said.

Worse still, it could precipitate collapse in Spain — whose economy is much larger than Greece's.

"There isn't enough money in the system to bail out Spain," Kirkegaard said. "The country is too big and it would require too much capital. The Europeans don't have it, and I would contend that even the IMF doesn't have that kind of money."

One thing Greece could do is "sell off its crown jewels by privatizing government assets," said Eswar Prasad, a professor of trade at Cornell University and a senior fellow at the Brookings Institution. "But everyone is going to recognize it as a fire sale, so the question is how much money they could raise."

For now, however, the EU has little choice but to keep propping up Greece, Kirkegaard said.

'Games Of Chicken'

Even if Athens gets another bailout installment and pays maturing bonds on time and in full, it's not off the hook because it will still have to dig deep to pay back the EU and IMF.

Kirkegaard sees a lack of political will in Greece to impose the type of spending cuts and tax increases needed to shrink the debt — a situation he likens to what's happening in the U.S. However, he was quick to note that U.S. economic problems are "in no way" near those of Greece.

"I think in many ways, the kind of political brinkmanship and games of chicken that are being played out right now in the eurozone between the Greek government and the EU ... will be repeated in the U.S. about a month from now" when the showdown over the debt ceiling occurs," Kirkegaard said.

"Then the kind of dynamic is the same," he said. "You can only take the painful political decision at the stroke of midnight."

The good news for Greece is that if it can manage to get its fiscal house in order, debt markets are likely to be "extraordinarily forgiving," said Prasad of the Brookings Institution.

"Many countries have been able to get private financing just a couple of years after defaulting: Argentina, Russia," he said. "But they had to restore competitiveness and get back to decent growth for that to happen."

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