Key Drivers of the Greece Debt Crisis

The global economy has experienced a number of seismic shocks in the past couple of decades, the latest of which is the Greek financial crisis. What actually led to the problems in Greece and what steps are being taken to remedy the situation?

During the past couple of decades, there have been a series of crises that have caused large problems in the financial markets, such as:

• The meltdown of junk-bond market and a resultant credit crunch, which led to recession in US in 1990.
• The bond market collapse in 1994 - the worst in the past 50 years.
• The Asian financial crisis in 1997-1998.
• The dotcom and telecom bust in 2000-2001.
• The terrorist attacks in the US on 11 September 2001.
• The 2007 US housing bubble/sub-prime crisis.

The latest has been the Greece debt crisis, which has had serious repercussions around the world, from the financial markets to other sectors that are directly or indirectly linked to financial sector.

Past Economic Crisis - US Housing Bubble

The main reason for the US economic recession was the vast number of defaults on loans issued to sub-prime borrowers. In many cases, these were issued without proper checks to the applicants’ credit history, job type and repayment capacity. The sub-prime mortgage crisis was actually symptomatic of a deeper malaise - a surfeit of global liquidity that led investors to under-price risks across all sectors. This resulted in dramatic increase in the defaulting and foreclosure of mortgage-backed securities, which in turn affected the financial systems across the globe.

Factors leading to the sub-prime crisis included:

• Loans to sub-prime borrowers who typically had weak credit histories and poor repayments capacity, which amounted to US$600bn by 2006.
• Inflows of funds from the fast-growing economies far from US, such as Asia-Pacific and the Middle East.
• Low interest rates on credit card, auto and housing loans from 2002-2004, which made credit easily available.
• Policymakers did not recognise the important roles played by the investment banks and hedge funds (which were not regulated by the Federal Reserve in the same way as commercial banks).
• Critical mistakes made by the credit rating agencies when giving investment-grade ratings to mortgage-backed securities (MBSs) based on risky sub-prime mortgage loans.

Figure 1: Sub-prime Loan Disbursed Amount

Present Economic Crisis - Greece Debt Crisis

As the global economy was recovering and the general assumption was that the US recession was over, the Greece debt crisis emerged. This raised the bigger question mark on the credibility of the financial markets operation and the fate of Greece. Ultimately, the financial contagion of Greece spread west across the Mediterranean and subsequently could be felt across the US and Asia-Pacific. The International Monetary Fund (IMF) has started to cast a long shadow across the soft underbelly of the eurozone.

With another financial crisis on the doorstep and further doubts about the government's ability to manage its deficit, the Greek bonds and banking stocks have taken a beating. These dire market results prompted warnings from economists that a painful economic contraction this year could be worse than expected.

Year-on-year, Greece has been (and was) spending money it doesn't actually have or own. Previous governments took undue advantage of the economic good times to borrow money and spend it on pay rises for public workers and projects such as the 2004 Olympics. Greece began to run up a bigger and bigger deficit. Once the world economy crashed following the US sub-prime (and consequent credit) crisis, the Greece gamble backfired. This resulted in a loss of faith by banks across Greece as well as in Europe as a whole as to whether the country would be able to manage its money or not. Eventually, banks became suspicious as to whether Greece would be able to continue to pay off its loans or would in fact go bankrupt. Observing these conditions, banks now started charging Greece more to borrow cash - making the problem even worse.

Factors in the Greece Debt Crisis

Breach of eurozone rules and regulations

Greece was heavily in breach of eurozone rules and regulations, in particular the Stability and Growth Pact, which requires members to keep their deficit below or around 3% of GDP. Greece, with a deficit of around 13%, is clearly a long way over this agreement, and the true state of its finances were kept from the investor community across the globe for some time. In order to keep control of this deficit, drastic cuts in public spending and tax rises are now necessary to bring it down by 2012.

Political actions

Greek politicians latched on to the euro as a means of credit enhancement, obtaining a de facto subsidised interest rate to lower their public debt interest costs. This allowed them to borrow even more.

The Greek government has to turn over debt and borrow even more money to cover ever-widening deficits. The deficits are exploding because of a rapidly shrinking tax base as the economy implodes and ever-rising interest rates due the increasing default risk. In these circumstances, more EU money, even on soft terms, is really only making the longer-term situation worse.

Overextending of loans by banks

When the global economy was booming, Greece also wanted to reap the benefits of this, despite having a large deficit. Banks within and outside Greece were very generous in awarding huge loans as they perceived Greece as having a fast-growing economy, not knowing that it was sitting on the deficit.

Tax evasion and welfare payments

Like many countries, the Greek government relies on borrowed money to balance its books. The recession has made this harder to achieve, because tax revenues are falling just as welfare payments start to rise. In Greece, tax evasion is a problem and welfare programmes are unusually generous.

Steps to Reduce the Budget Deficit

Greece has promised to take necessary steps to reduce the budget deficit and to curb its present crisis. These steps are:

• Reduction in public sector pay.
• Freeze on salary caps for the highly paid.
• Hiring freeze on the civil service.
• Overhaul of the existing tax system.
• Massive cut on pensions.
• Reduce corruption within government and the private sector.

Role of Investment Bankers in the Greece Debt Crisis

Investment bankers have played a vital role in the Greece debt crisis. Between 2000 and 2002, Greek government officials entered into a deal with US investment bank Goldman Sachs. Under the deal, which was known as a currency swap, Greek dollar and yen debt was reportedly exchanged for euro debt for a period at an advantageous rate to be reversed at a later date. The effect was to show less debt in the near-term.

The deals carry some of the hallmarks of the financial crisis - such as off-balance sheet liabilities and highly complex financial arrangements, which helped Greece to postpone a certain number of debt repayments.

Greece wasn’t necessarily doing anything new - Italy did something similar in the 1990s, while Belgium has also been mentioned by analysts as using financial derivatives to improve its reported fiscal position.

Financial analysts across the globe is not against this, but they do suggest that such deals should be more transparent and comply with accounting standards.

Greek politicians, with the help of investment bankers, played an important role in employing novel financial instruments to manage its debts, which they argued they achieved without breaking the existing rules of the government. They have also argued that the debt refinancing operation with Goldman Sachs was meant to mask the country’s debt and insisted that it was conducted in accordance to then-existing EU accounting rules through the deal.

Effects Across the Financial Market in Greece and the Wider World

Stock market crash

Once the news of financial crisis in Greece was out, a negative picture of stock exchanges across the globe could be seen. The Dow Jones Industrial Average plummeted by nearly 1,000 points, or about 9% - a steeper drop than even in the wake of the Lehman Brothers collapse in 2008. Japan’s Nikkei 225 index closed down 3.1%. In Europe, the FTSE 100 in London was down by 2.6%; in Frankfurt’s DAX fell by 3.27% and the CAC-40 in Paris dropped by 4.13% (as of May 2010).

Problem for investors

With all the major rating agencies (S&P, Moody’s, Fitch) cutting the ratings on the Greece economy following the emergence of the debt crisis, the average investor with Greek bonds perceived these to have a greater risk, and started to sell Greek government bonds and stocks. Another option was that they started demanding higher interest rates on their loans, causing rates to rise which, in turn, choked economic growth.

Problem for banks

Foreign banks that provided huge loans to the Greek government effectively created a bridge to spread the Greek crisis to other nations, particularly within Europe. Banks in many large nations are effectively backed by their governments, this support a result of the effort in many financial centres to protect banks during the credit crisis. Given that banks in Europe hold large claims on Greece, if Greece gets in trouble and those claims lose value, the governments of the banks that hold Greek paper are exposed.

Spreading from one European country to another, these debt troubles lead to a pullback in bank lending, slowing the continent's economy further. In turn, this had an indirect effect on the recovery in the US, as Europeans reduced their demand for US products and services accordingly.

Conclusion

As the world was recovering from the credit crisis, the Greece debt crisis came as an unwanted shock for the entire financial community. The Greece debt crisis has now forced the politicians, bankers, financial analysts and economists across the globe to think twice before involving themselves with novel financial products promoted by investment bankers.

With Greece now receiving a US$145bn bailout package from the EU and the IMF to save the country from bankruptcy, the biggest question still to be unanswered is whether Greece is really going to be able to control its spending and reduce its budget deficit to 4.3% by 2011, and 2% by 2012 and 2013, as promised.