April 30, 2010

* APRIL 28, 2010 Contagion Fear Hits Spain Cut to Credit Rating Opens New Phase in Crisis as Cost of Greece Bailout Debated

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Greece remained at the heart of market woes. The cost of insuring $10 million of Greek government debt against default for five years jumped to more than $900,000, from $824,000 on Tuesday, signaling extreme fear of a default, before falling to $760,000 by evening in London, according to CMA DataVision.

That respite was sparked by the news that the aid package for Greece could be significantly larger than expected and by assurances from senior EU and German officials that it won’t involve restructuring Greece’s debt.

The IMF appears to hope that signaling a willingness to offer Greece roughly three times what it and the EU have already pledged will achieve what their previous efforts have failed to do—assuage investor concerns about a default. During the global financial crisis, the U.S. and many European countries were successful with a similar strategy, pledging huge sums to backstop their banks.

Economists say Spain is still some way from needing a bailout like Greece, as Spain’s overall public debt is relatively low despite the country’s gaping budget deficit. The IMF expects Spanish public debt to reach around 67% of gross domestic product this year, compared with 124% in Greece.

But countries’ individual circumstances might count for little if the Greek mess isn’t resolved quickly and decisively, economists warn. “Markets tend not to discriminate as much when there’s panic,” says Ken Wattret, European economist at BNP Paribas in London.

S&P said it cut Spain’s credit rating because it expects the Spanish economy to grow by only 0.7% on average until 2016, lower than previous forecasts. Sluggish growth hurts tax revenues and pushes up spending on jobless benefits, making it harder for a country to balance its budget.

Critics Assail Rating Firms For Fueling Woe in Europe

IMF chief Dominique Strauss-Kahn said it wasn’t clear whether the rating firms were reacting to the financial markets, or vice versa. “You shouldn’t believe too much what they say even if it may be useful,” he said in Berlin.

Ratings agencies have been criticized for their role in the U.S. financial crisis, in particular over conflicts of interest and their failure to recognize the high risks inherent in complex structured products. They have also been panned for throwing fuel onto the fire of crises by belatedly ratcheting down ratings.

Many European investment institutions, like those in the U.S., are highly sensitive to debt ratings. Life-insurance companies typically seek to hold only very safe investments, which means that when bonds are downgraded to junk, they sell them.

Many institutions have in-house rules that assign a percentage of a portfolio to top-rated triple-A bonds, and a smaller percentage to lower-rated double-A bonds and so on down the ratings ladder.

After a downgrade, the institutions adjust their holdings, selling the downgraded debt and seeking to replenish their quota of high-rated debt. Many rely on just one agency and for investors in government bonds that was most commonly S&P, Mr. Broyer said.

Banks, big investors in government bonds in Europe, are also sensitive to ratings. They are forced to increase the capital they must have as a cushion against losses if bonds they hold are downgraded to junk. This reduces their profitability, and encourages them to sell.

In the U.S., ratings agencies have been under scrutiny, including a year-and-a-half-long investigation by a Senate subcommittee. Questions have been raised about whether the agencies were too lenient in their evaluation of mortgage-related debts in order to win business.

Many U.S. institutional investors retain guidelines on the credit quality of securities that they can hold and a downgrade from S&P or Moody’s to junk status can force selling.

But after the financial crisis, there have been some moves away from relying on their ratings.

In Spain, Crisis Stays Undercover


MADRID—Spain’s worsening financial crisis remains a strangely low-key affair. One in five people here are out of work, but generous unemployment benefits, strong family support networks and a bustling informal economy are helping maintain people’s lifestyles. Bars and restaurants in the city center are doing brisk business.

“It seems to me the situation here is less bad than in Greece,” says Manuel Herrera, a 30-year-old Peruvian immigrant, who has seen the recent images of angry mobs protesting in Athens. “Here in Spain, the crisis is not so noticeable: People still go out for beers, to buy cigarettes, whatever.”

But the Asian-restaurant chain he works for as a cook has closed down four of its 12 restaurants, and Mr. Herrera says he sees a sense of hopelessness setting in that could point to prolonged economic stagnation.

“The Spanish were not ready for this crisis,” he says. “The situation’s not getting any worse, but it’s not getting any better either.”

For years, Spain was one of the euro zone’s biggest success stories. Membership in the common currency in 1999 brought historically low interest rates that fueled a credit and construction boom, which transformed the country into one of Europe’s chief growth engines. Through 2007, Spain created more than one-third of all euro-zone jobs and absorbed four million immigrants.

The global financial crisis brought that crashing down. Spain is grappling with 20% unemployment and a double-digit budget deficit that threatens to land the country in a Greek-style financial crisis.

Though the government expects the economy to return to growth in the first quarter, that follows contractions in six consecutive quarters.

On Wednesday, Standard & Poor’s cited low growth prospects resulting from mounting banking-system stress, high household debt levels and low export capacity as primary factors behind its decision to downgrade Spain’s sovereign debt.

Thirty-year-old Eduardo lost his job as a computer programmer a year ago and says many of his friends are also out of work. He still isn’t ready to take just any job: “There are jobs out there, but most of them don’t pay to well, or they require higher levels of experience.”

Until recently, the government of Socialist Prime Minister José Luis Rodríguez Zapatero has focused on anticrisis measures to cushion the pain of the unemployed by extending benefits, cutting taxes and taking measures to create short-term jobs for construction workers. It has gone to great pains to maintain good relations with unions.

But the government has changed gears amid mounting pressure from international investors to show it can pull the economy out of the doldrums and get its debt levels back on a sustainable path. It has announced plans to cut the public-sector wage bill, push back the retirement age and reform Spain’s rigid labor market. The plans are vague thus far and have yet to ruffle many feathers.

The government is counting on a quick agreement on a support package for Greece to contain the euro-zone financial crisis and buy Spain more time to get its fiscal house in order. In an interview, Deputy Finance Minister José Manuel Campa said Spanish bond spreads have been blown out to “exceptional” levels that he believes are temporary. “Considering that they have been affected by the Greek situation, the sooner it is resolved, the better,” he said.

The Euro Can Survive a Greek Default

In many ways, a messy default would actually leave the single currency in better shape.

The Greek government has now hit the panic button and activated the IMF/euro-zone rescue plan. However, it is not clear that this bailout (whose implementation still requires approval by the German parliament) would work. Financial markets remain unconvinced, as evidenced by the elevated risk premia for Greek debt. The experience of Argentina also shows that even repeated IMF programs cannot always stave off failure.

For European Union policy makers this raises a fundamental question: What will happen if the proposed €45 billion aid package doesn’t put an end to the Greek tragedy? Would a default by Greece signify the end of the euro?

Behind this often-posed question is the assumption that the notion of “default” has a precise meaning, which is not the case. Ratings agencies define default as missing any contractual payment beyond the grace period. In reality, however, markets have often been quite forgiving in situations in which a government only reschedules, i.e. does not pay on time, but makes a credible promise to repay the full amounts due at a later date. Such a “soft default” would certainly not mean the end of the euro.

The real question is thus: Would a messy (and massive) default under which the country refuses to repay in full signify the end of the euro?

Yes and no.

A messy default would certainly end the idea of the euro area as a club whose members are all equal and work toward a common goal, namely the stability of the common currency. Membership in such a club protects against financial problems because members are supposed to behave well and help each other in case of unjustified speculative attacks. Although the EU treaty says that members are not liable for each other’s public debt, there is an implicit political commitment, as we are seeing right now, to provide emergency help.

The quid pro quo for this solidarity is of course the expectation that all members abide by certain standards, for example those embodied in the Stability and Growth Pact, that aim to limit budget deficits and debts. The continuing misreporting of fiscal data by Greece has already severely damaged the idea of the euro as a “gentlemen’s club.” But the club could still be saved if Greece undertook a determined national effort to service its debt and avoid a messy default.

However, even a messy default by Greece alone would not necessarily mean the end of the euro area. The day after a formal default, Greek banks would no longer have access to the regular monetary policy operations of the European Central Bank because the ECB could no longer accept their collateral—Greek debt—which would immediately have junk status. The country would thus effectively cease to be part of the euro area. Its status would resemble that of Montenegro, which adopted the euro as legal tender without officially being a member of the single currency zone.

In Greece, following a messy default, euro notes and coins would still circulate in the economy, but one euro in a Greek bank account would no longer be automatically equivalent to a euro in a bank account elsewhere in the euro area, as Greek banks might immediately become insolvent and thus be shut out of the payment systems. Until Greek solvency was re-established, the euro zone would thus de facto have lost one of its members, even though the Greek Central Bank head would still sit on the Governing Council of the ECB and the Greek finance minister would still be a member of the Euro Group, with their normal voting powers intact.

Given the problems in credit markets that would result, the Greek economy would be hit hard. But the impact on the rest of the single currency zone should be minor given that the country represents only about 2% of the euro area’s GDP and is not home to any systemically relevant financial institution.

In many ways, a messy Greek default would actually leave the euro zone in better shape. Its institutions would probably be strengthened because it would have become clear that the framework is strong enough to withstand the failure of one of its members. Tolerance toward violating deficit and reporting standards would be much reduced. The club would have been transformed into a federation whose peripheral members can be told to “get lost” so to speak. As a result, majority voting would tend to replace consensus as the normal way of decision-making.

The spanner in the works would of course be contagion. The main reason why even Germany has agreed to the bailout package for Greece is the fear that a messy default would trigger speculative attacks on government debt and financial institutions in systemic countries like Spain and Italy.

But there is no fundamental justification for contagion. The self-financing capacities of Spain and especially Italy are much stronger than those of Greece. However, markets can at times be irrational. The real test of the euro zone is thus whether it can protect from speculative attacks those members that do follow at least the spirit of its rules. Despite its large debt level, Italy, for example, has for most of the time kept its budget deficit below 3% of GDP.

So far the signals from financial markets are encouraging. After an initial bout of nervousness in February of this year, when it first became clear that the second leg of the financial crisis could imply sovereign default, markets have increasingly differentiated between the weaker members of the euro area. Risk premia have tended to move together in the same direction, but with completely different orders of magnitude. (The credit default swaps for Greek debt are now trading at around 600 basis points, compared to only 170 for Spain and even less for Italy.)

The default of any systemic country would indeed mean the end of the euro zone, but for the time being this remains fortunately only a tail risk.


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