The European Sovereign Debt Crisis Explained: Greece & Co
This feature piece is a work in progress that is aimed to help our readers to understand the worsening sovereign debt crisis engulfing the euro zone. We are updating the piece as the crisis evolves. You can check out a timeline of the crisis here. Any questions or comments just reply below.
What does all this talk of sovereign debt stuff even mean?
To start at a very basic level let's run through the basics of sovereign bond markets, don't worry it's not that tricky.
Governments borrow money from the private sector and foreign governments if they can't pay for all their spending with taxes and government revenues. A government will issue bonds at bond auctions every so often and market participants will come in and bid for them. Market participants lend the government money and in return the bondholder will receive the face value (the amount lent) of the bond at maturity and payments from the bond issuer called coupons.
These sovereign bonds will trade in a secondary market and their prices will fluctuate with supply and demand. When prices change the return that the bond offers will also change. To provide a bit of a simplification, the return the bond gives if held to maturity is called its yield. Rather than quoting prices for bonds, yields are most often quoted in financial markets.
All that you have to remember is that if prices go up, yields go down and vice versa. Yields going up means higher borrowing costs for governments.
Different maturities
Governments borrow at different maturities with most major economy's governments borrowing at varying maturities of 3 months, 6 months, 1 year, 2 year, 10 year, 20 year, and 30 years. The UK even issued bonds that have no maturity.
Phewwww now that we've got that very quick and dirty explanation of sovereign debt markets out of the way let's look at where things start to go wrong.
How does a government pay back its debts?
Ok so a government borrows money, but how does it pay it back? Governments use two main options to repay debt;
1. Revenues from taxes and state owned assets etc.
2. Issue more debt
Issue more debt is an option? Yes, you wouldn't think that would be a good solution to any debt problem, but that is how countries like the US meet their bond repayments. It's the equivalent of using one credit card to pay off the other.
Now you may start to contemplate how problems arise.
Sovereign Debt Defaults
Sovereign debt defaults are nothing new. Russia and Argentina are two of the biggest and most recent examples in history of when a government has defaulted on it's sovereign debt. A default occurs when a government is no longer willing or is unable to pay the money it owes to bond holders.
Can't a government just raise the funds by issuing more bonds?
Yes, absolutely. However it comes back to the fact that borrowing costs are determined by market participants, not the sovereign nations themselves. In times when markets simply do not want to touch the government's debt at all they will face extremely high borrowing costs. It is simply supply and demand; with very low demand prices will fall and yields (borrowing costs for the government) will rise. In effect governments will be getting short term gain for a much worse position in the future.
There is one dynamic that we haven't touched on yet. We stated that borrowing costs are determined by market participants, but not who these market participants are. There is a bit of a sneaky participant in most government bond auctions and especially in secondary sovereign debt markets. The 'independent' central bank of the nation is an extremely large sovereign debt market participant. Central banks have a key characteristic that no other market participant can ever possess - they can print money. This means that a government can borrow however much money they like at whatever cost they like if the central bank stands on the other end of the transaction and simply prints money to buy the debt.
Greece and the euro zone
Well it took us a while but now we've got all that necessary stuff out of the way we can finally turn to the euro-zone. Right so what has gone so terribly wrong in this grand financial experiment called the euro-zone and in particular Greece?
We run through the full sequence of events in our Greek crisis time line. We'll run through it very briefly here. Basically the Greek government prior to Papandreou were extremely bad at accounting (either that or they were outright deceptive). Government expenses, revenues, debt levels, inflation rates were all reported incorrectly so Greece could adopt the euro. Of course the principal reason Greece wanted to adopt the euro was so it could borrow more at lower rates and the government could spend a lot more, which is exactly what it did when it got the euro in 2001. Terrible accounting and deception continued unchecked until Papandreou took office in 2009. The new government ran through the figures a little more finely and eventually reported that Greece was essentially broke.
Can't Greece borrow more money?
Well recall the higher the yield the higher the borrowing cost for a government. Well the chart below shows that Greece faces an interest rate of around 70% for its 2 year bonds.
Greek 2 Year Government Bond Yields, Source: Bloomberg
Greek 2 years have been getting most of the press since they are so extraordinarily high, however at all maturities yields on Greek debt are at astounding levels. This means that the Greek government faces an extremely high cost if it wants to issue more debt to pay interest on its existing debt (the use one credit card to pay off the other method).
Yields are so high because the banks and institutions that hold Greek bonds simply don't want them and are willing to sell them in the secondary bond markets very, very cheaply.
Why can't Greece just print money to repay its debt?
Ok so yields are extremely high, can't Greece just print money, buy up a lot of bonds to push prices up and yields (borrowing costs) down? No, and that is the problem the markets are all too aware of.
The most fundamental reason that a government would default on its debt is because it can't print the currency that the debt is in. Greece has issued a lot of bonds in a currency (the euro) that it cannot print. An 'independent' European Central Bank (ECB) controls the print button. This means that a Greek central bank can't simply walk in to the market for Greek bonds and buy them up and lower the borrowing costs for Greece so that it can borrow more money to repay its existing debts.
The markets know this. They know that Greece can't press print and that is why nobody wants to hold their debt. In fact there is a very large market for insuring against debt defaults from both the private sector and the government sector. The Credit Default Swap (CDS) market allows people to pay a premium to insure against the risk of default (just like how an individual might insure his house against the risk of a flood). The cost of insuring Greek bonds against default hit a new record high on August 5th 2011.
Euro Area 5 Year CDS Premia
State Revenues
So Greece can only borrow at extremely high costs (which would worsen its situation) or pay its debt using taxes and state asset revenues. We've pretty much crossed off the issue more debt options so let's look at taxes and revenues.
Greeks pay tax?
Of course Greeks don't like to pay taxes. We do not intend this statement as any sort of racial slur - it is simply a fact. It is how Greece got into such a terrible state in the first place (no pun intended).
Ok so a government doesn't necessarily have to raise taxes (or even get people to pay the ones they should be paying). It can lower state expenses also. Revenues the same, expenses down means more money left over to pay back debt.
Well there's a problem there too. Greece has an absolutely huge government sector which contributes around 40% of GDP.[1] So there are a hell of a lot of people who work in the public sector. And where do you think the Greek government looks first for expense cuts? Well wages of course.
Other things the Greek government can try and do is sell state owned assets like electricity and water stations, some of those islands tourists seem to like so much. However again, problems. Greece got so excited about spending money it didn't have that it went out did some very silly things with its assets. Greek officials saw the revenue coming in from highway tolls, airport landing fees and the likes and with the help of some savvy Wall Street banks they packaged up the revenue streams in securities and sold them to get lump sums of money.
The government had also gotten in a bad habit of giving away state assets to various officials and non-officials including the much publicised Vatopaidi monks. Monks did he say? Yes, in fact the Vataopaidi scandal as it has become known was one of the major points that led to the previous government being voted out.[2]
Honestly, could you even make stuff like that up?
So with very few room to manoeuvre the Papandreou government has been forced to try to push through parliament umpteen tax increases, wage cuts, and distressed asset sales in order to pay its credit card bills on time.
Anyway budget cuts, tax increases, asset sales, none of it has worked. The Greek government still has to borrow money to pay its existing debts. In fact the government has had large deficits for over 15 years. 15 years!
Greek Government Budget 1995-2011
What were they thinking when they let Greece adopt the euro?
Ok so what about Greece?
Well you get the point, Greece is screwed. So what? Greece is a spec of sand in the global economy. It had a GDP of only US$318.1bn in 2010 which is less than 10% of the euro zone's biggest member Germany. [1]
Dangers of Contagion
The reason the European debt crisis is getting so much attention is because similar problems also plauge Portugal, Italy, and Spain. Collectively with Greece these nations are dubbed the 'PIGS'.
All European countries that use the euro cannot print themselves out of debt, however it is the PIGS that are in the most dire fiscal positions. The PIGS are all receiving bail outs from other countries and the IMF.
The sovereign debt crisis really is a crisis of confidence in European governments. Governments can theoretically borrow to the skies to fund their budget deficits. It is only when market participants begin to question the ability of governments to repay the debt that things start to get a bit hairy.
The reason Greece plays such a crucial role is that it was in many ways the catalyst for the crisis of confidence. When Papandreou took office and announced the 'real numbers' in Greece markets started to look around and say 'hang on, maybe we shouldn't have lent all that money to that dodgy government, and if they're dodgy maybe those other guys are dodgy too.' In short you get a situation where no one wants to lend money to governments that really, really, need the money because they run their countries so extremely poorly.
'It's only when the tide goes out that you learn who's been swimming naked'
- Warren Buffet
How much Greek debt is there really out there?
Well in 2010 debt to GDP in Greece stood at 142.8%. With GDP of $305bn, the level of debt stands at around $400bn.
Greek Government Debt To GDP
So who's holding the hot potato?
That debt isn't just floating around. It is on the balance sheets of banks and financial institutions. Mostly European banks.
It is easy to see Greek bonds on bank balance sheets. Soc Gen, Europe's second biggest lender has roughly $2.5bn of Greek debt on its books (of which it recently wrote down $500m). [3]
What is harder to see is a bank's actual exposure to euro zone debt. Remember when AIG was nationalised in 2008 just days after the collapse of Lehmans. Well AIG had sold an astounding amount of silly CDSs that insured against the collapse of banks and institutions like Lehmans. Now who do you think is writing CDSs on all those euro zone bonds? Who really knows?
What about securitization, who knows how many other derivative and securitized products exist based on European debt?
There is a veritable mountain of paper out there that can bring the financial system to its knees just like post-Lehmans should a euro zone government default.
Who can save them?
There are three potential saviours for the PIGS since the market has turned its back on them.
The IMF
The IMF provides loans to countries when they are in 'need'. These loans have until recently been predominantly to developing countries. During the European sovereign debt crisis however countries like Portugal and Greece have had their hands out for some pretty generous loans.
The critical thing about IMF loans is that they come with conditions attached. Conditions like 'Greece, you've got to cut spending and raise taxes!'.
The IMF holds countries to such conditions and will hold back sending money if the conditions aren't met.
Greece has been unable to pay its debts for at least a year now. What it has actually done is turn to other governments and the IMF and borrow more money to repay Greek bond holders. The eventual outcome to the Greek default debacle will be decided by a battle between the markets and policy makers. If Greek policy makers can't satisfy the IMF and euro zone policy makers then the markets will win.
The European Central Bank (ECB)
The ECB has the power to print euros and buy European sovereign debt. The ECB could print euros and buy Greek bonds which would enable the Greek government to effectively borrow more money at a lower cost. The ECB has conducted moderated purchases of Greek and other euro nation sovereign debt however it is restrained by its mandate to maintain price stability.
The ECB is independent of any single euro area member state. Following the first world war Germany and to a lesser extent other European nations experienced a period of sustained and severely detrimental hyperinflation. The severe disruption to economic activity witnessed during the high inflation period has meant that the ECB is extremely unwilling to stray from its mandate of maintaining price stability.
The fact is that it is hard to print euros and buy vast amounts of sovereign debt without the possibility of higher inflation. This means that the ECB is severely constrained in how effectively it can help solve the European Debt Crisis.
Other Euro Area Member States
There are 20 euro area member states. Potentially the nations who are in a more fiscally sound position could bailout those who are experiencing difficulties. This would effectively translate to a country like Germany or France lending to the PIGS.
A slightly more elegant solution has been put on the table by the euro area member states that involves the use of a fund that is partly guaranteed by each nation. The fund has been labelled the 'European Financial Stability Fund' (EFSF). The EFSF would essentially sell special bonds to the market to raise money to lend to the euro countries that need it. The crucial aspect of the fund is the guarantee by each euro area member state over a proportion of the bonds. The guarantee from 'more reliable' nations means that the bonds can attract a higher credit rating and can raise money at a lower cost.
Related
Take a look at our Markets Vs. Policy Makers score board for a brief history of who's won in the past.
Check out the Sovereign Debt Crisis Time Line
References
[1] CIA World Factbook, Greece
[3] Time to buy European banks?
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Comments
Why did the US / European banks lend to countries like Greece to start with? Was it in search of higher returns?
Posted by SK, 26/12/2011 5:55am (5 months ago)
Hi SK, That's a good question. There are many reasons large financial institutions will hold sovereign bonds. Sovereign bonds typically attract a higher credit rating and as such can be held in higher proportions on a bank's balance sheet as part of their capital requirements. Yes, one of the reasons that a European or US financial institution would hold specifically Greek bonds in the first place is because they offered slightly higher yields (higher returns). Many of the financial institutions who initially demanded Greek bonds were in fact unaware of Greece's dire fiscal position due to Greek finance officials misreporting treasury figures. When the new government took office they scrutinised the figures more closely and then announced the true nature of Greece's fiscal problems. Hope that helps.
Posted by My Money Calculator, 26/12/2011 3:25pm (5 months ago)
Assuming about 350 billion in total debt, that means about less than 19 % of the bailout are going to allow Greece to continue its overspending. About 23 % goes to Greek institutions, though at this point, all of that is held by the ECB, so it is not fully benefiting Greece. 18 % are going to the ECB directly and 40 % are going to banks and insurance companies outside of Greece. So at least 58 % of every bailout Euro is going outside of Greece. Greece is getting a bailout, but you can see why Merkozy got so scared at the idea of a referendum. The bulk of the money that Greece is "getting" comes right back to the rest of the EU. Whatever posturing is going on, Greece will get away without meeting any of its stated goals, or at least it will until the EU decides it has written down enough principal and that the ECB can handle the shock. At the end the Ancient Greeks deceived EU and go away with free hundred billions of Euros.
Posted by Bluerose, 31/12/2011 2:17pm (5 months ago)
How did the Greek goverment end up needing bailouts from the IMF or EFSM ?
Posted by Ballack, 03/03/2012 9:38am (3 months ago)
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