The capitulation in the Greek sovereign bond market over the past 10 days or so, notwithstanding the Greek government’s decision to access the €45bn financial assistance package available from the EU and IMF, has led many commentators to conclude that Greece is sliding inexorably to some form of debt restructuring. Much of this commentary seems to imply that a restructuring is now the least-cost option open to both the Greek and euro area authorities. But is this really the case?

Certainly, debt restructurings can offer a way out for countries that find themselves with unsustainable fiscal positions. And there are examples of countries (Uruguay, Jamaica, Belize) that have organised orderly restructurings in the recent past. But these are countries with very small, domestically-focussed bond markets. Greece is an entirely different kettle of fish – outstanding debt is around €300bn, with 70% or so of that held outside Greece. The ramifications from a Greek default, therefore, would be significantly greater, arguably making Argentina’s 2001 default look a sideshow in comparison.

For the rest of the euro area, in particular, a Greek default has the potential to wreak serious consequences, hence why its governments have, with varying degrees of enthusiasm, cobbled together its financial rescue package. What Greece’s euro area compadres hope to avoid is:

• Contagion – allowing a Greek default would undoubtedly turn market attention to the fiscal position of the other so-called PIIGS. In the past week, as Greek bonds capitulated, the bond markets of the other periphery euro area countries came under varying degrees of pressure.

• Banking losses – while it is impossible to tell exactly how much, a great deal of Greece’s outstanding debt stock (perhaps €70bn) is held by banks in the euro area, with German banks alone holding up to €30bn. It is clear, therefore, that a Greek default would inflict huge losses on what are already in some cases weakly capitalised euro area banks, possibly to the extent of requiring government intervention to offset the losses.

For Greece itself, while a restructuring offers the prospect of gaining more time to get its house in order, or even slashing its outstanding debt stock in a stroke, it is far from obvious that the benefits would outweigh the likely significant costs. In particular:

• Funding the deficit - while a default would enable Greece to cut its outstanding debt stock, it would do nothing for its annual deficit. Greece plans to run a deficit of at least 8½% of GDP this year – a default would mean that Greece would find it very difficult to finance such a deficit from the market. Remember, unlike most defaulting countries, Greece cannot print its own currency to pay its bills. And, indeed, the government’s finances could be put under further pressure by…

• Potential output losses – significant (and disorderly) defaults are typically associated with large economic contractions in the countries concerned as a result of a combination of, among other things, the knock to confidence, the fiscal contraction resulting from a loss of access to market funding and the effects of the losses borne by private sector holdings of government debt. There are obvious wealth effects via private sector holdings in pension funds, etc., and the biggest impact can come via its impact on the domestic banking sector….

• Banking sector losses – Greek banks themselves are large holders of Greek government debt. A default would therefore mean that Greek banks incur large losses, potentially pushing them into insolvency. In any case, a default would mean that Greek government debt immediately lost its eligibility as ECB collateral, meaning that Greek banks’ funding sources would dry up rapidly. The impact of such a banking crisis on the economy would be very large indeed.

• Higher long-term borrowing costs – Over the longer term, a default would likely push up Greece’s borrowing costs for a significant period following the default.

Greece undoubtedly finds itself in an almighty hole. And it is easy to see why some commentators view the default option as both inevitable and easy. But it is neither. A default would have the potential to impose severe costs on both the Greek economy itself and on the economies of some of Greece’s euro area partners. And while Greece is in for many years of pain as it attempts to fix its fiscal position, the pain that will impose is likely to be nothing compared with the consequences of default. As such, if it can get the support of the EU and the IMF firmly behind it, and secure funding for 2010, we expect the Greek government to press ahead with its fiscal consolidation efforts over the coming months. As these bear fruit, this should hopefully restore a degree of market confidence. But even if it doesn’t, if the Greeks do as they are told and bear down on their deficit, expect further external support to be forthcoming, with default only likely if the Greeks stop acquiescing to their new paymasters’ demands.

Grant Lewis, Head of Research

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