Roubini on Greece’s Impending Default Crisis

Greece, Kos Island, ruins of stadium at archeological site

The markets are falling hard – again – in great part due to the impending Greece default/bailout.

Nouriel Roubini, Dr. Doom, wrote a piece on Forbes magazine in which he says the credibility of the euro and European institutional arrangements is on the line.

At their Jan. 18, 2009, meeting, eurozone finance ministers kept pressure on Greece to fulfill its commitment to cut its budget deficit below 3% of gross domestic product by 2012. In February the eurozone finance ministers will more fully evaluate the country’s spending plans and recommend a timetable for Greece to trim its deficit, estimated at close to 13% of GDP in 2009.

Since the eurozone is a monetary union with a no-bailout clause rather than a political or fiscal union with the associated fiscal federalism, budget cuts to contain the explosion of Greek public debt are urgently needed. In 2010 a sustainable fiscal adjustment must be delivered to restore policy credibility, market confidence and ECB/EU member-state solidarity.

Roubini says that the current and latest default crisis was triggered by three coinciding events:

1. Greece’s sharp budget deficit revisions from as low as 3.7% of GDP to 12.7% in October,
2. the announcement of the beginning of the ECB’s exit strategies,
3. the Dubai default

While in March spreads were broadly driven by a common systemic risk factor, the latest spike bringing Greek yields and CDS spreads to new highs is mostly a country-specific story, brought to light by a change of government and the revelation of far larger budget deficits than previously known and a severe cyclical and structural deterioration in public finances. In tackling the deficit, Greece faces a Hobson’s Choice: whether to accept social pain with financial and economic stability, or instability. Whatever it chooses, Greece will face economic pain and difficult socio-political fallout. Deep spending cuts or tax hikes, which comprise the bulk of Greece’s current plan, will curb or even derail recovery, perhaps inciting social unrest. But if the debt becomes un-financeable in the primary market or if Greece elects to exit the euro and devalue and re-denominate its liabilities (a la Argentina), this could render its banking system insolvent and tip it into economic and financial isolation and decline, also with dire socio-political consequences.

While a buyers’ strike has been averted for now with Greece’s successful auction of five-year government debt at 6.2%, the additional yield investors requested was substantial. The possibility of a buyers’ strike in the primary market in the future may further test Greece’s political commitment to fiscal adjustment and economic stability, as demanded by its treaty obligations and the strictures of a currency union.

Going forward, once Greece has delivered what the EU Commission, ratings agencies and stakeholders in the markets judge to be an adequate pound of flesh, we expect the ECB to take on a more constructive stance, especially in view of the stricter collateral requirements that will be put in place by the end of 2010. The risks of not doing so would entail a judgment that Greece could, in theory, be surgically removed from the eurozone without starting a domino effect in other countries with high or escalating public debt burdens, some of which are far larger economies and hence could have an impact on the regional and global financial and economic systems. Alternatively, a sovereign upgrade to A- by two ratings agencies after the budget effort meets approval could also be part of the solution.

The endgame

Roubini expects "the extraction of a pound of flesh and a bit of a fiscal compromise that together restore debt sustainability." He states that will require a combination of further sharp fiscal adjustment, like Ireland and a signal of support from the ECB. In response, CDS spreads will peak, and improved signals from the ratings agencies will bring cash bond yield spreads back down to earth.