Moral hazard meets Greek tragedy for EU


THE public sector deficit issue in Greece appears to be heading for a dénouement with the market getting jittery about Greek government bonds and wondering whether the country will default, or even withdraw from the Eurozone. A sovereign default is a serious issue at the best of times, but in this case there is added complexity and seriousness due to the fact that Greece is in the euro. It is difficult to overestimate the impact on the markets and investor confidence if a euro-member defaults.

The chart below shows the three-year credit default swap (CDS) levels for Greece as well as Germany, Ireland Portugal and Spain over the last 12 months. As the price of pure credit risk, a CDS price implies probability of default for the entity concerned. Putting Greece aside for the time being, we see that Ireland is at 132 basis points (bps), and in fact apart from Greece it has the highest CDS price in the euro-zone. The country is struggling with a housing-led recession and was recently downgraded to AA- by the rating agency Standard & Poors. Contrast that with Germany, at a mere 12 bps. Greece on the other hand is trading at 385 bps.

In other words, the market has, in only the last few weeks, raised the price of Greek default risk by more than double, from over 150 bps earlier this year. Is this a risk worth taking, or will Greece default? For the risk-averse investor, a better trade might be to sell protection on Ireland rather than Greece. In an unfunded trade, this is an income of over 1 per cent for one year. But the question of Greece all depends on what view one takes of the entire euro project.

From the start EU leaders have emphasised that the euro represented another tool to forge “ever closer union”. In other words, it was a political construct rather than an economic one. Despite a set of stringent rules on fiscal discipline required of all euro members, it is the lack of such discipline exercised by countries such as Greece, but also to an extent Ireland, Portugal and Spain, that now threatens severe market disruption and devaluing of the euro. If a member defaults, the impact on the euro would be severe; most probably at least parity with the US dollar, from a current level of 1.42, if not worse. This could unravel the whole “ever closer union” project.

If the EU did decide to act as a “lender of last resort”, it could be a signal for other countries to loosen their fiscal discipline, in the belief that they would be bailed out in the future. This is the “moral hazard” risk that remains prevalent in the banking system. However, if the Greek government was to default, the euro itself would come under sustained pressure and the CDS spreads (and bond yields) of the weaker euro members would also rise. This is an equally unpalatable situation for the EU. The markets could force a solution anyway: for example, what happens if spreads widen to 500 or 600 bps? The Greek government will find it harder to refinance its debt, and with a repayment due in April 2010 this could be the crunch time.

Therefore, the debate under way now is one in which the EU must decide between the moral hazard risks of a bailout, or the contagion risk of allowing the Greek government to default.

This makes Greek salvation via the International Monetary Fund (IMF) more viable. IMF officials arrived in Athens last week and are reviewing the situation. The announcement of an IMF bailout programme would drive Greek spreads lower, even if the amounts being offered by the IMF were relatively small. But for the EU the IMF solution is a clean one. It would be a strong signal towards other member states to get their finances back into shape, or risk loss of control over their finances to the IMF.

The chances of a euro break-up are small. For both the strong euro-zone members as well as the vulnerable ones such as Greece this would be a lose-lose situation. For the stronger members it would raise the risk of contagion towards other member states, and this would put significant downward pressure on the euro. This is the type of volatility that euro members want to avoid. It would give them a temporary export advantage, but the credit spreads for euro members to issue sovereign debt would widen substantially as well.

All this makes the euro a less strong currency than it has been since the onset of the banking crisis. In fact we have an interesting reversal of fortunes in prospect for the second half of the year, when we expect that the anticipated rise in US dollar rates sees the dollar strengthen, just as continuing public sector debt worries in the euro-zone starts driving the euro down.

Moorad Choudhry is editor of the EAB Treasury Morning Shout.