Yesterdays downgrade of Greece’s credit rating by the Fitch rating agency has potentially far-reaching implications. Beyond the national implications there are also ones for the Eurozone as it is the first country in it to have a credit rating of less than investment grade A. This poses future problems for the European Central Bank but more of that later.
If one analyses Greece’s recent past economic history at first one may be surprised by its current status. During the period 1997 to 2007 its economy grew at an average of 4% a year which was twice the average of the Eurozone. This was helped by aid from the Eurozone leading up to and following it joining the Euro in 2001. So far so good. However the economy has structural rigidities and there was a considerable expansion in the public sector. I found some rather disturbing numbers on the growth of the Greek public sector but have been unable to fully authenticate them. The net effect was that the economy ran a public sector deficit of some 5% of Gross Domestic Product (GDP) in 2008. So after some good years for the economy the public finances were in poor shape. As the impact of the credit crunch became more severe unemployment rose (currently it is estimated at 9.6%) and the public finances deteriorated further. There was also considerable public unrest a year ago particularly in Athens. The new Socialist government is now estimating that the public-sector deficit in 2009 will be 12.7% of GDP. There is some political squabbling over this number as the previous government was estimating it at half this size.
These numbers have unsettled financial markets and in addition these deficits which are not only high but are also rising has pushed up the Greek National Debt as a percentage of the size of its economy. This ratio is used as it is a rule of thumb on how repayable the national debt is i.e you compare it to the size of the underlying economy. It was estimated as 95% of GDP. The new government has estimated that at the end of 2010 it will be 121% of GDP. This is what has hit Greece’s credit rating. Not only the rise but the acceleration.
So the rating agency Fitch has judged Greece to be worthy of a credit rating of BBB+ ( negative outlook).
Implications for European Monetary and Fiscal Policy
One of the rules of the European Fiscal and Growth Pact (a condition of entry to the Euro) was that the public sector deficit would not exceed 3% of GDP. Oops! Greece is not alone as for example Ireland (before today’s budget) has been forecasting a public sector deficit of 14.7% of GDP . So the Eurozone badly needs to review this rule as it now has no credibility. In case you are wondering why Ireland has not been downgraded with Greece whilst its annual position is worse the Irish wisely used some of the good years to repay some of their national debt which fell from 95% in the early 1990s to 25% in 2007
The European Central Bank relaxed some of its short-term emergency help for the markets last week. It will offer less liquidity and plans to also change back the credit level of required for collateral it will accept to A- from the end of 2010. It had as an emergency measure been accepting collateral down to BBB-. So as things stand Greece will be unable to obtain funding form the ECB as of the end of 2010.This will increase the short-term funding costs of its national debt. Essentially it has been able to benefit from its banks borrowing from the ECB at 1% and then using it to buy Greek government bonds. So the bonds find buyers and the banks make a profit.Will the Eurozone change criteria for one country with the implication that its overall credibility will be reduced? In some ways Greece might be helped if other countries are downgraded too as this would weaken the ECB’s bargaining position!
Will Greece Leave the Euro?
This answer is clear-cut. Lets us imagine that Greece did leave the Euro and returned to the Drachma. In its current situation its new currency would have to be at a discount to its current level implied by Euro membership. After all it could hardly be seen as a strong currency could it? As the currency fell it would make the national debt problem worse as it would be attempting to repay them with a less valuable currency. Also new borrowing would be likely to be more expensive as Greece would no longer be under the umbrella of the Eurozone debt envelope . So in essence the conditions which make Greece wonder about leaving the Euro will also make it remain a member as the longer term benefit of a lower currency is unlikely to help it in time to pay the extra debt costs. Indeed in the short-term the terms of trade will move unfavourably as well.
Whilst leaving the Euro is a very unwise decision for a country during these troubled times and in my view is very unlikely a sovereign default is much more feasible. We will have to see how the world economy develops over the next few years as economic growth is a powerful tool in this area, but public sector deficits are rising in many countries as are national debts. In the Eurozone this can be measured by ten-year government bond spreads. What these do is measure how much more or less national governments have to pay on their debt compared with the German 10 year bund. So for this purpose it is effectively used as a benchmark or indeed “Gold Standard”.
As of last night’s close using this measure put Greece’s bonds at 2.21% over the German Bund. This was a rise of 0.50% on the previous day. To give other examples the Irish were at +1.61% and Italy was at +0.79%. However it was at a lower level than when Greece went on negative watch back in February 2009 when it reached +3.00%. So Greece is being punished for its fiscal problems and the punishment makes the problems worse.
I am trying to think of someone who might want to change jobs with the Greek Finance Minister. I hope he is the cheerful sort! His problems are really around long-term solvency of the nation so there is not really a quick fix.