PAT MCARDLE and JOHN MCMANUS
Fri, May 07, 2010
What is the ‘bond market’ and why has the Greek rescue package not succeeded in convincing markets? As for Ireland – what is the best- and worst-case scenario?
1 Why do countries have to borrow? What are bonds?
We elect governments to run countries and to do things the private sector would not do efficiently, eg the police force or social welfare transfers. Governments have no money of their own; their spending must be covered by taxes. If they spend more than they take in, they bridge the gap by borrowing. Unlike most normal people, governments rarely pay back their borrowing. However, if they cease borrowing for a period then debt as a percentage of gross domestic product (GDP) can fall to low levels, as happened in Ireland during the Celtic Tiger.
All governments reacted to the current crisis by running unprecedented budget deficits and borrowing the difference. As a result, euro-area debt rose from 66 per cent in 2007 to 85 per cent this year. The Irish and Greek figures are 25 to 77 per cent and 96 to 125 per cent respectively.
Countries borrow in many ways, from deposits in the post office to long-term bonds. A bond is an IOU which promises to pay back the amount borrowed at a certain date with a series of interest payments in the meantime. Hence the expression, “my word is my bond”.
2 What went wrong with the Greek economy? Why can’t they borrow any more?
Even when times were good, Greece had very high borrowings and debt. Some years back it engaged in accounting tricks to keep the ratio down; close to 100 per cent of GDP. Basically, it overspent and undertaxed but some of this was concealed in the returns it sent to Brussels. The revelation, by a government that was newly elected last September, that its deficits in recent years were wildly understated sent shock waves through the markets, which began to doubt that it could continue without major adjustment. Greece now has the highest debt burden and the largest interest-rate bill of the euro countries.
The market effectively stopped lending to Greece, forcing it to call in the International Monetary Fund (IMF) and the EU. The same would have happened to us had the Government not begun to address the deficit in 2008.
3 Why does it matter? Why don’t they just default or reschedule their debt? Is that not what countries do when they can’t repay their debts?
Less-developed countries default or reschedule their debts. A euro country has never defaulted and lenders to such countries, typically large pension funds as well as a multitude of other investors, do not expect to lose their money. It would thus be regarded as a very bad precedent. The Greek programme agreed with the IMF and the other member states seeks to avoid default almost at any cost; instead it envisages swingeing cuts in government spending and higher taxes.
This is very unpopular in Greece, which has no tradition of balancing the books. Greeks are protesting on the streets about cuts in pay and social welfare. However, the alternative is worse, for without external assistance Greece would run out of funds to pay wages and social welfare within a month.
4 Who or what is the “bond market”? Are they rational investors managing people’s savings or greedy sociopaths?
The main buyers of sovereign debt are typically pension funds and other institutions looking for stable long-term investment returns to match their liabilities: the pensions they must pay to their customers. In totality they, along with various other classes of investors, make up “the bond market”.
But as with all assets, government debt attracts speculators looking to make short-term profits from market events rather than hold the investment for the long term. The prospect of a Greek default is the sort of event that speculators would find attractive.
5 Why has the €120 billion rescue package not succeeded in convincing the market that Greece will not default? (Do people not believe that the Greek government and people can implement the required reforms?)
The €120 billion removes the need for Greece to borrow for more than two years. It does not guarantee that Greece can make the adjustments necessary to regain the confidence of the markets and resume borrowing in a few years’ time. Ireland was able to resume borrowing immediately because there was confidence that the Government would deliver. Some fear that Greece may be forced to the ultimate option of restructuring or delaying the repayment of its debt anyway. So the markets have kept the quoted rates for Greek borrowing very high.
This does not matter at the moment given that Greece will not be tapping them for funds, but it is a sign of lack of confidence.
6 Is there a chance that it could still work and the markets will start to believe Greece can pay its debts and everything will calm down?
Yes – if Greece delivers on its austerity package, sentiment could change at any stage over the next two years.
7 Is there anything that can be done in the short term to calm the market? What about this weekend’s summit of EU leaders, for example?
Very little. The problem now is not Greece but the spread of contagion to others. It is unlikely that either the IMF or the EU would make a major change at this stage to the Greek plan. Lingering doubts about whether the German parliament will ratify the deal are another factor. The summit this weekend is likely to put pressure on all concerned to pass the necessary legislation quickly, thereby removing one source of uncertainty.
The European Central bank (ECB) is under some pressure to help ease the strain, by buying Greek bonds indirectly for instance. ECB president Jean-Claude Trichet seemed to rule this out yesterday, saying it had not even been discussed.
8 Why is the apparent failure of the Greek rescue package causing such a problem for the wider euro zone?
It raises doubts about the euro zone’s solidarity and ability to protect members, and opens the door to speculation against other weak candidates such as Portugal, Spain, Italy, Ireland and, possibly, the UK.
9 Why is the euro so weak?
It is weak because investors are putting their money elsewhere given the uncertainty about Greece and other peripheral states. The turmoil surrounding Greece has added to the doubts about the viability of the single currency.
The euro has fallen by about 10 per cent since late 2009. This is helping member countries gain competitiveness and boost exports in much the same way as the UK is doing. It also relieves pressure on Irish exporters to the UK.
10 What is all this talk about a Greek default precipitating a fresh banking crisis?
Many European banks are big holders of Greek government debt and would suffer substantial losses if Greece defaulted. Some fear that the losses could be so big that it would result in a rerun of the 2008/2009 banking crisis which was triggered by the losses incurred by banks on subprime mortgages.
11Are Portugal, Spain and Italy really in the same boat as Greece?
Yes and no. They face similar budgetary problems to Greece – as do we – and will have to demonstrate to the market that they can get their deficits back under control. However, various other mitigating factors, such as Spain and Portugal’s relatively low level of debt, differentiate them from Greece and mean it is feasible for them to borrow more and manage their way out of difficulty.
12 When will Portugal’s problems come to a head?
If and when speculation shifts to them. The debt markets are still open to Portugal and it raised a €500 million six-month loan on Tuesday. However, it had to pay an interest rate six times higher than it paid for a similar loan in January.
It has to repay another loan of €4.6 billion on May 30th, but after that it does not have any loans falling due until April next year.
The government will have to demonstrate that it is tackling its deficit between then and now. Last week it announced further measures.
13 If it came down to it, could the other euro-zone members not help Portugal in the way they are helping Greece?
Yes – the amounts involved in supporting Portugal are small relative to the funds spent to resolve the banking crisis in Europe.
14 But what happens if/when Spain gets into trouble? Or Italy?
Getting harder, but could still be doable if there was sufficient will. At that stage everything would hinge on whether Germany was prepared to support a bailout on that scale.
15 Is the euro zone doomed then, or is that just scare-mongering?
It would be in serious trouble if Spain was to be forced into a default, which is unlikely to happen. But in extremis it would collapse to a small number of states, possibly the five that Germany wanted in the euro zone in the first instance – that is the original six minus Italy.
16 What needs to happen to remove the risk of something as catastrophic as a Spanish default destroying the euro? Do we need some sort of systemic response or a mechanism to allow countries to leave the euro and default/reschedule their debt?
The obvious solution is closer fiscal union allowing direct transfers between states, as is the case in the US.
The next-best solution would be a European IMF that would give the market confidence that the euro zone could deal with a fiscal crisis in a member state despite the lack of an underlying fiscal union. But establishing such a structure could take some time and would probably require the reopening of existing European treaties. Plans for closer scrutiny of member states’ books are to be announced next week.
As things stand it is not possible for members to leave the euro zone. Even if they did, their debts would remain in euro so it would not solve their immediate fiscal problems. However, if they left they could then default without consequences for the remaining members.
17 Are these sorts of solutions realistic given what we know about the dynamic within Europe? Could Germany not just cut and run?
As with so much that we have witnessed in the past year, a German exit was unthinkable until now. But it is probably no less fraught or difficult a process than the creation of a European IMF or implementing any of the other long-term solutions being proposed to address the lack of a fiscal union in the common currency area. But now that this fundamental weakness in the euro zone has been exposed, it will have to be addressed if the euro is to be viable in the long term.
A German exit – while it might have political appeal at home – is not necessarily in Germany’s interest. The setting up of a new deutsche mark would in effect mean it has allowed all the other euro-zone – or former euro-zone – countries to devalue against it, which would damage hard-won German competitiveness.
18 What is the best- and worst-case scenario for Ireland?
The best option is that the Greek bailout works and we return to (relative) life as normal. Even under this scenario we may have to accept higher borrowing costs as markets remain nervous about Greece.
The worst case is that the bond markets lose faith in Ireland because of what happens in Greece and other peripheral countries.
Then we are faced with seeking EU help and if that is not available then IMF help. Either way it will involve a tougher austerity package