Watching Greece Without Going Over the Edge

(Caixin Online) It's been a painful few weeks for global asset markets. Global equity markets traded steadily down, the euro weakened sharply, commodity-related currencies saw sharp initial sell-offs, global spreads widened, and most volatility indexes tracked steadily upward.

Why? To some extent, markets were reacting to recent monetary policy changes by the People's Bank of China and fears of mainland tightening. Others were concerned about global liquidity. But for the most part, recent market behavior can be summarized in one word: Greece.

Greece's problems have been well-publicized, so we only need a short reminder of what's going on. The Greek economy has always been one of the weakest links in the euro zone, with very high debt and deficits for years. The 2008-'09 global financial crisis essentially tipped the situation over the edge: Greece's fiscal deficit rocketed from 6 percent of GDP in 2008 to around 12 percent last year as revenues fell due to the recession and stimulus-related expenditures climbed sharply. As a result, the Greek debt to GDP ratio, which was already close to 100 percent of GDP before 2008, ballooned to 110 percent of GDP by 2010.

These numbers alone are bad enough, but global markets also punished the government by raising financing costs dramatically. For many years, Greece essentially paid the same interest rates as other euro zone members, despite its considerably worse fiscal situation. But long-term yields on Greek bonds rose from around 4.5 percent last year to nearly 7 percent today – close to 400 basis points higher than those in the strongest European economies.

And this created a devastating problem. Greece was not the worst-behaved European economy in the run-up to the crisis, but like other members on the European Union "periphery" such as Spain, Ireland and Portugal, it did see a rapid rise in private borrowing and private debt, as well as a housing bubble. As a result, it's now facing an extended period of slow growth and possible deflation as financial deleveraging pressure sets in. According to the International Monetary Fund, the Greek economy will only grow around 1 percent year-on-year in real terms over the next three years, and perhaps only 2 percent in nominal terms.

So with the costs of servicing debt at 7 percent per annum, nominal growth of only 2 percent per annum, and a yawning primary deficit to boot, Greece is now facing an inevitable explosion of its debt ratio and looming default, unless something changes quickly.

Which brings us to two questions for the markets: First, will we actually get to the "worst-case" scenario, i.e. will Greece default on its debt? Second, are there other Greek crises waiting in the wings, either among its European neighbors or in the emerging world?

Will Greece Default?

For Greece, there are really only two ways to avoid default: slash the budget radically, or find a bailout route. The good news is that in the near term we're likely to see a "weak" combination of both – a significant fiscal adjustment and some outside funding – that will allow the government to keep servicing its debt, as all players involved have a very strong incentive to avoid a disastrous scenario. In short, no default tomorrow.

The bad news, however, is that neither of these options is likely to come close to solving the problem, which means the default question will continue hanging over Greece for years to come. In this environment, it's simply impossible to rule out a disaster in the medium term.

In January, the Greek government presented a medium-term budget plan aimed at bringing down the deficit rapidly to 2 percent of GDP by 2013, and stabilizing the debt ratio at 115 to 120 percent of GDP. The trouble is, this goal is almost certainly too optimistic.

To begin with, while there is room to boost tax revenues by removing exemptions and loopholes, much of the adjustment will have to come from painful spending cuts, and not just in a single year, mind you, but successively in every budget for the next five years. Greece does not have a good track record for these kinds of adjustments, and there is enormous potential for social and political unrest that could easily push the government to backtrack or even cancel retrenchment plans.

This is particularly true since, even if the government succeeds in pushing through unprecedented budget austerity measures, the effect on the economy would likely put underlying growth assumptions wildly out of reach. The current government plan assumes Greece can grow at least 1.5 percent in real terms and twice that pace in nominal terms, but the impact of such a massive withdrawal of fiscal stimulus probably implies a further outright contraction of the economy going forward; i.e. instead of growth, putting the budget back on track could mean a continued and protracted recession.

Finally, for any realistic plan to succeed we would also have to see market financing costs come down fast; ideally the very announcement of a "shock and awe" adjustment program would give investors a sharp boost in confidence and reduce interest spreads on Greek debt. But that clearly hasn't happened. The market sell-off only intensified after the government's budget plans were made public, in part because investors fully understand the crushing difficulties with implementation and the unrealistic nature of underlying assumptions.

In short, Greece very probably needs a bailout as well, and this is what markets are really waiting for. At some point, they will probably get one. Again no one in the EU – or for that matter the global economy – has any interest in seeing Greece default, not least because of the worries about severe contagion in other exposed markets and the unpredictable impact that could have on the world economy, so we should look for others to lend a helping hand.

Who might those others be? Perhaps most likely the EU itself, although it's not impossible the IMF would be called upon to act in a more formal sense. (Greece would of course resist any suggestion that they need to go cap in hand to the IMF, but at the end of the day they also may not have any choice.) We don't mean to suggest a bailout package for Greece tomorrow; since this could play out over many months yet. However, sooner or later we believe the money will come.

Will that be the end of the story? Again, probably not. Cash injections can help in 2010, and again in 2011, but keeping in mind the conclusions from our analysis above, i.e. that the sheer magnitude of adjustment involved will likely prove beyond Greece's ability to deliver, we suspect sponsors will eventually tire of providing an open-ended lifeline to the government and the economy. So watch for more tension and turmoil down the road.

Other Greeces Out There?

Are there other disaster cases waiting in the wings? Fortunately, it turns out Greece is relatively unique in terms of the vicious combination of debt, deficits and poor growth prospects. We don't see immediate default scenarios playing out in other parts of Europe or the world. But there are clearly other countries we should worry about, and most of these are Greece's neighbors on the European periphery: Portugal, Ireland and Spain (there's also Britain, but this is a topic for a separate note).

How bad are these economies? Again, not nearly as bad in terms of the immediate pressures. All are running very onerous fiscal deficits, above 10 percent respective GDPs. But Portugal entered the crisis with a public debt/GDP ratio of around 65 percent, and the figures in Ireland and Spain were around 30 to 40 percent. So the respective starting points were better, and this has allowed their bonds to continue to trade at much lower spreads even as fears of Greek default began to spread.

Problems, though, loom in the medium term. Each of these countries had a massive surge in credit and leverage activity, fueling bubbles in housing, construction and other services in the economy, and all are now facing a sharp drop in real growth potential together with deflationary pressures – i.e. the same kind of "vicious circle" mathematics that makes Greece's debt levels unsustainable today could apply to its neighbors in the next few years as well. Of course, they have a bit more time to take needed budget adjustments and spur new growth, but investors would be well-advised to keep a cautious eye.

And now for the good news: These are certainly the worst major cases in the global economy today. It's very fashionable for pundits to forecast a U.S. debt crisis, but for the time being U.S. numbers look a good bit better in terms of debt/interest rate/growth dynamics. And far more important, the U.S. economy has one tool at its disposal that smaller euro zone economies do not: the ability to simply print money to fund new deficits in the form of U.S. Federal Reserve purchases of Treasury bills and bonds. It is precisely this ability, for example, that allowed Japan to embark on an unprecedented 20-year fiscal binge without having to worry about rising spreads or default risk. While the U.S. economy is different in many ways, the basic principle still applies.

Nor, despite all the attention paid to emerging market risks, do we see big public debt problems in the emerging world. Of course, most emerging economies have also allowed budget deficits to widen sharply in the aftermath of the crisis. But it's important to remember that this was not an EM crisis per se. As a result, the emerging bloc as a whole has three crucial elements going for it:

First, much lower debt and deficit levels coming into the downturn. There are exceptions, but the average EM country saw debt loads fall dramatically over the past 10 years in the aftermath of 1990s crises, as growth picked up and governments cleaned up budgets and spending policies. As a result, the emerging world as a whole actually ran a fiscal surplus in 2006-'07, the first time in many decades we saw that result.

Second, much better growth prospects. Again, this does not hold for every country, but the main distinguishing feature between emerging markets and advanced economies over the past five years has been the eye-popping amounts of private debt and leverage generated in the developed bloc – and the relative lack of it in the EM world. This explains why so many emerging countries did so well during the 2008-'09 downturn, and also why they are recovering so much faster in 2010. Going forward, most emerging economies will see much faster real and especially nominal growth numbers, precisely because they don't face the same structural deleveraging pressures as in much of the advanced world.

Third, and also crucially, much lower growth-adjusted funding costs. Its a popular rule of thumb that nominal interest rates should equal nominal growth rates in developed economies, but this almost never holds in the EM world. Relative to the pace of real and nominal growth, EM interest rate structures are far lower today than in most advanced countries, allowing a much greater degree of flexibility in dealing with fiscal concerns.

Mind you, there are always exceptions to each of these points. For example, the Baltic and Balkan states, together with CIS countries such as Ukraine, saw enormous private credit cycles during the past five or six years and now face severe "Greece-style" deflation and recession pressures crimping fast growth. Unlike Greece, however, these countries also came into the crisis with extremely low levels of public debt: 16 percent of GDP for Ukraine, 19 percent for Romania, 5 percent for Estonia, etc. Of course, these figures could grow rapidly over time. But they also provide a buffer that allows economies to absorb longer periods of weak or no growth without immediately facing fiscal disaster.

There are also countries with very high debt and deficit levels, such as Egypt and India. But these countries are growing at a double-digit nominal pace – and funding deficits at much lower interest rates, on the order of 6 percent to 8 percent per annum for debt borrowed on market terms. This doesn't mean zero risk of rising spreads and costs, of course. But given stronger growth fundamentals, it's much more unlikely that any near-term shocks could push these countries over the edge with Greece.

Jonathan Anderson is head of Asia-Pacific Economics for UBS.