Greece's Long, Slippery Slope to Default

Is Greece defaulting? It's a question definitely worth exploring, because what's happening now on these rocky shores of the Mediterranean Sea may be a mere warm-up for much bigger debt crises to come.

The European Union might help Greece roll over its existing 300 billion euro debt. But EU assistance would severely limit the amount of new debt Greece could issue. And the Greek government's 30 billion euro fiscal deficit would be hard to finance.

As financial institutions in western Europe hold most of Greece's existing debt, it is in the EU's best interest to protect their value. Otherwise, Europeans could plunge into another financial crisis.

Greece may have hidden a large amount of debt through revenue securitization, interest rate swaps or other derivative agreements off the balance sheet. It's unlikely the EU would guarantee such contracts, unless the counterparties are European banks. Fallout from noncompliance of such derivative contracts would trigger market shocks.

In the long run, Greece may have to officially default. It has accumulated foreign debt to support consumption. It could tighten its belt and stop borrowing money, i.e. import less. But to pay off existing debt, Greece may have to increase exports to create a large, current account surplus.

Greece's debt is 120 percent of national GDP, excluding hidden debt, and it's running a current account deficit that's more than 12 percent of GDP. An estimated 70 percent of Greece's national debt is owed to foreigners. To repay, Greece has to build current account surpluses of 10 percent of GDP or more. But Greece doesn't appear to have industries competitive enough to swing its current account by one-fifth GDP.

East Asian economies made precisely that kind of swing in current accounts to pay off foreigners after the Asian Financial Crisis of the 1990s. They could do so because they were export-oriented to begin with and accumulated foreign debt to finance investment. To stop borrowing, countries in the region could just stop investing. To increase current account surplus, the region could devalue to increase market share in global trade.

Greece's need for foreign borrowing is due to a budget deficit that ultimately supports the country's consumption level. It must cut the budget deficit, i.e. stop paying millions of people, to end demand for foreign borrowing.

This step would be politically difficult. Even though two-thirds of Greece's population supports retrenchment, the one-third against could make it impossible. If the EU assistance program is structured to make it impossible for financing a fiscal deficit, Greece has to cut spending. As a result, we can expect political turmoil in Greece for years to come.

Greece can't devalue a currency to increase exports. Even if it withdraws from the euro and devalues, it doesn't have enough industry to increase exports quickly. It is difficult to see how Greece will ever be able to repay foreign lenders. Western financial institutions that hold Greek bonds will have to look to their own governments for bailouts.

What's Coming

With this in mind, we see inflation and public finance as the next crisis arenas. The global financial crisis has saddled major governments around the world with large fiscal deficits that are unlikely to fall in the near future. Government spending had increased during the bubble years due to high tax revenues, which actually reflected an asset inflation tax. Now that the asset bubble has burst, revenues are too low to support spending. Moreover, aging populations continue to increase their expenditures.

Without painful cutbacks, governments are heading toward bankruptcy. As long as they can borrow, inflation won't be too high. And when governments can't borrow any more from financial markets, they can print money. Countries such as Japan and the United States can do this. But printing money is a way to inflate away debts, and it's technically a form of bankruptcy.

Hence, the sovereign debt crisis is ultimately an inflation crisis. What occurred in Germany in the 1920s could be repeated in Japan and the United States in the future, possibly within a decade.

Small economies that borrow in foreign currencies are facing stress now because the market knows they have less wiggle room. Their financial situation isn't black and white; there is a vast gray area between solvency and bankruptcy.

The crisis in Dubai, for example, stirred up a financial storm a couple of months ago. Abu Dhabi was supposed to bail it out. But did Abu Dhabi really bail out Dubai? It's not clear. An announced US$ 10 billion in assistance turned out to be only US$ 5 billion. The other half was tied to a previous loan. Besides, US$ 10 billion won't be enough to rescue Dubai from US$ 100 billion in debt.

The market was interpreting the assistance as a first step toward a complete bailout. Instead, now we are hearing that Dubai is asking creditors to take a 40 percent haircut. Is that default? The euphemism is debt restructuring. But to the banks, it feels very much like default.

Dubai's story provides a good example of what could happen in the future in other countries. When financial markets panic, vague bailout talk appears. The language is never clear. But it does soothe the market and can force hedge funds to cover short positions, which pushes up the value of distressed bonds. Nothing changes psychology like rising prices. Even without any change, the crisis feeling dissipates. And once bitten, hedge funds hesitate to come back. Such stalling strategy is a cheap way for governments to push back the inevitable. Ultimately, default is inevitable, even if it is done quietly.

The New Dubai

Greece has replaced Dubai as a key concern. Greece's debt crisis, three times larger than Dubai's, will play out in a series of controlled explosions.

How the United States handled the Wall Street debt crisis could serve as a template for the EU's dealings with Greece. The U.S. government effectively guaranteed the existing debt of Wall Street firms, halting cascading destruction among debt holders, and guaranteed certain amounts of new debt issuances. The trick was to segregate debt into different compartments, then apply different treatments. Guarantees usually have fixed durations. It worked in the Wall Street bailout for two reasons: Wall Street firms could cease to add debt, and their assets appreciated when panic eased.

Greece could be much messier because it can't stop adding new debt without political turmoil.

The market was convinced of a German government bailout for Greece, similar to what Abu Dhabi was expected to do for Dubai. The argument was "they must." But nobody is forced to bail out anybody.

Besides, Germany has its own struggles. Its national debt could top 80 percent of GDP by 2011, and its aging population will put enormous stress on its fiscal budget. Indeed, Germany is considering measures such as pushing back retirement ages to control national debt. A German government that bails out Greece would likely fall in the next election. So any bailout measure would be tightly circumscribed.

The roots of Greece's crisis run in all directions. The most popular reason given is that the government abused low interest rates and borrowed excessively after joining the euro zone. Like other countries in southern Europe, Greece had high inflation and interest rates before joining the euro. But the Maastricht agreement creating the euro said interest rates in the zone's countries would be similar. That is, Greece would enjoy German interest rates – an arrangement that enriched many banks and their traders. But it was a bubble. Joining the euro could not change the underlying economic structures of southern Europe's economies.

Losing international competitiveness has added problems. Southern European economies used to depend heavily on labor intensive industries because they had lower labor costs than their northern neighbors. Now globalization has obliterated cost advantages, as their labor costs are much higher than those in developing countries. They lost global trade advantages, which pushed them to rely even more on borrowing to maintain living standards, which a low interest rate environment made possible.

Years of artificially propping up living standards by borrowing from foreigners means that, when the debt bubble bursts, one must take a huge cut in living standards. Greece probably needs to cut its living standards by one-fifth, either through inflation or deflation. Most economies decrease living standards through inflation at home and devaluation abroad. Cutting wages is too difficult politically. Greece, being in the euro zone and without a central bank, may have to cut domestic wages.

Alternatively, Greece could withdraw from euro, establish a new national currency and central bank, forcibly convert all debt into local currency at a fixed rate, and begin a massive devaluation. This path would be the least painful way to adjust. It would effectively default on its 100 percent of GDP in foreign debt. The market may think this path is impossible, but it is logical. I'm afraid Greece will follow this path unless someone bribes it not to.

Some EU countries think the euro is the EU centerpiece and, if Greece pulls out, the currency may fail completely. These countries might be willing to bribe Greece to stay in. Of course, Greece would take a bribe if it's big enough, i.e. the bribe exceeds payments on existing debt. Still, it wouldn't resolve the problem of unsustainable living standards.

While the market may think of ending Greece's crisis in terms of bailout or default, the reality is much more complex. The crisis is likely to drag on for a long time. Greece doesn't have the capacity to pay foreign debt, and while this may take years to clear up, Greece will default. More indebted countries may follow.

Andy Xie is a board member of Rosetta Stone Advisors Limited