The tragedy of the Acropolis economy is a manifestation of another moral hazard that has surfaced at a time when the debate on the financial crisis has just about ebbed. Bailouts were the final norm when financial institutions went under (excluding Lehman). But this story is quite different and comes on the back of first, the Dubai crisis that briefly cast a shadow, and now with Greece on the precipice of a sovereign default.
The bailout of Greece is a necessity because it is a part of an integrated monetary system that has worked well, notwithstanding Italy and France deviating at times. Greece is not able to service its debt, which is at 115% of GDP and accompanied by a fiscal deficit of 13.6%. Normally, countries that have this problem can raise interest rates or devalue their currencies. Or they can simply print currency. But, this is not possible as Greece is a part of the Euro system.
One could have taken the stance that the country can be asked to fend for itself as punishment for bad governance as it has been fudging its economic numbers. But, its public debt of around 100 billion euro is held mostly by European banks (over 70%). Therefore, if Greece fails, so would the banks holding these bonds. S&P has reduced its rating status to junk bonds on the premise that 30-50% of the principal cannot be repaid. It is not surprising that the 2-year bond rate had touched 20%, while those of all other potential problem countries also rose commensurately. Therefore, Greece with a share of 2.6% in the Euro group has the potential to wreck the system if the problem is not solved.
The Euro members and IMF will provide 45 billion euro as a bailout package for 2010. Greece will still require 40 billion euro on an annual basis till 2014 to repay debt and another 70 billion euro as fresh borrowing. This will work, provided fiscal stringency is followed, something which is alien to the nation?s political economy. This is the risk that the other countries are taking in the rescue operation.
There are four issues that deserve some thought. The first is that there is a sense of panic that has crept in as every country is evaluating the financials of the other. It is now felt that similar problems exist or could come up in what, with a touch of humour, have been referred to as the PIGS nations or PIIGS countries?Portugal, Ireland, Greece, Spain and maybe even Italy. Their debt levels are not as alarming but are held by banks in this group. If Greece is bailed out, then these governments may just go slow on reforms knowing that others could pitch in.
The second is that nations like Turkey, which would like to enter the Euro group, will have to wait for longer until the proverbial dust settles. There will be greater scrutiny for such admission and the norms will be strengthened with necessary compliance checks to ensure that there is less scope for acts of indiscretion.
The third is that the concept of a Euro will have to be revisited. The question today is that we will never really come across like-minded countries that will be disciplined forever. While norms were laid down for fiscal deficit, current account balance and monetary expansion, practically speaking the single currency will always run the risk of exacerbating problems when they arise. This is so because all policies relating to exchange rate and money supply get linked with the macro system from which there is no easy escape route.
The fourth is that there will be some rethinking for the world to do with regard to the US. The nation has the advantage of owning the currency that everyone accepts. The US fiscal situation is in a mess but the government has the power to create more money, as Fed bonds are acceptable. The euro was to act as a check on the dollar, but with the current state of flux, US hegemony will continue for some more time.
This entire episode is hence noteworthy, as it actually brings to the forefront the issue of sovereign risk and the possibility of failure. The spread of globalisation makes it hard to ignore any nation in distress and the creation of a single currency makes it even more awkward. Clearly there will be greater debate on how the euro should work. Moving back to one?s old currencies may be retrogressive. The solution lies in strong surveillance systems; and this is where we never seem to learn even after a crisis. More importantly, strong deterrents have to be put in place to avert such situations?which again are not visible in Greece?s rescue package.
The author is chief economist, CARE ratings. These are his personal views