After Dubai, will Greece be next?

Greece?s bond and stock markets have fallen sharply in the past few weeks amid fears for its banks and economy, as the European Central Bank (ECB) prepares to wind down emergency funding for the Eurozone financial system.

The volatility in financial markets in Greece, one of the weakest Eurozone economies, is an early warning of potential problems for other Eurozone banks and economies after the ECB ends its unlimited offer of loans to financial institutions. When ECB?s Jean-Claude Trichet said that certain sinners on the edges of the Eurozone were ?very close to losing their credibility?, everybody knew he meant Greece.

Greece?s budget deficit is expected to reach 12.7% of GDP this year, more than four times the EU deficit limit of 3% of GDP, while the country?s gross government debt is forecast to rise to 125% of GDP next year.

The desirability of slashing the Greek budget deficit from over 12% of GDP to less than 3% is clear. Since 1981, the Greek budget deficit has only been that low once, in 2006. True, over the previous decade the deficit did shrink from a ruinous 15% of GDP to within a whisker of 3%. But that took more than 9 years. Now, PM George Papandreou proposes tightening almost as much, in half the time. Increasing public sector pay and taxing bankers? bonuses will not get him there.

The interest spread between 10-year Greek bonds and German bunds has jumped to 178 basis points (bp). Greek debt has decoupled from Italian debt. Athens can no longer hide behind others in EMU?s soft South.

It is also worth noting the growing divergence between the PIIGS CDS spreads and those of Germany. Greece?s five-year CDS spreads have risen from a recent low of 100 bp reached in August to 208bp on November 26 and 171bp at present, while the CDS spread on German bunds was virtually flat over the same period at 22bp. With Greece?s public debt higher than 100% of GDP, investors have suddenly woken up to the scary prospect that the budget deficit is also forecast to hit 12% of GDP in 2010 and 2011.

On the eve of the Dubai crisis unfolding, Greek stocks plunged (on Thanksgiving day), posting their biggest loss in more than a year and dragging the country?s benchmark index into a so-called bear market, as shares in the nation?s lenders slumped.

The ASE Index fell 6.2% to 2,225.32 at the close in Athens, the worst performer among 18 western European benchmarks. The gauge extended its fall from last month?s high to 23%. A bear market is generally defined as a drop of more than 20%. The FTSE/ASE 20 Index of the country?s biggest companies slipped 7.3% to 1,153.29. The Cypriot General Index plummeted 11.4% to 1,432.3.

Greece has long been skating on thin ice. The current account deficit hit 14.5% of GDP in 2008. External debt has reached 144%. Eurozone creditors?German banks?hold euro 200bn of Greek debt.

A warning from the Bank of Greece that lenders must wean off the ECB?s emergency funding has brought matters to a head. Greek banks have borrowed euro 40bn from the ECB at 1%, playing the ?yield curve? by purchasing state bonds. This EU subsidy has made up for losses on property, shipping, and Balkan woes.

Greek banks are more dependent than others in the Eurozone on ECB loans, with those outstanding from the central bank of $57bn, 7.9% of their total assets. The fall in the Greek markets is a warning to financial institutions not to become too addicted to the support of the central bank.

The ECB has $995bn in outstanding loans to commercial banks. It is expected to announce that its unlimited offer of one-year loans in December will be the last of its kind. In the past two one-year liquidity operations, banks have borrowed at 1%, significantly lower than rates offered in the private markets, which means they will face higher costs for their funding in future.

In essence, the Greeks have issued a warning to the rest of the Eurozone. Other Eurozone financial institutions will have taken note as the time has come to prepare for life outside. The days of unlimited cheap funding from the ECB are coming to an end. It?s not imminent, but the writing is definitely on the wall.

Credit default swaps

Recession has come late to Greece, but will bite deep in 2010. It takes three years for defaults to peak once the cycle turns. In 2007, Greek CDS was nearer 15bp, because it was a member of the European Monetary Union, and its euro-denominated bonds were considered quasi-protected by other euro states. But in the past year the fiscal positions of many emerging market nations, such as Turkey, have become more favourable relative to the western world. Meanwhile, Greece has plunged into a profound budgetary mess, notwithstanding its use of the euro.

As markets reeled from the Dubai shock and investors fled from risk, the bid-offer spread on five year Greek CDSs was 201bp-208bp, according to Markit. All this is a bitter blow to Greek pride. However, there is a much bigger moral here, which cuts to the heart of the Dubai saga as well.

Two years ago, global investors generally did not spend much time worrying about so-called ?tail risk? (a banking term for the chance that seemingly remote, nasty events might occur). After all, before 2007, when the world was supposedly enjoying the era of the Great Moderation, the world seemed so stable and predictable that it was hard to imagine truly unpleasant events occurring. But in the past two years, a seemingly safe financial system has crumbled. And while the financial markets have stabilised in the past six months, that lesson about tail risk cannot be easily unlearnt. The sheer psychological shock of 2007 and 2008, in other words, has left investors looking like veterans from a brutal war.

The Greek economy is flirting with deflation and, unlike the wider Eurozone, could go on shrinking for some time. Its real exchange rate has appreciated, almost at par with Spain, which for its part finds a fifth of its workforce unemployed. Since labour costs have risen as well.

Prior to the global slowdown, the country was growing at annual rates of 4% or more, with consumption boosted by the low interest rates it enjoyed as a Eurozone member. But Europe?s recession has exposed a massive loss of competitiveness. Unit labour costs have soared more than 40% since Greece joined the Eurozone in 2001 (in Germany, they remained almost constant before edging up this year). Even currency devaluation will not help regain competitiveness.

In February of this year, Peer Steinbr?ck, the former German FM, abruptly ended speculation by saying the Eurozone would act if someone got into trouble. There was no concrete action plan. No work had been done to amend European treaties. There was no budgetary appropriation. Just a sentence. Investors believed him and all was well?for a while.

The speculation is now back, but there is one difference. The Eurozone will not come to the rescue this time unless Greece meets a number of conditions the European Union is likely to impose in the coming months. This is how a Greek default could differ from the Dubai debt bailout by Abu Dhabi.

This year, Greece?s budget deficit will rise to 12.7% of GDP. The country?s public debt-to-GDP ratio is headed for 135%. Gross external debt?private and public sector debt owed to foreign creditors?was 149.2% at the end of last year. The real exchange rate has gone up by 17% since 2006, which means the country is losing competitiveness at an incredibly fast rate. Had Greece not been in the Eurozone, it would be heading straight for default.

The government?s 2010 draft budget foresees deficit reduction, to about 9.1% of GDP. But, lion?s share of the total deficit reduction effort is earmarked to come from tax measures, and most of those from the fight against tax evasion. Tax evasion is always the first item on the list of desperate governments.

The European Commission and Europe?s FMs are rightly asking for genuine deficit reduction. So is George Provopoulos, the Greek central bank governor, who demanded that two-thirds of the entire deficit reduction effort should come from spending cuts. Athens has been shortening debt maturities to trim costs, storing up a roll-over crisis next year. Some euro 18bn comes due in the second quarter of 2010.

Modern economies have reached such debt levels before, and survived, but never in the circumstances facing Greece. They can?t devalue: they can?t print money.

The tourist trade is withering, down 20% last season by revenue. It is hard to pin down how much is a currency effect, but clearly Greece has priced itself out of the Club Med market. Wages rose a staggering 12% in the 2008-09 pay-round alone, suicidal in a Teutonic currency union. Greece has slipped to 71st in the competitiveness index of the World Economic Forum, behind Egypt and Botswana.

Greece?s most pressing financial problem is the possibility of a buyers? strike by nervous foreign investors. The ruling Pasok party has pledged to shrink the deficit by 3 percentage points. That will be a painful adjustment, with little track record to support it, although perhaps credible this time given Pasok?s parliamentary majority. And while Brussels has censured Greece for its Maastricht-busting budget, France, Spain, Italy, Belgium and Portugal are close behind. Raising funds is likely to become increasingly hard for all profligate countries.

So what happens if Greece cannot meet a payment on its bonds, or fails to roll over existing debt? About two-thirds of Greece?s public debt is held by foreigners. Greece is looking to raise some euro 31bn ($46bn) in new borrowing and euro 16bn to roll over existing debt next year. In the absence of help from the Eurozone, the Greek government would have to resort to the International Monetary Fund if it were to encounter difficulties refinancing the debt.

It can be estimated that in Greece, the real effective exchange rate would need to decline by more than 30% to secure a return to balance. Since devaluation is not an option, the adjustment has to take place through inflexible labour markets. The unpalatable question is the level of unemployment at which competitiveness is restored. While some adjustment is now taking place, the German consumer will have to do more to support the deficit countries. That cannot be taken for granted.

What, then, is the risk of a regional version of the break-up of the Bretton Woods semi-fixed exchange rate system in the early 1970s? Suggestions that Italy or Greece might choose to leave the club seem implausible, because the prospect of devaluation would cause money to drain from the banking system, while the value of debt and the cost of debt service would soar.

All this does not mean that it is correct to expect the world to melt down imminently. The fact that the CDS spread for Greek bonds has swung from 5bp to 200bp, in other words, should not be interpreted as a sign of an imminent Greek default, or a likely break-up of the euro. The CDS market is pretty illiquid and prices can swing on low volumes.

But what the CDS market does capture is the perception of tail risk, or low-probability outcomes. Or, to put it another way, the market projects what could occur if the current fiscal and political situations were taken to logical extremes.

Much of the time investors are tempted to ignore those logical extremes. After all, investors have known for months that Dubai World was dangerously over-leveraged. They assumed that this would not be too dangerous, because they thought that foreign investors would always be protected.

Now, however, that assumption has been challenged. Tail risk has resurfaced with a vengeance.

Little wonder that CDS spreads of some other debt-laden emerging markets, such as Hungary, have swung adversely on the coattails of Dubai and Greece.

The downgrade of Greek sovereign debt by Fitch to triple B-plus has come as a shock. S&P has placed Greece?s sovereign?s A- rating on negative CreditWatch. The agency expressed doubts that the government?s fiscal policies will deliver a sustained reduction in the budget deficit and national debt burden. Of course, this view has been shared by the CDS market for some time, with spreads widening significantly in recent months. But the threat of a downgrade to BBB+ added to negative sentiment on Greece. If the downgrade is implemented, Greece will be the first member of the Eurozone to have a rating below single A.

If other rating agencies followed Fitch?s and Standard & Poor?s lead, then Greek government debt could no longer be used as collateral. Greek banks would be left high and dry. In extremis, Athens would also have lost an important source of funding given that government bonds account for about 10% of Greek bank assets.

Still, this remains a drama rather than a tragedy, for now.

Default remains a long way off. Further, if rising bond yields and the downgrade shock force the government to slash spending, then markets will have done what neither local politicians nor Euro-entry managed to do.

?The author is a Wharton Business School MBA and CEO, Global Money Investor