Why Greece Will Default

FT's Wolfgang Münchau has a mostly excellent commentary on why Greece will default, but not this year.

The key point he notes is that Greece has an insolvency problem, but not a short-term liquidity problem. This is the exact opposite of the problem that was faced by Bear Stearns and Lehman Brothers. While it could be argued they were solvent, well at least Bear Stearns, they both suffered from a liquidity crisis. They couldn't borrow funds to pay outstanding obligations.

Münchau observes, correctly, that credit markets are still open to the Greeks, but at a price:

The Greek government has demonstrated that it can still borrow at a rate of about 6 per cent but if you do the maths on the public debt dynamics, as I did recently, it would be hard to arrive at any other scenario than an eventual default.

Münchau then explains:

The adjustment effort needed to prevent a debt explosion is extremely large. The Nordic countries achieved adjustment on a similar scale during the 1980s and 1990s, but they had two advantages over Greece. They did it in a different global environment; but more crucially they were, in part, able to devalue and improve their competitiveness. As a member of a large monetary union Greece can improve its competitiveness only through relative disinflation against the eurozone average, which in effect means through deflation.

By deflation, Münchau means a lowering of wages and other prices to generate greater national revenues. He latersmisses this idea as impractical, which is a good thing, since he confuses wages and national-macro gymnastics. If wages are at market levels, he does not explain how on a national level the government could nationally lower wages below market levels without creating further havoc inside the Greek economy, and risk lowering national production.

Münchau then outlines the options Greece has:

To get out of this mess, one of five things will have to happen. The first, and most optimistic, solution would be a significant fall in the euro’s exchange rate, say to parity with the US dollar, coupled with a strong recovery in the eurozone. This might just do the trick to sustain Greek growth as it adjusts. The second is that Greece gets access to low interest rate loans from the European Union and the International Monetary Fund. The third would be a private sector debt restructuring to prevent a Fisher-style debt-deflation dynamic. The fourth is that Greece leaves the eurozone. The fifth is default.

Here's Münchau explaining why option 5, default, is the likely outcome:

If you go through the options one by one, you realise that the first is improbable. The EU has in effect ruled out the second. The third would require an unlikely additional bail-out of the European banks. While option four would be most convenient for the Germans, the Greeks are not so stupid as to leave the eurozone. That leaves them with option five: to default inside the eurozone. It is the only option that is consistent with what we know.

Next Münchau points out there is not yet true panic about Greece:

When a country such as Greece pays 300 basis points over the yield of a supposed risk-free bond, this means, mathematically, that investors see a probability of around 17 per cent that they will lose 17 per cent of their investment. So in other words, a spread of 300 basis points is a valuation in which default is still considered improbable. If those perceptions changed from improbable to, say, moderately probable, the yield spreads between southern European countries and Germany would explode.

For the time being, Greece can get by because of its excellent debt management, which is why I am confident that Greece is not going to need an immediate bail-out.

This is true and thus Münchau implies that the real problems for the Greeks will come when the interest they are paying balloons out of control, and that may be true. But their current day-to-day survival hinges on confidence in the markets holding up so the Greeks can continue to borrow. How long this condition exists is an open question. Yesterday, when presumably Münchau checked the rates on Greek debt there was a 300 basis point spread versus Bund 10-year rates. This morning it is 400 basis points. Greece on new debt will have to pay 7%. The noose gets tighter and Münchau will have to recalculate the long-term survival date.

Bottom line: The EU may continue to throw sweet nothing kisses (and maybe some pocket money)to Greece, but the financial end is near. Greece may survive a year, until the intrest rate paymnets swallow the country up, but it may only have hours if traders say, "enough".