The Greek Debt Crisis - Some Underlying Factors - Term Paper Example

The Greek Debt Crisis: Some Underlying Factors Table of Contents 1. Introduction 11 2. The Maastricht Agreement 11 2.1 Background 11 2.2 “The Greek Problem”: Financial Criteria vs. Interest Rates 22 3. The Credit Default Swap Problem 33 Fig. 1: Greek CDS rates, April 2009 – April 2010 54 4. The Role of Credit Rating Agencies 55 5. Conclusion 66 References 79 1. Introduction The economic crisis in Greece has attracted worldwide concern and posed a serious threat to the stability of the unified European economic system. While the ultimate cause of the Greek crisis must certainly be identified as its own apparently unsound fiscal management and the effects of the worldwide economic crisis that began in 2008, a number of other potentially aggravating factors have been identified. First, the terms of the Maastricht Agreement that established the basic framework of the European economic union has apparently contributed some obstacles, particularly in the conditions set for interest rates. Second, the effect of the trade in Credit Default Swaps, and more specifically, the volatility of the pricing of those debt-insuring instruments have been blamed for making the Greek crisis worse and hampering the country’s ability to initiate recovery efforts. And finally, the credit ratings assigned to Greece’s sovereign debt by the major credit ratings agencies – ratings which are now uniformly unfavourable – have been blamed for both manipulated the financial markets before the collapse of the Greek economy, and for sabotaging Greece’s and the EU’s efforts to respond to and recover from the crisis. This report briefly examines each of these three factors that potentially have impacted the Greek economic crisis in an effort to determine whether or not the assessments of their effects from economic analysts and market observers are correct. 2. The Maastricht Agreement The Maastricht Agreement, or Maastricht Treaty, was signed in 1992 and was not so much a new treaty among the European nations as it was a consolidation of earlier treaties, principally the Treaty of Rome that had first established the European Economic Community, and the Single European Act which had amended the Rome treaty by setting the objectives of greater European cooperation and a single currency.1 2.1 Background The Maastricht Treaty’s main objective was to set up the framework and timeline for the coalescence of Europe into the EU as it appears today. In terms of the economic provisions, the Treaty set out a plan for monetary union in three phases to be completed between 1990 and 1999. In the first two stages, member states sought to achieve convergence of their economies based on four criteria: inflation, interest rates, exchange rate stability, and fiscal stability.2 In order to qualify to become a part of the monetary union, each country was required to meet certain economic benchmarks. Price inflation could not be more that 1½% higher than the average of the three lowest inflation rates among member states; interest rates on long-term government securities could not be more than 2% higher than the average interest rates in those same three countries; the currency exchange rate could not fall outside a range set by the European Monetary System; the government’s budget deficit could not exceed 3% of its GDP; and the ratio of public debt to GDP could not be more than 60%.3 2.2 “The Greek Problem”: Financial Criteria vs. Interest Rates Although the criteria were rather clearly defined, some degree of discretion was permitted in determining a country’s qualification for joining the monetary union, and therein lies the apparent root of the Greek crisis, and by extension, the threat it has posed to the entire European economic structure. Only once since joining the monetary union has Greece actually met the convergence criteria (in 2006), and even then it is believed that Greek economic planners manipulated the data – such as including the output of the black market and prostitution in the GNP – to present a better economic picture.4 Even then, the situation could only be positively spun to a certain extent; the most optimistic forecasts from Greek economic planners at the end of 2009 were for a deficit of around 9% of GDP,5 and a debt ratio of slightly more that 120% of GDP.6 The impact of interest rates under the convergence criteria is obvious. While Greece could exercise a bit of “flexibility” in publishing its economic indicators, particularly after it had already joined the monetary union, the restriction on interest rates could not be avoided. Under the convergence criteria, the ceiling on interest rates was 2% higher than the average of the three lowest countries; in December 2009, for example, the three lowest were Germany, the Netherlands, and Finland, with an average of 3.34%, which would have limited Greece to a 5.34% rate.7 Prior to that, the allowed rate was even lower; by December 2009 the European Central Bank was already apparently exercising some of its “discretion” in allowing Greece to post a 5.49% interest rate. Currently, the limitation is suspended, and Greece’s rate stands at 12.01% (as of December 2010).8 The point is if the criterion had been more flexible sooner, Greece may have been able to better manage its fiscal woes by raising its long-term interest rate. 3. The Credit Default Swap Problem A Credit Default Swap (CDS) is a form of insurance against default of a debt held by an investor9, such as a government-issued bond, an example of the sort of instrument that would have been involved in CDS markets concerned with the Greek crisis. CDS were implicated in Greek crisis because as the news of the country’s debt situation grew increasingly dim, the cost of insuring that debt, measured in basis points, surged; this was further aggravated by the downgrading of Greek’s sovereign credit rating by a number of agencies as discussed in the following section. What appeared to have happened was that the CDS spreads and yields on Greek government bonds drove each other higher as the bad news about Greece’s financial circumstances mounted. The faltering global economic recovery and Greece’s tenuous situation made CDS spreads increase – i.e., ‘debt insurers’ were demanding higher prices to insure Greek debt obligations. This is turn drove the yield on bonds higher, as bond buyers demanded a higher payoff for financing the Greek government through bonds for which the odds of their being paid off in full and on time seemed to be growing longer. Higher bond yields in turn signalled to CDS traders that the debt was even more uncertain, and drove spreads higher in a continuous cycle, and both CDS spreads and bond yields eventually reached record highs of 941 basis points and 10.57% respectively by mid-June 2010.10 As an illustration of how CDS spreads reacted to current events, an enormous spike in rates occurred just when the Greek government announced it had “discovered” $40 billion worth of previously undisclosed debt in early April 201011, particularly in the short-term one-year issues, as shown in Figure 1: Fig. 1: Greek CDS rates, April 2009-April 2010 (Source: Sanders, 2010) What responsibility for creating or aggravating the Greek debt crisis can be ascribed to CDS rates seems to be a matter of perspective. Conventionally, CDS rates can be thought of as an indicator of the credit risk of the reference entity, such as a government issuing bonds or a bank issuing mortgages or commercial loans.12 So CDS could “cause” the Greek debt crisis in the sense that the rates could signal lack of investor confidence in Greece’s ability to repay debt, making it harder for the Greek government to finance its obligations through the issuance of bonds, which would not be popular with investors unless yields were high; this was what happened in fact, as explained above. The balance of opinion about the role of CDS rates, however, seems to tilt in favour of their being an effect rather than a cause of the debt crisis. Geoffrey Wood of the Cass School of Business in London asserts that the rise in CDS spreads was due to the knowledge of some investors holding Greek debt that the Greek government was not being forthright about its true financial status, and that those investors were simply hedging; the signals sent by the CDS spreads to other investors were that Greek debt was a potentially unsound investment, but it was the underlying factors – such as the “discovery” of the $40 billion in additional debt – that made it so, not the signals of CDS spreads.13 In the same context, Anthony Sanders of George Mason University testified before the US Congress that, far from being an aggravating factor in the Greek crisis, CDS spreads were actually a valuable warning system for alerting international investors and regulators of a growing calamity in Greece.14 4. The Role of Credit Rating Agencies Between April and June 2010, all three of the major credit rating agencies – Standard & Poor’s, Moody’s, and Fitch – cut their ratings of Greece’s sovereign debt status. As of July 2010, Fitch gave Greece a BBB- rating with a negative outlook, just one step above junk status; Moody’s rating was Ba1 (non-investment grade/junk status) with a stable outlook; and Standard & Poor’s was BB+ with a negative outlook, the same rating level as Moody’s but with a more pessimistic long-term outlook.15 The ratings from the major agencies have a significant impact because they guide investors as to the soundness of countries’ debt obligations and their ability to meet them. In effect, the poor ratings given Greece by the three major agencies expressed the judgment that investing in Greek sovereign debt had become very risky, and that the probability of the country defaulting on its debt had significantly increased. The ratings have the major consequence of driving up interest rates charged to Greece to borrow money, and the increase in bond yields is partly a reflection of that effect.16 The credit rating agencies have been harshly criticised for their role in the Greek debt crisis in two respects. First, they are accused at having given unrealistically favourable ratings to ‘toxic’ assets, specifically sub-prime bank assets – for example, the mortgage-backed securities that caused such woe in the US financial markets – but by implication, other unstable assets such as Greek bonds as well.17 The implication here is that the credit rating agencies were irresponsibly promoting trade in unstable assets, contributing to a sudden collapse when the debt obligations underlying those assets could not be met. Second, the ratings agencies are implicated in sabotaging investor confidence in Greece’s economic recovery efforts by not taking into account “…the fundamentals of the Greek economy and the support package prepared by the ECB, IMF and Commission” in assessing (and ultimately lowering) the country’s rating in 2010, according to a European Commission statement.18 What this suggests is that the major credit rating agencies are not perceived as being objective monitors of credit risk, but instead use the influence of their ratings to deliberately manipulate financial markets. The trouble with that hypothesis, however, is that it is debatable whether their impact on markets – which is clearly recognisable in the reluctance of investors to take on Greek sovereign debt even after the announcement of a recovery plan – is actually deliberate or not; it is just simply not clear what the agencies would gain from doing so. At this point, the question appears to be moot; from December 2010, Commission regulators have had new powers to monitor credit ratings and the rating methodologies, presumably eliminating or at least reducing the opportunity for subjective manipulation of the markets by the agencies.19 5. Conclusion Even though the terms of the Maastricht agreement, the market for credit default swaps, and the actions of the three major credit ratings agencies did have some effect on the Greek economic crisis, it must be recognised that the crisis must have originated from the country’s own fiscal management. While there are other countries in the EU – such as Ireland and Portugal – that are currently having economic woes, at least one or two of these three factors, particularly the Maastricht criteria and the CDS markets, should have had more uniform effects on all the EU economies, and that is clearly not the case. Thus, it does not appear that any of these factors individually or in combination can be blamed for causing Greece’s economic troubles. The convergence criteria of Maastricht place limitations on national budget deficits, debt-to-GDP ratios, and long-term interest rates. The direct effect on Greece’s economic problems from these criteria appears to be in the limitation on interest rates; presumably, if Greece had more discretion in setting rates, it would have a more useful tool for controlling its own economy. On the other hand, the inability of the country to meet the other criteria tends to lessen the weight that can be given to this argument; having only met the standards once in the past several years, and even then under questionable circumstances, Greece may not have been able to control its economic decline through interest rates alone. If there is a clear problem with the Maastricht criteria as it relates to the Greek crisis, it seems to be that the criteria were not strict enough, or were at least not appropriately enforced. The “discretion” allowed European Commission examiners in determining the fitness of member states to join the monetary union should have been limited. It is easy to speculate, however, that the strict enforcement of the criteria would have had likely political implications in keeping some states out of the union for at least a period of time, and that is perhaps the consideration that resulted in the “discretion” being exercised. Likewise, it is difficult to assign blame for the crisis to the CDS market and the volatility of CDS spreads. These seem to have been more a reaction to the Greek situation rather than a precursor to it, and may have indeed served as a good warning system about the true state of the crisis.20 Certainly, high CDS spreads would serve to discourage investors from taking on Greek debt issues, but the sequence of events was that the high risk carried by Greek debt became apparent before spreads increased, and not the other way around. The credit rating agencies, however, do seem to have significantly contributed to the deepening of the crisis, if not actually helping to cause it. It was known as early as 2004 that Greek budget numbers had been manipulated by the government,21 and yet the uncertainty of the soundness of the Greek economy was not reflected in the ratings issued by S&P, Fitch, and Moody’s. The complaint, however, that the junk-bond level ratings they have since given the country’s sovereign debt are not reflective of economic fundamentals or the potential benefits of the recovery plan22 might not be entirely fair, either – on the face of things, they would seem to describe the current state of the Greek economy fairly accurately. But the sentiment behind the complaint may not be misplaced: having been willing to overlook what they must have known was a set of economic circumstances that were less-than-ideal before the global downturn, it seems a bit disingenuous for the credit rating agencies to stand on principle now when they could potentially contribute, at least in a small way, to the recovery effort. In that context, the most positive development to have come out of the crisis in recent months is the increased oversight of European regulators on the ratings issued and their underlying methodology. References Baum, M.J. (1996) “The Maastricht Treaty as High Politics: Germany, France, and European Integration”. Political Science Quarterly, 110(4): 605-624. Dodman, B. (2010) “Credit default swaps ‘not to blame’ for Greek crisis”. France24 News, 3 June 2010. [Internet] Available from: http://www.france24.com/en/20100305-credit-default-swaps-%E2%80%98not-blame%E2%80%99-greek-crisis. European Central Bank. (2009) Credit Default Swaps and Counterparty Risk. Frankfurt: European Central Bank. [Internet] Available from: http://www.ecb.int/pub/pdf/other/ creditdefaultswapsandcounterpartyrisk2009en.pdf. European Central Bank. (2011) “Long-term interest rate statistics for EU Member States”. [Internet] European Central Bank, updated 13 January 2011. Available from: http://www.ecb.int/stats/money/long/html/index.en.html. Haywood, K., and Dobson, P. (2010) “Greece Credit-Default Swaps Surge to Record on Economic Concern”. Bloomberg Businessweek, 23 June 2010. [Internet] Available from: http://www.businessweek.com/news/2010-06-23/greece-credit-default-swaps-surge-to-record-on-economic-concern.html. “The Maastricht agreement on economic and monetary union.” World Economic Outlook, 1 May 1992. [Internet] Available from AllBusiness: http://www.allbusiness.com/public-administration/national-security-international/310234-1.html. “Maastricht Treaty”. (2010) [Internet] Eurotreaties. British Management Data Foundation, update 2 January 2010. Available from: http://www.eurotreaties.com/maastrichtext.html. Reuter, W. (2009) “Timebomb for the Euro: Greek Debt Poses a Danger to Common Currency”. Der Spiegel, 8 December 2009. [Internet] Available from: http://www.spiegel.de/ international/business/0,1518,665679,00.html. Rogers, S. (2010) “How Fitch, Moody's and S&P rate each country's credit rating”. [Internet] Guardian.co.uk, updated 19 July 2010. Available from: http://www.guardian.co.uk/ news/datablog/2010/apr/30/credit-ratings-country-fitch-moodys-standard#. Sanders, A.B. (2010) “Credit Default Swaps on Government Debt: Potential Implications of the Greek Debt Crisis”. Congressional testimony before the House Subcommittee on Capital Markets, Insurance, and Government Sponsored Entities (US), 29 April 2010. [Internet] Available from: http://mercatus.org/publication/credit-default-swaps-government-debt-potential-implications-greek-debt-crisis. Wachman, R. (2010) “Greece debt crisis: the role of credit rating agencies”. [Internet] Guardian.co.uk, 28 April 2010. Available from: http://www.guardian.co.uk/business/ 2010/apr/28/greece-debt-crisis-standard-poor-credit-agencies. Waterfield, B. (2010) “European Commission's angry warning to credit rating agencies as debt crisis deepens”. The Telegraph (UK), 28 April 2010. [Internet] Available from: http://www.telegraph.co.uk/news/worldnews/europe/greece/7646434/European-Commissions-angry-warning-to-credit-rating-agencies-as-debt-crisis-deepens.html. Read More