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Discuss the Effects of Greece Defaulting or Restructuring Its Sovereign Debt

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Discuss the effects of Greece defaulting or restructuring its sovereign debt.

The Eurozone is currently facing a serious sovereign debt crisis. Many Eurozone member countries have high, unsustainable levels of public debt. Greece is the most vulnerable of the highly indebted nations with the highest ratio of public debt/GDP (160% in 2010), a significant structural deficit (14% of GDP in 2010) and one of the largest current account deficits in the Eurozone (12% of GDP in 2010). Despite desperate efforts to avoid a Greek default with austerity measures, economic reform and increased European integration, a Greek default seems unavoidable. Drawing on the experiences of previous sovereign defaults, this essay will evaluate the consequences of a Greek default or debt restructuring on Greek economic growth and the European banking system; both in the case of a Greek default within the Euro, or catastrophically, in the case of a Greek default together with Greece's withdrawal from the Euro. Since the Eurozone contributes almost 20% of world GDP, more than twice as much as China and only slightly less than the US , the crisis has the potential to devastate the global economy and the whole global banking system.

The historical background behind the current European sovereign debt crisis is key to understanding how the consequences of a default will affect Greece and the European banking system and why we have already seen a partial Greek sovereign debt restructuring. The Eurozone's geographical periphery is highly indebted for a variety of reasons. Greece is a unique case because the blame for the high levels of public debt can be assigned to the fiscal irresponsibility of the government, rather than the irresponsibility of the private sector, as seen in the credit-fuelled, private-sector property bubbles in Ireland and Spain. In the early noughties, the Greek economy had strong economic growth fuelled by cheap access to credit and demand from the booming global economy. The government ran large structural deficits during this period (2% of GDP in 1999 up to 18% in 2010), leveraging up to expand Greek economic growth and to support the uncompetitive Greek economy against the stronger Eurozone nations. This can be seen on the graphs below.

Greek public debt/GDP ratio over time

However, as global demand contracted in 2007 and 2008, Greece's main industries of shipping and tourism declined. Public debt spiralled out of control and it became clear in late 2009 that the government had been dishonest about the full size of the public deficit. As uncertainty escalated in the financial markets, the cost of lending for the government hit record highs, with 10 year government bond yields reaching 18.55% . In May 2010, the EU and IMF agreed on a Greek bailout package totalling €110 billion to avoid default. The survival of the Greek economy relies on these loans being released by the IMF and so depends on the introduction of economic reforms and austerity measures.

As the full scale of Greece's public deficit became apparent, sovereign debt restructuring became unavoidable. A restructuring of debt involves altering the terms of the debt agreements of outstanding debt obligations. This can include extending the maturity of debt or, as in Greece's case, reducing the value of existing debt - a "haircut". In October 2011, the private sector agreed to take a 50% 'haircut' in their Greek bond holdings to reduce Greek public debt by more than €350bn (£307bn). This controlled debt restructuring has allowed more time for other reforms to have an effect in Greece, such as the austerity measures being pushed through parliament. However, this has also imposed losses on European banks who owned the debt, most significantly Greek banks. Although the debt restructuring will reduce Greece's debt to 120% of GDP, the risk of default remains4. Reuters calculates that Greek sovereign credit default swaps are pricing in more than a 90% chance of default .

Why are Greek credit default swaps pricing in more than a 90% chance of default? Well, Greece is still running a structural deficit to the tune of 14% of GDP in 2010. So the total government debt is still rising. As seen in Reinhart and Rogoff's 2010 paper titled Growth in a Time of Debt, large public and external debt prevents growth. When the public debt/GDP ratio rises above 90% we expect the median economic growth rate to fall on average by 1% per year. Greece's public debt was 160% last year. Even if Greece defaults, it must reduce its deficit with expenditure cuts and tax rises. Austerity measures are contractionary. Labour market reforms, deregulation and privatisation must be used to stimulate long-term growth; in the short term economic output and growth will contract severely. Growth reforms work slowly and in the short term the decrease in tax revenues would require even stricter austerity measures to avoid a worsening of the primary deficit.

So a default seems unavoidable as Greece does not have enough time to make the necessary reforms to survive. If Greece were to default or restructure its debt within the Euro, the effects of the default would be severe, but these effects could be managed with effective policy responses from the ECB and European governments. The announcement of a Greek default within the Euro would spook the markets but not to the same extent as a Greek default outside of the Euro. A default within the Euro would force the writing down of Greek sovereign debt, by both public and private bondholders alike. This would cause huge losses for the European banking system. Solvency issues would arise. There would also still be the problem of Greece's primary deficit which would have to be addressed. The effects of austerity measures would destroy Greek economic growth but other countries would be far less affected than in the case of a disorderly default. With policy measures, the effect of a default within the Euro could be limited and the European banking system could survive. Policy makers have suggested that the European Financial Stability Facility (EFSF) create preventive credit lines, issuing bridge loans to financially weak countries. The ECB could provide financial injections for banks to stop them getting into solvency difficulties. Certain banks would still go bankrupt; but even the Greek banks could receive EFSF aid even if the Greek government is cut off from financial assistance. Most importantly the entire system will not collapse as anticipated in the case of a disorderly default.

If the Greek cabinet decided to default on its sovereign debt and leave



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