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Special Topic 2:  Greek sovereign debt crisis

Recent developments in Greek debt crisis

During June markets came to believe that Greece would be unlikely to meet the fiscal targets required to receive its next tranche of the bailout package agreed with the EU and IMF in May 2010.  Despite previous austerity cuts, the government appeared likely to miss the 7.4% deficit target originally set out for 2011 as tax receipts came in lower than expected.  Markets became concerned that without the next €12.5 billion of bailout funds, Greece would default on its debt, causing a chain reaction amongst banks in Europe (and possibly elsewhere).
These fears were quelled somewhat later in the month as a confidence vote for the current Greek government and new austerity measures were passed by its parliament.  Even though Greece is now expected to receive the next tranche in July, most commentators believe a new bailout package will be required with Greece unlikely to be able to return to the market in 2012 as planned.  Many also consider that a restructuring of Greece’s debt is inevitable, whether it occurs now or sometime in the future.

Three possible longer-term outcomes

The European Union (EU), European Central Bank (ECB) and the International Monetary Fund (IMF) will continue discussions in July on the new bailout package.  Germany has stepped back, to the relief of markets, from its preferred option of a debt swap – bondholders would have been incentivised to swap existing bonds for longer maturity bonds.  This option would have avoided the EU/ECB/IMF having to advance Greece additional funds, but may have been considered a default, triggering a further downgrade of Greek debt and pressure on creditor banks.

A more likely option is a debt rollover – national finance ministers would negotiate with their locally affected financial institutions to buy new Greek bonds, maturing several years later.  (France and Germany appear to be advancing this approach.)  The debt rollover would involve voluntary participation, which would be expected to be low.  The main advantage of this option is that it would not widely be considered a default, although this is not assured.  These first two options would include “private sector involvement”, ie banks sharing some of the burden and taxpayers would not bear the full cost of the bailout.

The main problem with the third, more radical option, a partial default on Greek debt (a haircut) is that it may have a contagion effect.  Depending on the size of the haircut, banks could be severely affected, possibly requiring bailouts themselves to survive.  Banks in countries such as Germany and France may survive intact (the main foreign creditors to Greece), but others in Portugal and Spain could suffer, triggering concerns of wider ramifications.  There is considerable uncertainty about the impact of a default on financial markets.  European authorities are keen to prevent such an outcome, but it is not clear that Greece can completely avoid a default on its debt over the next few years.

Implications for New Zealand limited so far

So far the impact on New Zealand has been limited.  Yields on government bonds have eased recently (Figure 10); while this is in line with global trends, it shows that New Zealand sovereign debt is still viewed as a safe investment.  There is, however, some evidence that the market for commercial bank debt has been affected with one bank postponing a euro-denominated covered bond issue “given the current market volatility and its limited funding needs.”  European banks’ sales of covered bonds fell in June despite their perception as safe assets.
A further deterioration in the Greek crisis would affect New Zealand through trade and/or financial channels.  As the Euro area makes up only about 10% of New Zealand’s goods exports, the direct effects on trade would be somewhat limited.  A general slowdown caused by a contagion effect would lower demand in the region, impacting on commodity prices and export demand.  However, unless this had a significant confidence effect, spreading elsewhere in the world, we would expect the direct impact to be limited.

If the contagion effect spread to other parts of the world, the impact on New Zealand could be much greater.  In such a case, we would expect the New Zealand exchange rate to provide a buffer, as it did during the global financial crisis in 2008-09.  The yield on NZ government bonds also fell at that time, in line with global trends (Figure 10).

The effect on New Zealand through the financial channel could be more significant.  A default by Greece would likely trigger markets to more of a “risk off” tone, increasing demand for more “safe haven” assets, such as US Treasury bonds.  Typically, the NZD is seen as a risk-sensitive currency, so a Greek default could lead to a depreciation in the NZD, as happened in May 2010 when Greece’s first bailout was being negotiated (Figure 10).  However, the issue has been less clear-cut recently, with increased interest in New Zealand government bonds on some occasions of greater risk because they are perceived as safe.  There may also be an element of market diversification at play.

Figure 10 – NZ dollar and government bond rates
Figure 10 – NZ dollar and government bond rates   .
Source:  Reserve Bank of New Zealand

Some commentators have suggested that a Greek default could be similar to the Lehman Brothers collapse during the global financial crisis.  This saw banks unwilling to lend to each other, driving up funding costs for New Zealand banks.  While there may be a slight increase in funding costs in the event of a Greek default, we would expect it would be smaller as there is a clearer picture of the levels of exposure to Greek debt.  Another reason for a smaller impact is that since the crisis, the RBNZ has introduced regulations requiring banks to have a lower proportion of short-term funding, lowering the risks to funding costs of high impact events.  Nevertheless there would still be risks to New Zealand if Greece were to suffer a sovereign debt default.

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