Two scenarios, bad and worse, forGreece after resorting to bailout

Drama is a Greek word but this does not mean Greece should become the protagonist in the one that is presently unfolding by doing its best to turn a debt-refinancing crisis into a solvency issue. However, this is exactly what the country did, finding itself in uncharted territory. From now on, one of these two scenarios will likely play out: Either there will be an orderly significant drop in living standards for the next two to three years with a subsequent strong economic recovery, or there will be a disorderly protracted crisis which will take many years to unravel and will cause damage to the eurozone. Prime Minister George Papandreou went against his own ideological beliefs on Friday when he bowed to market pressure, announcing that his government will request to activate a bailout package, estimated at between 40 to 45 billion euros, from the Euopean Union and International Monetary Fund. The announcement of the formal request helped at first to drive Greek spreads over German Bunds down by a hefty 120 basis points or more from their stratospheric levels but the yield spreads had gained some ground again by Friday evening. The spread paid on the five-year credit default swap (CDS) by investors who wanted to hedge their bond holdings against a Greek default had gone up to 600 basis points versus 623 points on Thursday’s close and 563 points earlier on Friday. The reaction of the CDS and cash bond markets in maintaining the inverted form of the yield curve, namely the short dated bonds yielding much more than the longer-term bonds, reflected concern that Greece may still go belly-up. This has to do with doubts about the country getting the necessary funds on time, doubts whether the bailout package will suffice to cover the country’s borrowing needs in the next couple of years and the possibility of Athens defaulting on its public debt. Although there is tough language from politicians in some European countries about the conditions under which aid will be disbursed to Greece, there is little doubt the government will bow to the demands of the IMF and the EU to secure the disbursement of 8 to 10 billion euros before May 19, when some 8.5 billion euros of 10-year bonds expire. However, the biggest challenge facing Greece will be to show the markets it can succeed in one of the most ambitious fiscal consolidation projects in the developed world by turning a primary budget deficit of more than 8 percent of gross domestic product (GDP) in 2009 into a primary surplus of 2.6 percent of GDP in 2011. It should be noted that the primary budget does not take interest payments on public debt into account. For public debt to stabilize and then fall, the primary surplus should be greater than the interest payments on the debt. Many commentators doubt whether Greece can carry out such a reduction in the budget deficit while the economy is in recession and most of its public debt is held by foreigners who have lost confidence in the country’s ability to service its debt in the future. Under these circumstances Greece could either receive a greater bailout package from the EU and IMF and produce a remarkable turnaround in its public finances in such a short period or default on its public debt. In the first case, the public will have to swallow the bitter medicine of austerity leading to a contraction in the economy in 2010 and perhaps 2011 with a glimpse of hope of recovery from 2012 on, perhaps in the second half. It is reasonable to expect that sharp cuts in budget expenditures, another round of tax hikes and limited credit to the private sector by the banking sector will lead to a drop in domestic demand and GDP, despite help from the external sector: a rise in export receipts and a drop in imports. A cumulative loss of output in the order of 8 to 10 percent of GDP from 2009 through 2011 is not unlikely. The economy is expected to shrink by over 5 percent in 2010 based on current projections. Even so, this is an assumption based on low implementation risk on the part of the Greek authorities and a high level of social tolerance, which is not at all certain. If, however, the austerity program is implemented in an orderly fashion along with the accompanying structural measures in social security, labor market etc, the country will buy time for the latter to provide the basis for sustainable economic growth alongside fiscal discipline from 2012 on. This is the good scenario. The bad scenario, which nobody hopes to see, is poor implementation of the agreed program by the authorities and high social and political tensions. Under this scenario, the country will fail to live up to its commitment and will enter a protracted period of economic decline, where the economy will choke off as foreign financing dries up. The only option may be a debt restructuring, keeping the country out of capital markets for years to come and dealing a blow to its economic potential and growth. It is clear to any market participant that mismanagement of the current crisis and a very poor starting point in terms of high public debt as a percentage of GDP has brought Greece to a very difficult situation. It is up to its politicians and the large majority of the public to choose the right scenario leading to a virtuous cycle down the road, instead of a vicious one.

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