Financial Markets and the Economy

In Greece the government dept and the money owed to pension funds, summing up to 1,2 trillion was becoming a huge burden . All the national services were running on a deficit and they were showing great inefficiency. In addition to this, corruption was obvious in every sector and tax evasion was more than a common practice.

Generally Greek banks followed a very conservative strategy and did not invested in high yield assets nor did they get involved in the toxic real estate mortgage bonds market in the US. In this environment, Greek banks had lend Greece 30 billion Euros that had been stolen and squandered. Seeking to buy high yield bonds, Greek banks invested in promising GGB and now but a 20-25 % decrease in the price of the bond is enough to wipe out the 25% of the Greek Banks equity.

With Mr. Papandreou going public about the real dept of Greece, yield rates increased and the Greek bonds lost their value.

Greece's debt is rated as BBB- (S&P), A2 (Moody's) and BBB- (Fitch) and the European Central Bank (ECB) may not accept Greek debt securities as collateral any longer after the end of the year, creating a big problem on liquidity. As a result if the Greek Government defaulted on its debts, the Greek banks would go bankrupt. Greece is still believed to be the most possible member in the euro Area to default due to sovereign crisis.

The results for the Greek Economy and its existence in the global market would be catastrophic (inability to pay for its necessities and inability to borrow money from the markets with a "rational" interest rate).

Similarities between Portugal and Greek Financial Crisis

Portugal is a similar country that was running on deficits although the problem isn't as hard as in Greece. Portugal faces public sovereign problems and this puts extreme pressure on Portugal's banks. Although Portugal's solvency is not in question, its debt affordability over the medium term and the economy's ability to withstand fiscal consolidation downgrades its credit rating.

On February 4, 2010 Portugal attempted to sell T-bills although it didn't managed to receive the expected number of bidders. One part of the problem has been the investors' punishment in the Greek bonds issuing, as bonds plunged and yields rocketed. The cost of insuring Portugal's sovereign debt against a default rocketed at November 2010 and speculation implied that the country may have to follow Greece and Ireland in seeking an international financial bail-out. Portugal's credit ratings are better than Greece's and this poses Portugal not at risk of refinance its operations, however they should proceed in cuts in public spending, a move that was not welcomed by the people.

To balance the budget the only way is to increase revenues or to cut expenses. Higher revenues can be succeeded by higher growth or higher taxes. In Greece as we know tax evasion and corruption in bureaucracy have been a burden in implementing an efficient plan.

While Portugal is doing better than Greece in terms of controlling its budget deficit and public debt, its poor long-term growth prospects, drastic loss of competitiveness imply low expectations for growth. Moreover, Portugal's reliance on Spain-itself vulnerable-as a market for 25 percent of its exports, adds to the contagion risk.

The Portugal Banks are facing challenges and they have to rely on governmental support. The inability of government to support the Portuguese banks has led to the downgrade of the debt ratings.

Ireland Crisis

Ireland Financial crisis was created inside the country and could be considered "home-made". It started in a period when globally there was an era of growth. Financial integration in the Euro area allowed financial institutions in Ireland to access cross border funding. And based on that, Ireland experienced a significant financial boom. Living standards rose by far, and that is what happened with asset values.

The boom in property investment market was certain, but fiscal and banking policies and financial supervision should have been prepared for a bust. But in fact, budgetary policy

veered more toward spending money while revenues came in. In addition to this, the tax pattern created a lot of troubles since it was connected to property and spending and Ireland had an unusual system with tax deductibility for mortgages, and significant and distortive subsidies for commercial real estate development, yet no property tax. Moreover competition from abroad increased and the need for bank governance and risk management was crystal clear.

IMF and ECB were not very critical of the policies followed and no measures were taken there to let room for man oeuvre. Lending in property and especially commercial property and individuals had increased in a level that imposed high risks. The response of supervisors to the build-up of risks, despite a few praiseworthy initiatives that came late in the process, was not hands-on or pre-emptive.

In 2007 a decline in Irish property values and the Freezing up of the world's interbank system, showed that the Banking system would face problems in order to finance its operations. This implied threat of Banks' default, caused the government's intervention in order to bail them out.

"Anglo Irish" Bank exposed to the Irish property bubble, and been involved in scandal in 2008 had a major drop on its share price. Ireland had entered into recession in the beginning of 2009 and unemployment rose by 3 degrees. The residential and commercial property markets went into a severe slump with both sales and property values collapsing.

The Government in order to face the recession started taking controversial measures that evoked an unexpected public outcry. However the cost of saving the Banks pushed the National Debt to 125% (by 2015).

As we can see, these are two different debt structures. In the first case the problem was caused by fiscal imbalances that drove banks into the black hole and in the second case the problem started as a banking crisis that evolved into a sovereign debt crisis.

2. Describe and elaborate on the term "Greek statistics". What is the role of Goldman Sachs?

The term "Greek Statistics" stands for the effort the Greek statistical authorities did to disguise the huge budget deficits the Greek government created. Creative accounting took priority when it came to totting up government debt. For all the benefits of uniting Europe with one currency, the birth of the euro came with an original sin: countries like Italy and Greece entered the monetary union with bigger deficits than the ones permitted under the treaty that created the currency. Rather than raise taxes or reduce spending, however, these governments artificially reduced their deficits with derivatives. Since 1999 and the Maastricht treaty no country-member of the European economic union- should exceed the budget deficit limit of three percent, while total government debt must not exceed 60 percent. The Greeks have never managed to stick to the 60 percent debt limit, and they only adhered to the three percent deficit ceiling with the help of blatant balance sheet cosmetics.

After recalculating the figures, the experts at Eurostat consistently came up with the same results: In truth, the deficit each year has been far greater than the three percent limit, when in 2009 it exploded over 12 percent. Greece's budget deficits had been badly understated. In order to lower them, all sorts of expenses, like pension debt or defense expenditures, were moved out of the books. This way Greece managed to retain the deficits so as to meet the targets.

Nevertheless, Greece would be able to disguise its true financial state for only as long as lenders assumed that a loan given was as good as guaranteed by the European Union and no one outside of Greece paid much attention. Therefore, professional aid was necessary to achieve it. Here, in 2001, entered Goldman Sachs, which engaged in a series of apparently legal but nonetheless repellent deals designed to hide the Greek government's true level of indebtedness. Goldman Sachs first helped Greece to borrow billions of Euros in secret, and then told it how to get round the European restrictions on public debt. The deal involved so-called cross-currency swaps in which government debt-issued in dollars and yen- was swapped for euro debt for a certain period -- to be exchanged back into the original currencies at a later date. Such transactions are part of normal government refinancing. Europe's governments obtain funds from investors around the world by issuing bonds in yen, dollar or Swiss francs. But they need euros to pay their daily bills. Years later the bonds are repaid in the original foreign denominations.

In the Greek case however, the US bankers devised a special kind of swap with fictional exchange rates. That enabled Greece to receive a far higher sum than the actual euro market value of 10 billion dollars or yen. In that way Goldman Sachs secretly arranged additional credit of up to $1 billion for the Greeks. This credit disguised as a swap didn't show up in the Greek debt statistics. Eurostat's reporting rules don't comprehensively record transactions involving financial derivatives. That deal, hidden from public view because it was treated as a currency trade rather than a loan, helped Athens to meet Europe's deficit rules while continuing to spend beyond its means. Critics say that such deals, because they are not recorded as loans, mislead investors and regulators about the depth of a country's liabilities. Wall Street did not create Europe's debt problem. But bankers enabled Greece and others to borrow beyond their means, in deals that were perfectly legal. Few rules govern how nations can borrow the money they need for expenses like the military and health care. The market for sovereign debt - the Wall Street term for loans to governments - is as unfettered as it is vast.

While such accounting gimmicks may be beneficial in the short run, over time they can prove disastrous. Still, as recently as 2008, Eurostat, the European Union's statistics agency, reported that "in a number of instances, the observed securitization operations seem to have been purportedly designed to achieve a given accounting result, irrespective of the economic merit of the operation." The involved parties became so experts in these transactions that the term "Greek Statistics" became a pun among the European Fiscal Authorities to describe any data that have been manipulated. A country, like a bank, is "too big to fail". So Greece will be rescued - at a price. The European Central Bank claims to know all about Wall Street's game, and ECB president Jean-Claude Trichet is taking a very hard line with the Greek government, warning that Greece will have to take "vigorous steps" to mend its ways, "under close and constant EU supervision". In other words, hand over control of its economic affairs and reduce its 2009 deficit - 12.7% of GDP - to 3% by 2012. To cut the deficit by almost 10%, particularly in an area of weak growth, is an almost impossible task, requiring major surgery rather than "discipline". Oddly enough, the aim of the exercise is to strengthen the euro at the very time when the US and China are devaluing their currencies in order to consolidate the process of recovery.

3. In what way does the Greek crisis affect the European Banks and other countries? Provide evidence on the existence of financial contagion during the recent financial turmoil?

The integration of the Euro Area and the use of the common currency in the Euro Zone create a big dependence and a big concern towards the financial crisis in Greece. The Greek Financial crisis may have a negative effect on its euro partners and may affect even the healthiest and strongest economies like Germany.

In the table below we can see the European banks exposure to Greece.

EUROPEAN BANKS

As we see Spain, Italy, Germany, France, Belgium and Portugal are holders of GGB. According to CIRA, over 50% of the Greek public debt is held abroad. French Banks have the greatest exposure to Greece ($79 bn), followed by Switzerland ($78,6 bn) and Germany ($43,2 bn). In this way they have been infected with the Greek Dept and they face losses as GGB downgrade.

INFLATION

Indirectly, the European Union affects the biggest members negatively. By keeping interest low to help countries like Greece in danger from sovereign debt, it increases liquidity in the Eurozone and creates opportunities for cheap lending for other countries. And this is a problem as Germany is diverging from countries that face economic turbulences like Greece Italy and Spain. Germany for the first time has expanded by 3,6% compared to 2009 and the inflation rose unexpectedly pushing the euro rate above 2%.

Price stability, a major target of the EU, is been tested, however there is the danger that withdrawing money from the market will create panics and push up interests rates, exacerbating the crisis.

Credit Risk Spread

Since the belief that countries facing similar problems (ex Portugal) may default, negative trends in the market are formed and risk yields increase. An additional problem is that banks having invested in GGB may need to seek finance from the government and that transfers the risk to the state and finally to the taxpayer.

Generally the problem derives from the downgrade of Greek Bonds that currently are in foreign hands (European Banks and other financial institutions hold more than 50% of the Greek Government Bonds). This way the Greek sovereign debt crisis directly affects all the euro zone.

Financial contagion

The risk here lies in Bulgaria and Romania, where Greek banks own 29% and 16% of banking sector assets. If Greek banks lost access to funding, that might encourage them to shrink their balance sheets in these two countries rather aggressively, putting downward pressure on growth there.

Real contagion

The role of the European Union is to propel price price stability throughout its members. There is an implicit need for actions to be taken in order to achieve this goal. If Eurozone falls due to to "untreated" rising sovereign risk or due to widespread fiscal tightening to address the rising sovereign risk, this will make banks very cautious concerning their balance in the region, and potential potential growth will suffer.

Trade: With the need for low interest rates ECB have increased the amount of money in circulation and that makes the Euro more expensive towards the Dollar and the Yen. Consequently the demand for imports will be increased and the demand for exports will be decreased.

Concuding

Advanced economies have suffered large scale costs in the aftermath of the crisis.. A sharp decline in potential GDP and sizable bank rescue packages are likely to constrain the scope of scale consolidation over the coming years. At the same time, developed countries may be facing increasing risks to long-run debt sustainability if they fail to undertake structural reforms, particularly in their pension and healthcare systems. These circumstances suggest that, although defacto sovereign defaults may be a mere theoretical possibility, findings convey considerable policy implications in terms of European and global sovereign debt management policies. The main message is that, since sovereign debt markets involve asymmetric information and political risks due to the electoral cycle, even countries with relatively solid fundamentals cannot avoid international contagion. Furthermore, stronger commitments to the supranational coordination of debt policies may be inevitable. (Sovereign Credit Risk Contagion in Advanced Economies, Norbert Metiu, September 30, 2010)

4. Describe the Greek debt structure and the possible resolutions of the current situation. What is the market's view of the Greek deficit problem? Explain.

Greek Government Debt is estimated at 301 billion at 2009, 125% of the GDP. At 2010 the amount of the debt will reach 136% of the GDP and as announced by the accounting authorities the amount reaches 340,3 billion. The increase in the government dept in the latter year can be attributed to the coverage of the government deficit and in the increase of governmental material procurement and the coverage of organization of Regional Authorities.

The dynamics of the public debt is affected by factors that are inside the direct control of policy like the privatization policies and the target of running primary surplus and privatization are of, the interest rate changes, the pace of growth factors as yet who are not in the rate of exchange and inflation influencing economic policy, but practitioners of direct control the public debt dynamics

Debt composition regarding expiration

Most of the debt issued in the period January to September 2010 was loans from the EU and the IMF (45%). The second higher concentration is on Treasury Bills (short term maturity) reaching 23%. Afterwards come the midterm maturity bonds of 5 years maturity (15%), 10 years maturity (8%) and other undefined of about 9%. All debt is denominated in Euros.

Debt composition regarding rate

As we can see from the chart Greek Government debt is based in fixed rate.

Duration of the debt and average cost of borrowing

Last but not least, cost for Greek borrowing shows a trend by which from the time Greece entered the European Union in 2001 costs were steadily decreasing from 6,2% in 2000 to a lower limit of 3,1% reached in 2005 and then rising again up until now, but not surpassing 4,3% in 2010. This is due to the entry of euro as currency in Greece, that stabilized the economy and produced phenomenal stability in the area, stability that was once again lost when Greece misreporting became known and the term "Greek Statistics" has since been used as a pun by the European fiscal authorities. Finally we have to mention that Greece lost its ability to borrow in the long term. As the following diagram shows the majority of the total debt is based on shorter loans that offer less risk and can be sold more easily. However the difference between the supply and the demand in the 3 years bond implies that the prices for long term bond

Resolution and the market's view

Greece is on a strong recovery run. The new taxation bill which includes significant rerating of profitable -dividend paying companies lets taxation priced in for some companies. From 2011 the corporation tax rate is set at 20% (from 24%), it applies to all profits and there is no longer any distinction between distributed profits and retained ones. Finally it reintroduces withholding tax on dividends at 25% (from 10%).

The Greek government and the EU policy makers expect a comprehensive solution to the debt problem. Many scenarios are considered like the extension of lending facility, IMF package reprofiling, bond buy back program and more. The most likely scenario up to now seems to be an extension of the duration of the EU/IMF loan, something already discussed and agreed on, and maybe a lower rate of interest in the future if Greece manages to successfully restructure its operations in the manner the European Union imposes.

If Greece becomes another last resort buyer for the GGBs with the ECB it could help restore confidence in the bond markets. However, for this and to meaningfully reduce the burden of debt, Greece must borrow hefty sums. Also some other problems, even if Greece gets to buy back most of its debt at a significantly lower price, still it is enormous, an unsustainable level, and this scenario of buying back the ECB holding of Greek debt only could imply haircuts for other holders, something that Both the Greek and the European financial system may not be willing to absorb now, while any buy back must be voluntary so as not to trigger the CDS.

Nevertheless efforts must be made by the Greek fiscal authorities in order to improve the country's financial picture. The new focus shifts towards structural reforms is more than welcome rather than pure austerity as it will promote growth.

Yet this scenario may not come comprehensively. More austerity and structural reforms may be imposed for the financial aid to come, meaning more economic pressure. The third and final scenario would be not to involve in short term or medium term developments, something rather unlikely as it would mean that the sovereign crisis across Europe could escalate much further.

The markets now have some reasons to be optimistic on Greece. To begin with now there is a base of operations to counter such phenomena, and major reforms are made to decrease deficits (pension plans). The government enjoys the support of the EU/ IMF and is committed to its austerity program and fiscal consolidation. There is a wish now for a permanent solution to the Greek debt problem. All these lead international investors to selectively look at Greek ideas again, especially deep value stocks as well as a cleansing up of the Greek system, where strong companies are to benefit from the closure of weak ones. Investors could properly return to Greece once they see that there is real improvement and commitment to change. An example that explains the former could be the new tax bill, a case where a government market friendly policy meets positive react from the markets..

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