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MAF 306 - International Finance and Investment

Report on the Greek Debt Crisis

Executive Summary

This report was commissioned to examine the Greek debt crisis. It has been structured in three parts – the causes of the Greek debt crisis, the effects of the debt crisis on the wider Eurozone and possible remedies for Greece, and a comparison of the current situation in Greece to previous financial crises.

Part one includes background information on the events leading up to the Greek debt crisis, mainly those surrounding Greece's entrance to the Eurozone. Likely causes of the crisis are detailed - Greece's high levels of debt to GDP, high levels of inflation and irresponsible financial decisions.

Part two shows the impacts of the Greek debt crisis on the rest of the Eurozone. It examines the historical value of the euro over the past 10 years and draws parallels between events of the debt crisis and the fluctuation in currency value. The costs and benefits of the euro are evaluated, with the lack of control of common monetary policy being highlighted as a major deficiency of using a single currency. Pro-growth strategies for Greece are also suggested, including reforms to Greece's labour market.

Part three compares the measures being implemented in Greece – austerity measures, bailout packages and debt swaps – against the actions taken in during the Latin American debt crisis of the 1980s. The report concludes that austerity measures are ineffective at reducing a country's levels of debt. Debt relief or debt rescheduling are recommended as a viable options for assisting Greece with its debt management.

Table of contents

Introduction

pg.6

- Part one: Background and causes of the Greek debt crisis

pg.6

o

Greece and the Eurozone

pg.6

o

What caused Greece’s debt crisis?

pg.8

- Part two: The effects of the Greek debt crisis on the Eurozone

o

The European debt crisis

pg. 12

o

The Greek crisis and the euro

pg. 14

o

The result of a single currency

pg. 15

o

Growth strategies for Greece

pg. 15

- Part three: Historical comparisons between the Greek Debt Crisis and the Latin American Debt Crisis

pg. 17

o

Greece's latest bailout

pg. 17

o

Latin American debt crisis

pg. 18

o

Effectiveness of debt-reduction measures in Greece

pg. 19

- Conclusion

pg. 20

- References

pg. 22

Introduction

This report examines the debt crisis in Greece, from its beginnings in the early 2000s to the most

recent developments. The analysis conducted here is split into three distinct sections, with each part

examining a different aspect of the crisis. Part one provides background information to Greece’s

entrance into the Eurozone, and investigates the initial causes of the Greek debt crisis. In part two,

the wider-reaching effects of the Greek crisis on both the euro and other members of the Euro are

explored and the strengths and weakness of the Eurozone are detailed. Potential economic growth

policies for Greece are also examined. Part three discusses the most recent developments of the

debt crisis, including the Euro summit in Brussels and the most recent bailout package. Greece’s

current situation is compared to previous financial crises, and their economic repair measures are

critiqued. Finally, some recommendations are given for Greece heading into the future.

Part One: Background and causes of the Greek debt crisis

Greece and the Eurozone

In 2001, Greece entered the Eurozone. This action can be viewed as the starting point for Greek

debt crisis as, in order to join the Eurozone, Greece needed to meet the financial criteria given in the

Maastricht treaty (1992). The Maastricht Treaty outlines the requirements for European Union

member states who wished to become part of the Eurozone. These criteria include stipulations that

government debt could be no more than 60% of gross domestic product (GDP) and the government

budget deficit could not exceed 3% of GDP (Shapiro 2014). By entering the Eurozone, Greece

relinquished their use of the drachma and implemented the single currency of the Eurozone – the

euro. The adoption of the euro gave the appearance of financial stability to Greece, counteracting its

historically high levels of inflation and lack of economic policy credibility (Ladvas, Litsas & Skiadas

2014). Most significantly, the adoption of the euro gave Greece greater access to private debt

markets (Kouretas 2010). Greece was able to increase their ability to borrow and lend at longer

horizons. This led to an increase in private investment and robust real growth rates of 3.9 per cent

per year over the period 2001-2008 (Robbins 2015).

In 2009 it was revealed that Greece had been hiding the extent of their budget deficit in order to

meet the criteria of the Maastricht Treaty. Prior to the election of George Papandreou on October 4

2009, the government of Greece reported what was considered a relatively modest fiscal deficit -

3.7% of GDP (Tiersky & Jones 2014). However, following the election, it became clear that Greece's

financial situation was far worse than previously claimed. It was revealed that the 2009 deficit was

15.4%, well above the previous estimate of 3.7%. It soon became apparent that this data had been

misreported rather than incorrectly estimated, and Greece's government had been "cooking the

books" for some time (Kouretas 2010). At this point, Greece was burdened with debt amounting to

113% of GDP - nearly double the Eurozone limit of 60% (Fig 1.1)

Figure 1.1: Greece’s deficit and debt as a percentage of GDP

1.1: Greece’s deficit and debt as a percentage of GDP Source: World Data Bank The announcement

Source: World Data Bank

The announcement that Greece had been understating its deficit seriously damaged the country’s

international economic reputation. The three largest Credit Rating Agencies—Standard and Poor’s,

Moody’s, and Fitch—repeatedly downgraded their rating of Greek government debt. Greece’s debt

dropped from a triple A debt rating to a C-; junk bonds (Phillips, 2015). Serious concerns were raised

about Greece’s ability to service its debt (Krugman 2011) and speculation arose regarding a possible

exit from the Eurozone(Arghyrou & Tsoukalas 2011). On 23 April 2010, the Managing Director of the

International Monetary Fund (IMF) announced that Greece made a request for a Stand-By

Arrangement; a financial assistance package to assist Greece with their debt repayments. On 2 May

2010, after days of negotiations, the IMF, the European Commission (EC) and the European Central

Bank (EBC) – informally known as ‘the troika’ - agreed on a three-year €110bn bailout package to

rescue Greece. This package was to be the first of three bailout packages that Greece has received

so far.

What caused Greece’s debt crisis?

Greece’s inclusion in the Eurozone has long been considered a mistake. In 2004 it was revealed

through close scrutiny of Greece’s budget figures that the country had never fulfilled the terms of

the Maastricht Treaty (Pascual & Ghezzi 2011). One of the major purposes of the Maastrich Treaty

was to ensure that all members of the Eurozone had similar financial policies, levels of debt and

inflation. Monetary policy for all members of the Eurozone would then be dictated by the ECB. But

by applying a common monetary policy to countries with widely varying fiscal policies, serious

financial issues arose, such as a large spread of inflation rates across the Eurozone countries (Fig.

1.2). For Greece in particular, inflation rates rose dramatically, which led to a decrease in

competitiveness. The normal counter to high inflation rates is currency devaluation, but due to the

use of a single currency, this was not an action Greece was able to take. The decrease in Greece’s

competitiveness led to a decrease in exports, leading to an overall trade deficit account (Fig 1.3).

Figure 1.2: Spread of inflation rates within the Eurozone

Figure 1.2: Spread of inflation rates within the Eurozone Source: Pictet WM – AA&MR Datastream Figure

Source: Pictet WM – AA&MR Datastream

Figure 1.3: Value of imports and exports of Greece (in million €)

1.3: Value of imports and exports of Greece (in million €) Source: Bank of Greece, Trade

Source: Bank of Greece, Trade Balance (annual)

Another significant contributing factor is Greece’s government; its irresponsible fiscal policies and

poor macroeconomic choices (Arghyrou & Tsoukalas 2011). For a government with a large deficit,

social spending was high. Expenditures included: a generous public welfare system, with full pension

payments made to early retirees, and full benefits and subsidies available to the unemployed (Fig.

1.4); low tax rates and high levels of tax evasion; over-employment, low productivity and high wages

within the public sector (Labrianidis & Vogiatzis 2013). Up until 2007, the government's expenditure

increased by 87%, while revenues grew only 31% (Ari 2014). This led to a large push to implement

austerity measures, from both the Greek government and Greece’s creditors. These consisted of

cuts to wages, employment and tax increases. These cuts have been cited as extensively contributing

to Greece’s plummeting GDP (Fig 1.5) (Krugman) (Arghyrou & Tsoukalas 2011).

Figure 1.4: Greece’s levels of unemployment

(Arghyrou & Tsoukalas 2011). Figure 1.4: Greece’s levels of unemployment Source: Thomas Reuters Data Stream 8

Source: Thomas Reuters Data Stream

Figure 1.5: GDP in the Eurozone

Figure 1.5: GDP in the Eurozone Source: Thomas Reuters Data Stream The high levels of debt

Source: Thomas Reuters Data Stream

The high levels of debt and uncertainty caused yields on Greek government bonds to soar. Prior to

2008, the spread between Greek and German 10 year government bonds - widely regarded as the

safest bonds within the Eurozone (Krugman 2011) - was very small, ranging between 10 – 30 basis

points. After the news of Greece’s levels of debt became public, financial markets started raising

interest rates in the fall of 2008 to compensate for the heightened risk of default (Tiersky 2015). By

January 2012, the yield spread between German and Greek debt had increased by 3,300 basis points

(Figure 1.6.). These high interest rates, reflecting Greece’s high level of default risk, effectively

excluded Greece access from the bond markets (Ari 2014). Faced with upcoming debt repayment,

the Greek government was forced to turn to the IMF and the Euro Commission for assistance.

Greece’s bailout package was the first of many in what would become known as the European debt

crisis.

Figure 1.6: Yield on 10Y Greece government bonds v yield on 10Y German government bonds

government bonds v yield on 10Y German government bonds Source: Atlas Data Bank Part Two –

Source: Atlas Data Bank

Part Two – The effects of the Greek debt crisis on the Eurozone

The European debt crisis

Although Greece’s GDP only made up 2% of the overall GDP of the EY, the concerns and lack of

confidence were still significant enough to impact other members of the Eurozone (Lapavitsas,

2012). After Greece’s request for a stand-by arrangement, other heavily indebted nations in the

Eurozone - Portugal, Ireland, Italy and Spain, (known collectively with Greece as the PIIGS) – came

under more intense scrutiny. Ireland, Portugal and Spain all received some form of assistance from

the EU (Tiersky 2015).

From looking at Fig. 2.1, it can be seen that Greece’s ratio of government debt to GDP and budget

deficit to GDP were considerably higher than the other Eurozone nations. This data helps to explain

why even though all of the PIIGS had budget deficits, Greece was so severely affected.

Figure 2.1: Levels of government debt and budget deficit as a percentage of GDP

of government debt and budget deficit as a percentage of GDP Source: Shapiro, 2014 The initial

Source: Shapiro, 2014

The initial bailout package Greece received allowed them to make the necessary repayments to their

creditors on time and avoid a default. However, by 2012 Greece’s debt was 152% of GDP and their

GDP in decline. It was becoming obvious that Greece had a level of debt that they would not be able

to repay, at least not within their specified time frames (Pascual &Ghezzi 2011). Although the 2012

bailout package included a haircut on their private sector bonds, removing approximately €107

billion from their debt total, it also gave them an additional loan of €130 billion (Robbins 2015). The

more assistance Greece received from the troika, the more their debt levels rose, and the more

unlikely it became they would be able to repay their debts.

Two alternatives existed: either forgive or reschedule some or all of Greece’s debt, or allow Greece

to default. By forgiving Greece’s debts, a dangerous precedent would be set for the other indebted

nations. However, by allowing Greece to default on its debts - making it the first advanced economy

to default on IMF loans - Greece would effectively exit the Eurozone. Either option would create

further instability and uncertainty in the already suffering Eurozone countries.

The Greek crisis and the euro

The Greek crisis and the euro Figure 2.2: Historical valuation of USD per 1 EUR Source:

Figure 2.2: Historical valuation of USD per 1 EUR

Source: Atlas Data Bank

Looking at Fig. 2.2 above, it can be seen that while major events took place in Greece in regards to

its debt crisis, there was also a simultaneous adverse effect on the euro currency. Substantial drops

in value can be linked back to specific incidents with the implementation of the first and second

bailout packages having a significant negative effect on the euro. This was in no small part due to

growing concerns by investors regarding the future of Greece, its risk of default and its ongoing

place in the Eurozone. The most considerable decrease occurs at the end of 2014, with the euro

nearly reaching parity with the US dollar. This could likely be in response to the ECB’s drastic rate

cuts (Detrixhe 2014). Along with the mounting fears that Greece would default and exit the euro,

investors and economists alike believed that this crisis was also an indicator of the lack of stability

within the Eurozone (Tiersky & Jones 2015). Many were wondering whether the creation of the

Eurozone and the use of a single currency was the right choice in the first place (Morley 2015).

The result of the single currency

There are many benefits to the Eurozone and the implementation of a single currency: tax-free

trade among members, freedom of movement around the Eurozone, simpler and cheaper trade with

a single currency and a single market and the promotion of peace and unity between countries as a

condition of being a member (Ladvas & Litsas 2012).

As illustrated by the Greek debt crisis, there are also many disadvantages. First among these is the

binding of monetary policy to a single central bank, the ECB. By refusing countries control over their

monetary policy, but allowing them to dictate their own fiscal policies, problems arise of disparate

inflation rates, levels of debt and government expenditure arise (Ladvas, Litsas & Skiadas 2014). The

structural differences in how each country operates– aggregate productivity, price and wage

competitiveness - impacted the effectiveness of the common monetary policy. Over time, this

created macroeconomic imbalances within the Union, which in turn directly affected levels of

employment and external balances (Ari 2014).

The ongoing events of the European debt crisis have also had a significant financial impact on the

stronger performing nations within the Eurozone, with the amount spent on debt bailout and

financial relief packages totaling billions of euros (Arghyrou & Tsoukalas 2011). As the economic

difficulties suffered by the PIIGS are seen as the result of years of reckless spending, fiscally

responsible nations, such as Germany and France are reluctant to spend their tax-payer dollars on

bailout packages (Mayeda & 2015). Yet the alternative - allowing nations to default on their loans

and exit the Eurozone - would have devastating economic consequences (Ari 2015). Thus far,

Greece's exit from the Eurozone has not been discussed as a viable option.

Growth strategies for Greece

If Greece is to stay within the Eurozone and attempt to repay their debt, options for economic

growth need to be considered. Traditionally, when a country is suffering the similar financial woes

as Greece - overvalued currency, high inflation, low economic competitiveness - the safety valve is

currency control. By devaluing their currency, Greece would be able to reduce their inflation,

increase competition and strengthen their economy (Krugman 2011). Given monetary policy is

shared by all countries and controlled by the ECB, this is not an option. Another alternative would be

to increase spending. Keynesian economics shows that in times of budget deficit, an increase in

spending will actually boost the economy, allowing for debts to be repaid faster (Blinder 2008).

However, as Greece's debt levels are already unsustainably high at nearly 180% of GDP, further

spending is viewed unfavourably by Greece's creditors (Gopal 2015). As Greece also has a low level

of tax collection - with tax evasion costing the Greek government at least 10% of GDP each year

(Gimein 2012) - attempting to raise revenue by increases taxes is unlikely to be successful.

The most successful strategy for growth within Greece is likely to come from major reforms to their

labour market. Although structural changes to an economy as a whole generally take a long time to

produce positive results, structural changes to labor market tend yield results relatively quickly

(Petrakis 2014). Greece's major problems with their labour market include high wages, low export

value and high tax evasion practices.

Between 2000 and 2011, the level of minimum wage was increased by almost 60% (Karamanis &

Naxakis 2014). High minimum wages affects youth employment, as employers are reluctant to

employ workers once they reach the level of minimum wage. This either results in employees being

terminated and replaced by younger and cheaper employees, or employers paying wages in cash to

cut costs (Petrakis 2014) Reducing wages will increase the involvement of youth and the long-term

unemployed in the labour force.

The increase in wages has also increased the prices of exports, reducing their overall

competitiveness and lowering Greece's net exports. The reduction of wages will also help to target

this. Analysis of the Greek economy shows there is excessive activity in sectors creating products

which are not internationally tradable, such as real estate, restaurants and construction (IMF 2013).

The Greek government needs to encourage people to move away from these non-tradable sectors,

which have historically been considered 'safe' investments, and instead create incentives for workers

and employers to invest in internationally tradable goods such as new technologies. This will boost

Greece's overall domestic growth, while effectively targeting their low export levels (Malliaropulos &

Anastasatos 2011)

Finally, Greece's taxation system needs to undergo significant reforms. Tax evasion in Greece has a

high value relative to GDP – evaded taxes were estimated at nearly 25% of GDP in 2012 (Gimein

2012) – and Greece has the lowest public receipts of all Eurozone members. This tax evasion

contributes significantly to the annual budget deficits and the extremely high level of public debt.

The primary source of this shortfall is personal income taxation (Mitsopoulos & Pelagidis 2011).

Rather than focusing on increasing taxes, as suggested by Greece's creditors, it would be much more

beneficial to Greece to make changes to their taxation system that reduce tax evasion. With

effective tax reform, Greece could recoup approximately €30 billion each year (Gimein 2012).

Greece has yet to effectively implement any strategies that are focused solely on promotion of

economic growth. Reforms that have been implemented thus far tend to revolve around fiscal

adjustment and debt reduction measures, such as cuts to spending and tax increases. The overall

result of these measures - generally termed austerity measures - will be examined in part three, with

reference to the Latin American debt crisis.

Part three: Historical comparisons between the Greek Debt Crisis and the Latin American

Debt Crisis

Greece’s latest bailout

Despite the bailout packages received since 2010, Greece continues to fall into larger debt, while its

economy has shrunk by 25% in the last five years. On July 12 2015, Greek Prime Minister Alexis

Tsipras met with the International Monetary Fund (IMF), the European Central Bank (ECB) and the

leaders of the other Eurozone members to discuss the terms of a third bailout package for Greece.

The third bailout package was a direct result of Greece missing the deadline for a €1.5 billion

payment to the IMF. After lengthy negotiations, it was established that Greece would receive a

bailout package of approximately €80 billion in exchange for agreeing to implement further political

and economic reforms (Euro Summit 2015). The major elements of this reform included: reforms to

the value added tax (VAT) system and increasing revenue by broadening the tax base from 13% to

23%; restructuring the Greek pension program; and the ongoing privatisation of Greek assets – ports

and airports - and the sale of broadcast and telecoms spectrum rights (Euro Summit 2015)

The Latin American Debt Crisis

Before evaluating the effectiveness of the debt reduction methods currently being undertaken in

Greece, it is worthwhile considering the details of the Latin American debt crisis:

Since the 1960s, US banks had been lending heavily to Latin American countries such as Brazil,

Argentina and Mexico. However, due to a worldwide recession, drastically increased oil prices and

reduced export prices, both Latin American current account deficits and net external borrowing

grew steadily from 1977 until 1982, until the Latin American region had levels of debt at 50 percent

of GDP (Pastor 1989). Following the realisation that they were unable to service their debts, many

countries implemented austerity measures, and cut spending on infrastructure, education and

health, froze wages and fired public sector employees (Sims & Romero 2013). The result was high

unemployment, steep declines in per capita income, and stagnant or negative GDP growth (Carrasco

1999). By 1989, it became clear to the US government that the Latin American countries would be

unable to simultaneously repay their debt and stimulate economic growth

In 1989, the new Secretary of the Treasury, Nicholas Brady, announced that the only way to address

the sovereign debt crisis was to encourage the banks to engage in “voluntary” debt-reduction

schemes (Carrasco 1999). Banks had a choice of three options, such as exchanging their existing

loans for 30-year debt-reduction bonds that would provide a discount of 35 percent of face value

(Vãsque 1999). These debt-reduction schemes served as a vehicle for debt-relief, with over $60

billion in loans being forgiven between 1989 and 1994 (Sims 2013). In exchange for the debt relief,

the eighteen countries that agreed to the Brady Plan also agreed to economic reforms that would

allow them to service their remaining debt (FDIC 1997).

Effectiveness of debt-reduction measures in Greece

There are many similarities than can be drawn between the Latin American debt crisis of the 1980s,

and the current debt crisis in Greece (Sims & Romero 2013). The situation in Latin American was a

real-life example showing why austerity measures do not help a country in times of economic

downturn. Yet Greece’s creditors still insist the strict implementation of austerity measures as a

condition of the bailout packages. Without the maintenance of government services and nation-

wide infrastructure, Greece's economy will increasingly shrink (Krugman 2013). This means Greece

debt burden increase over time, rather than decreasing. This is especially likely given the country's

GDP has already fallen by 40% since 2009 (IMF 2012). Furthermore, Greece has taken new debt in

the form of additional bailout packages while being told to reduce its existing debt by spending

significantly less. From this combination of factors, it seems highly unlikely that the debt will ever be

repaid.

A recent IMF analysis estimated Greece’s debt will peak at close to 200% of GDP in the next two

years (Bloomberg 2015). The IMF admitted that that it massively understated the damage that

spending cuts inflict on a weak economy (2012) and that Greece’s debt is currently unmanageable.

The most recent report from the IMF (2015) states that “further concessions are necessary for debt

sustainability”. The bond swaps of 2012 were the beginning of this, with approximately €107 billion

being removed from Greece's privately held debt – approximately 30% of their overall debt (RBA

2012). As the bond swap coincided with a second bailout package, Greece’s debt to GDP ratio

remained largely unchanged (RBA 2012).

The typical bond swap deal undertaken during the Latin American debt crisis led to about 30 to 35

percent forgiveness of a country’s debt (Vãsque 1999). While the average debt of countries in the

Latin American debt crisis was approximately 50% of GDP, Greece’s debt is nearly four times that

size. Despite their reservations, the troika, specifically the Eurozone leaders, need to start

considering debt relief as viable option.

Debt relief for Greece—which has to mean a reduction in the face value of the debt owed, rather

than just another extension of repayment deadlines—would reduce the current pressure for

austerity by making Greece’s debt load more sustainable. This would then allow Greece to pursue a

larger range of growth strategies, such as investment in infrastructure and creation of jobs. If any

lesson can be taken away from the Latin American debt crisis, it is the reality that no debtor can

continue paying its creditors without economic growth (Girón & Solorza 2015)

Conclusion

With hindsight, it can be seen that Greece's entrance into the Eurozone was a highly problematic

endeavour. Greece never truly met the required financial criteria and, once inside, their access to

cheap debt markets led to irresponsible spending and unsustainably high levels of debt. Greece's

debt crisis had wide reaching effects on Eurozone members, including drastically impacting on the

overall value of the euro and costing billions of euros in bailout packages.

Yet Greece's exit from the Eurozone would cause massive financial turbulence that would impact

financial markets worldwide. To this end, bailout packages are still being implemented.

Unfortunately, the austerity measures that accompany these packages serve only to slow Greece's

economic growth and increase their levels of debt. Greater emphasis needs to be placed on pro-

growth strategies, such as labour market and taxation reform, in order to assistance Greece's

economic recovery. Debt rescheduling and relief will also need to need to be reconsidered, as under

current conditions, it is unlikely that Greece will ever repay its debts.

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