Wednesday, January 27, 2010

Inaugurual article for Forbes: Anything but a drachma-tic Ouzo Crisis

Hello, I just wrote my inaugural article for Forbes. The editor who got in touch with me last week told me that he had stumbled upon my blog and liked my previous stuff on Greece (this blog is useful for a change), so he specifically asked me to write something on Greece's fiscal woes. Anyway, as is the case with my Hurriyet columns, the unedited article is below, you can see the edited version at the Forbes website.

But unlike my Hurriyet columns, you'll see that the unedited and final versions are a lot different- that goes for the title as well. Well, that's normal, as it had to go through two different editors. But even though it was a long process, they did a very tedious job, so many thanks to them as well. So, here we go:

The Greek fiscal tragedy playing across the Aegean has turned into a daytime soap opera in the past couple of weeks.

First, a European Commission report condemned the Greek authorities for falsifying budget data. It was then no surprise that the government’s Stability and Growth Program, or SBP, released a couple of days after the EC condemnation, was not taken seriously by markets. The climax was reached last week, as Greek credit-default swaps, which insure against default, hit record levels.

Monday’s first bond issue of the year quelled worries a bit, as investors flocked to the generous yields. The successful auction hints that, contrary to the consensus view, the government may not run into much trouble meeting its financing needs in the short term, but as long as its budget situation continues to hang like the sword of Damocles, the country faces at best a slow death from rising interest rates, as Moody’s rightly concluded in a recent report.

To predict how this drama will conclude, it is necessary to summarize how the Greeks came to this fiscal mess in the first place. Part of Greece’s woes is common to the Euro Zone: A currency union that has tighter monetary policy than the other major economies and a currency that is overvalued. Moreover, peripheral countries have fallen behind in competitiveness, and Greece distinguishes itself from the periphery with a large shadow economy and large public expenditures.

It is these structural problems and the lack of monetary policy or exchange rate devaluation as policy options that have left the Mediterranean quartet of Portugal, Italy, Greece and Spain, the so-called PIGS, and to some extent Ireland, with messy budgets. However, Greece stands out from the crowd by having both a high deficit and a large debt to GDP ratio.

So the ambitious deficit reduction plan of the SBP, which sees the deficit down from 12.7 percent last year to 3 percent in 2012, should have been welcomed. But for one thing, about two thirds of the adjustment is coming from revenue increases and one-off items, which depend on overoptimistic assumptions on growth and registering the shadow economy. Without any support from monetary or fiscal policy unable to devaluate itself out, it is also not clear how the economy could grow 1.5 and 1.9 percent in the next two years.

What if the SBP does not work out? The options then would be a bailout, leaving the Euro Zone and the dreaded d of default/ debt restructuring. An EU bailout has been ruled out by officials, with the German Finance Ministry stating clearly that “Greece must solve its own problems through its own efforts”. Leaving the Euro Zone, on the other hand, would mean complete catastrophe, to paraphrase Nikos Kazantzakis' Zorba, as Greek Central Bank Governor Georege Provopoulos articulates in a recent Financial Times column.

Even if Greece were to leave the Euro Zone or bailed out by the EU or the IMF, it would eventually have to face fiscal consolidation or resort to the dreaded d. In fact, all the options other than fiscal consolidation would bear huge costs not only for Greece, but also on the Euro Zone and the Emerging Europe.

First, there will be direct damage to countries with strong trade linkages with Greece and where Greek banks have large operations, such as Bulgaria and Serbia. Countries with similar fiscal woes, such as the other PIGS as well as Hungary and Latvia, are likely to be affected as well. But most importantly, it is the Euro Zone’s reputation and stability, which is at stake.

At the end of the day, these costs are so great that a return to the national currency drachma is very unlikely. So is the possibility that Greece will initiate an Ouzo Crisis in the Euro Zone and Emerging Europe, similar to the Latin American tequila crisis of the mid-nineties. The most likely outcome is that the Greek government will have to swallow the pills one way or the other and put its books to order, at the expense of large expenditure cuts and a deep recession.

To offer some comfort to my Greek readers, I should add that there are other countries suffering from the familiar Mediterranean disease of relying too much on overoptimistic revenues and not daring to undertake the essential expenditure cuts. For example, Portugal, which I identified as a risky country off the markets’ radar more than a month ago, is now vying for the spotlight.

Turkey is a country that has been forgotten in this Euro Zone melee. Its fiscal accounts are obviously nowhere as wretched as Greece’s, especially if you do simple number comparisons at the expense of ignoring country specifics.

But it is another Mediterranean country suffering from the same Mediterranean disease and treading rough fiscal waters, with largely underpriced risks.

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