Debt drama in Greece continues

On February 27, the Standard and Poor’s rating agency downgraded Greece’s sovereign credit rating to "selective default," citing the crisis‐hit nation's move toward "distressed debt restructuring." The widely expected move reflected Greece’s ongoing challenges: Despite the short‐term relief of a February 20 bailout package, the country still must overcome a number of obstacles – both to ensure receipt of the bailout funds, and to reverse the country’s deep economic downturn. Similarly, while the crisis facing other European countries has abated, the eurozone still faces recession in 2012. For investors, we believe the uncertain economic climate across Europe calls for caution, and resisting the temptation to make investment decisions based on short‐term developments.

Greece’s credit rating downgrade came in reaction to the Greek government’s move to retroactively reduce the value of portions of its outstanding debt, and to bind all of the creditors to the new, lower value. On March 9, the government announced that more than 80% of its private‐sector creditors had voluntarily agreed to a debt restructuring that calls for a 53.5% write‐down in the value of their bonds. The €200 billion debt restructuring is a critical step for Greece as it seeks to meet the terms of the February 20 bailout package, which was jointly negotiated by the International Monetary Fund, the European Central Bank and eurozone finance ministers.

Working through the bailout package
The chief objective of the €130 billion bailout package is to clean up the Greek government’s finances. A cornerstone of the plan calls for Greece to cut spending and raise taxes, which is intended to spark greater public confidence in the economy and help unleash more robust economic growth. That theory is questionable, though, as we’ve seen numerous examples of austerity measures depressing national economies, reducing tax revenues and raising the debt burden. With 55% of the fiscal consolidation Greece has already enacted having taken the form of tax increases, the economy is continuing to contract at double‐digit rates: it shrank 7% last year. There is a real risk that it will continue falling.

Short‐term challenges ahead
Greece faces a number of other short‐term challenges with respect to the bailout funds, and longer‐term challenges to revive its economy. As the country’s Finance Minister said recently, the road ahead will require, “work, work, work, a systematic effort, collectiveness, unity, mutual agreement and responsibility.”

Most important, the Greek government must enact (or make progress on) a long list of reforms as a condition of receiving the bailout funds. Progress on enacting reforms has been slow, which means that foot‐dragging on these measures could be an obstacle to Greece receiving the bailout funds it needs to stave off a default. "We've seen Greece derailing several times in the last two years," Dutch Finance Minister Jan Kees de Jager said recently. "Implementation risks are very high in the case of Greece."

National parliaments in the eurozone are also required to approve release of the funds. While they are likely to do so, it’s not a guarantee. Officials in a number of eurozone countries have been publicly critical of Greece, questioning whether the country deserves another bailout.

The country also faces the prospect of continued political uncertainty. Legislative elections are expected in April, and if a new government is swept into power, it may not feel bound by the terms negotiated by the current government.

Greece’s challenges are magnified by the weakness of economies throughout Europe. The International Monetary Fund forecasts that eurozone economies will contract 0.5% this year, so Greece is unlikely to see a growth in exports to other European countries. The tourism sector, which accounts for about 18% of GDP, is also likely to be flat.

Stumbling toward a resolution
Europe is stumbling toward a resolution of its current issues. Outside of Greece, conditions have improved in the eurozone, with Italy, Portugal and Spain selling government bonds at significantly lower yields. While Greece’s future is still uncertain, the economic turbulence has been underway for so long that governments, and financial institutions, have had an opportunity to prepare for a potential default. The lingering uncertainty is the potential for payouts on credit default swaps, and the risk that this will stoke fears and raise borrowing in other fiscally strapped eurozone countries. For investors, the situation in Greece, and throughout Europe, remains volatile.