Greece: The Certainty of Default and the Risk of a PIG Contagion

When Greece defaults holders of its debt are certain to take a haircut. The real risk however is that other PIG countries will follow them.

Greece may only represent 0.48% of global GDP but its total debt is a staggering €327 billion and in my opinion the nation has absolutely no chance of avoiding default. Here’s why.


In order to avoid a default Greece must meet the goal set by eurozone finance ministers of reducing its annual budget deficit from 14% of GDP to just 3% of GDP by 2012. Achieving such a drop would require a combination of enormous cuts in government spending and a dramatic rise in tax revenue.

Assuming that Greek authorities could successfully push through such measures, higher taxes and government spending cuts would have a serious adverse effect on economic activity. Higher taxes would reduce demand for goods and services and actually result in lower government revenues. Meanwhile spending cuts would cause unemployment – already approaching 16% – to rise further. This in turn would increase welfare payments and put even greater pressure on the public purse.

Just a matter of time

Even if the latest bailout from the European Financial Stability Facility (EFSF) and IMF is approved by eurozone governments it will only delay the inevitable. Sooner or later Greece’s creditors will have to accept that the country is insolvent and cannot service its existing debt. At which point Greece will default.

Haircuts and contagion

It is the German and French banks that are the most exposed to a Greek default. Together they carry a combined €81 billion of the nation’s debt. The bigger risk however is of a contagion whereby the other PIG countries of Portugal, Ireland and Spain follow Greece in walking away from their obligations – a strategy that has worked well for Iceland.

Back in 2008, when other nations decided to inject billions of dollars into their financial institutions to keep them afloat, Iceland placed its biggest lenders into receivership and chose not to protect the creditors of its banks. The ensuing crisis almost sank the country with the krona losing 58% of its value, inflation spiking to 19% and GDP contracting by 7% in 2009. Today however, without its huge debt burden, the economy is doing quite well. Both exports and tourism are up and their economy is projected to grow by 3% this year.

“Iceland did the right thing by making sure its payment systems continued to function while creditors, not the taxpayers, shouldered the losses of banks,” says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York.

The French and German banks have more than €613 billion in exposure to Europe’s vulnerable peripheral nations. That’s around half the total exposure of all European banks.

This exposure helps explain why Paris and Berlin are in favor of pursuing a politically unpopular rescue of Greece. They are also among the loudest voices pushing Athens to undertake painful austerity measures and €50 billion in asset sales.

In absolute (euro) terms, the German commercial bank Commerzbank AG is the most exposed to overall Greek risk – its shares are down 88% from their peak in 2007. A good potential short candidate is the iShares MSCI Europe Financials Sector Index Fund [EUFN] which is designed to track the combined equity market performance of the financial stocks within the countries of Europe.

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