Greece: A Resurgence of the Drachma
April 29th 2010
Fear that Greece may default on its debt obligations together with political uncertainty led to the rating agency, Standard & Poor to lower the sovereign rating on the country’s debt to BB+ from BBB-. This is ranked as “junk.” Recent downgrade makes this the first euro zone member to have its debt reduced to this level. “Junk” status means a country loses its investment grade standing. The rule of thumb for financial institutions is that they are barred from investing in “junk” bonds. This is because potential investors view the country as a risky place to invest.
Greece has become dysfunctional. No doubt, politicians and financiers have an understanding of what the symptoms and the causes are but are scrambling to find a precise prescription. Following last weeks meeting with the European Union and the International Monetary Fund, these agencies appear to be offering to solve a problem that requires a simple tool with a sledge hammer.
Greece is seeking 40bn euros (USD 60bn) from euro zone and the IMF. But conditions for accessing such funds have so far proved lurid. Furthermore, the Greek government’s cost of borrowing on the international money markets is at a record level amid investor concern over whether the bail-out package will be agreed upon. Greece is required to pay 12.57 percent to borrow in the international markets as compared to Germany that can borrow at 0.79 percent. This is â€˜loan shark’ territory. The country does not have any other access to source funds. Investors are also concerned that Greek government’s austerity measures will continue to prove decidedly unpopular with the Greek public.
Capitulation is terrible to contemplate but at times can be the only least painful solution. Greece appears to be in serious pain and on the verge. It is increasingly becoming the sacrificial lamb for the euro zone. Before the recent downgrade by S&P, Greece emerged as a country with a lot of fire power to fend off financial mayhem but has since shown lack of ammunition.
S&P also reduced Portugal’s debt rating by two marks to A- due to panic of a “contagion.” In addition, there is fear about the countries surging debt relative to GDP. Â Their assets have become risky. The downgrade on Greece and Portugal has incited investors to flee from riskier assets.
Greece’s economic reforms that led to it abandoning the drachma, in favor of the euro in 2002, made it easier for the country to raise money in the international markets. Following the governments’ excessive borrowing in recent years the country indulged in a spending binge that put a significant strain on the economy. The country in the last two months has been scrambling to find ways to rescue itself from its excessive debt. Its budget deficit is regarded as very high under the EU (European Union) standards. Greece’s budget deficit has soared to almost 13 percent of the Gross Domestic Product.
Greece will gain a temporary reprieve if it is able to raise the 9 billion euros it needs to honor its debt obligations that mature on the 19th of May 2010. This will be a short term fix as its huge budget deficit is likely to pose long term problems.
The region is becoming a nightmare for the European policy makers as the crisis spreads to other countries in the union. It is becoming obvious they may need over 500 billion euros (USD700billion) in aid to prevent the region from turning into an economic pandemonium.
Global financial markets digested the downgrade negatively. Financial markets seem to be obsessed with fright and feeding off its own paranoia. Almost USD 1 trillion of global equity value was erased in the markets following the downgrade although the markets have since recovered. The main concern is the expectation this will spread to other euro zone member states. On Wall Street, the Dow Jones index lost 2 percent shredding 213 points on the downgrade. Meanwhile shares in Greek banks gave up more than 9 percent on the same day.
What’s next for Greece?
Greece could adopt the option of leaving the euro. Revert back to their original currency: the Drachma. In doing so they can chose to devalue their currency to improve their competitiveness. This should reduce labor costs and advance exports.
The repercussion of such a move is apparent as this would cause a shatter in theÂ Â financial markets as investors panic and bail. Other nations would follow, which could potentially lead to a break-up of the union. Investors could chose to move their funds outside the euro zone, creating headache for the monetary union banking system in the process. Hence, it could be argued that it is in the European Central Bank’s interest to lend Greece the money it needs to meet its obligations, rather than risk the impairment to the currency if the country departs the union.
Other options could take the form of debt restructuring or a default on its obligations. This could translate into creditors (debt holders) taking a â€˜hair cut’ in recovering money that is owed. (Rumored is 30 to 50 cents in the dollar).Â S&P is also echoing the same and concluded that “their weak long-term growth prospects have made the country less credit-worthy.”
The Greek Drachma
First introduced in 1832 and last replaced by the euro in 2001. (At the rate of 340.750 drachma to the euro). The euro did not begin circulating until 2002 but the exchange rate was fixed on 19 June 2000, with legal introduction of the euro taking place in January 2002. Source: Wikipedia