By: Rab Jafri
As the Greece debacle unfolds, the EU and the IMF have agreed to provide Athens with a “bailout” package valued at 110 billion Euros (80 by EU and EUR 30 by IMF). With wage cuts, a freeze on pensions and a hike in sales tax set as preconditions for the aid package, Greece will find itself in a tougher situation than before the crises erupted. To label the funding option as a “bail out” is a bit misguided as most of the funds will be used to service Greece’s debt. The aid package going forward will buy Greece time but will not solve its fiscal problems, as past attempts by Greece have only produced marginal results.
To further put this into perspective, France and Germany’s banking sectors together account for roughly half of all European banks and have $900 billion worth of exposure to Greece. If Athens were to default, it would essentially start a banking crisis spreading throughout Europe triggering defaults in Ireland, Spain, Portugal and Italy. The 110 billion Euro package will be used for debt servicing; paying off or “bailing out” Greece’s creditors, more so the financial system of the European Union.
It would be naïve to think that the aid package could solve decades of Greece’s fiscal irresponsibility. The question lingers of whether or not Athens will be able to successfully implement its tough measures to stabilize the country's finances given strong public backlash. The government is already forecasting a -4% GDP contraction in 2010 and a -2.6% in 2011. Falling wages and prices are needed (and will be seen) in Greece in the absence of an exchange rate adjustment. The best five year fiscal adjustment over the last 30 years by Greece has been 8.5 percentage points of GDP over the years 1994-1998. Having said that, real GDP growth averaged 2.7% per annum during that period, while inflation averaged 7.5% per annum, meaning that nominal GDP was growing over 10% per annum. That, of course helps reduce the deficit/GDP ratios as the denominator is expanding robustly. Historically, countries have made fiscal adjustments, such as the case was with Ireland, which reduced its deficit to 9.9% from 1987-1989 while New Zealand’s deficits declined by 7.3 percentage points from 1993-1995. What is noteworthy is that these incredible tightening measures were taken during periods of strong growth and moderately high inflation. Both Ireland and New Zeland had strong growth which boosted revenues and higher inflation boosted nominal GDP. Back in 1999-1997, countries that were hit hard by the Asian Financial Crises saw their fiscal deficits deteriorate as they plunged into recession. It was only after the combination of sharply weaker currencies and a booming world economy that the deficits began to improve from 2000.
As of now the Euro has been unable to capitalize on Greek aid package announcement. It has been pushed below $1.3200 and is approaching the $1.3115, its next likely target is $ 1.30. The risk of a deepening contraction and deflation is haunting Greece and the Euro. It is easy to see why the markets are skeptical of the proposed fiscal adjustments and question how Greece can meet such a stringent adjustment path in the budget deficit.