Greece's New Bonds: Is Another Default Coming?

It was the dog that didn't bark. Greece defaulted and nothing happened in the markets. There was no contagion, no panic, and no bank meltdown because it was fully anticipated. For the often maligned euro area crisis strategy of "kicking the can down the road," the events were an extraordinary vindication and success because nobody cared when Greece finally did default. Of course, we don't know what the counterfactual would have been if Greece had defaulted in May 2010 or July 2011—if banks might have failed or if markets might have frozen. As a result, euro area leaders will undoubtedly be subject to an iron law of politics: You never get any credit for avoiding a worse scenario. Meanwhile, many analysts (see, for instance, Eichengreen 2010 ) can now feel vindicated by correctly predicting an eventual Greek default early on.

Fears of Another "Default"

The new concern is Greece's new long-term bonds that were thrust upon the country's hapless private creditors in last week's coercive bond swap. They have begun trading at north of 20 percent yields. In what is probably an illiquid market, these yields suggest that markets expect a second Greek default against private creditors.

The question, however, is whether this is a foregone conclusion, even if Greece requires additional euro area funding.

• If Greece "defaults" again, requiring more euro area taxpayer money, why would the euro area force another default on private creditors? Coupon payments are merely 2 percent on the new bonds until 2015, so the cash savings of defaulting on these bonds during the next three years would be relatively small.
• Such a default would also undoubtedly result in further losses in the euro area banking system, where most participating banks probably book these new bonds at their par value. They would not likely be in the general interest of euro area governments.
• A second Greek default against private creditors would also further undermine any notion of risk-free status for sovereign euro area bonds, reigniting potential contagion to other markets. Renewed contagion would make a mockery of attempts to restore the market credibility of euro area sovereign bond markets.

  The only scenario in which another default against remaining private Greek creditors and their newly swapped bonds will be sanctioned by the euro area is one in which Greece exits the euro.

• Note that Greece, which is living with a euro area–sponsored escrow account, no longer has the fiscal sovereignty to declare such a default independently.

Euro Exit Driven by Populist Sovereignty Concerns?

A future populist Greek leadership might seek an exit to safeguard national sovereignty, despite what would be an accompanying economic disaster. The prospect of an exit is also not nearly as high as current Greek bond yields suggest, however. Greece's new bonds will not likely exist until the last ones are redeemed in 2042. More likely they will be converted into eurobonds, perhaps in 20 years, rather than be defaulted against again.

Markets and Political Leaders Misunderstanding Each Other

Breaking the risk-free taboo of sovereign bonds has stirred fears of irreparable damage to the euro area debt markets and caused their cost of capital to rise. But euro area leaders say they are determined to restore pre–private sector involvement status quo of euro sovereign debt.

Ironically, euro area leaders' insistence on private sector involvement for Greece might have created a self-fulfilling prophecy with respect to the loss of risk-free status of their sovereign debt. Markets prefer not to have to think hard about such complex issues. They prefer the analytical shortcuts conferred by market conventions about "risk-free status" or rating agencies that have too easily granted AAA-ratings because the markets then avoid the trouble of making their own proper risk assessment. The status of sovereign debt for years as risk-free gave the markets a misleadingly convenient benchmark by which to price all sorts of other financial assets.

Eliminating the sacrosanct risk-free status of their debt has exposed euro area leaders to the markets' myopia and simplistic understanding of euro area politics. Current euro area economic research from various investment banks is full of long-term political judgments like this: "[P]rivate sector involvement cannot be ruled out at a later stage. As time goes by, reform fatigue may become a problem and support for more radical political parties may emerge" (see Kennedy 2012).

One has to wonder about the empirical foundation for such purely political pontificating by Wall Street and City of London economists. This weekend in Slovakia, the pro-euro centre-left Social Democratic Party (SMER) won an overwhelming electoral victory, securing an absolute majority in parliament. The far-right populist Slovak Nationalist Party (SNS) failed to clear the parliamentary threshold. After elections across the euro area periphery in Ireland, Portugal, and Spain, one has to ask: Where are the storied euro area populists actually coming to power? Upcoming Greek elections represent a new risk of populist gains, but such an outcome would go against a broad-based trend, setting Greece ever more apart from the rest Europe.

The Greek private sector involvement, along with long-lived Anglo-Saxon stereotypes about the 1930s in Europe and the emergence of the US Tea Party, have all fed into the financial markets crying wolf about populists taking the reins of power. The wolf remains off in the distance, if it exists at all.

References

Eichengreen, Barry. 2010. It is not too late for Europe. VoxEU.org, May 7, 2011.

Kennedy, Simon. 2012. Euro fate depends on whether Wyplosz or Kirkegaard is right Bloomberg.com, March 13, 2011.