The Greek Problem! By Macrostrategy.com
The biggest issue in the global financial market at this time is whether or not Greece is going to default on its sovereign debt. That depends on Germany. Germans are not keen on bailing out the profligate Greeks but German and Euro establishment may not have much choice. We'll see how the events unfold but the Greek 5-year CDS spread (355bp) implies 28% default probability over that period. The last time a sovereign defaulted was in 2002 when Argentina abrogated its obligations to international bondholders. How Greece and Europe deal with the problem will impact the Euro and the dollar. So, what exactly is the Greek's debt problem? Why is it become so now?
Greek debt became the headline issues late last year when the finance minister announced that the country's deficit to GDP ratio for 2009 would be 12.7% instead of 6.0% originally forecast. This raised alarm bells amongst international investors because Greece needs to roll-over Euro 16 billion of its debt in April/May. As the focus on Greek finance intensified more nefarious activities started to come to light. Specifically, Greece was accused of consistently under-reporting its debt to the Eurostat, the European statistical agency by using complex derivative transactions. In actuality this was an open secret; in fact, an Italian academic Gustavo Piga wrote a paper on this exact topic back in 2002.
The genesis of the problem goes back to 2001 when Greece joined the Euro. In lieu of its entry, it had to abide by the Stability and Growth Pact (SGP) established in 1996. SGP set two important targets for member states: a debt to GDP ratio of less than 60% and a deficit to GDP ratio of less than 3%. At the time of entry, Greece was within the deficit limits but its debt was over 100%. In 2002, the European Commission pressured Greece to reduce its debt not just interest payments on those debt. In order to comply, Greece used cross-currency swaps in very innovative ways.
A cross-currency swap involves the exchange of payments denominated in one currency for payments denominated in another over fixed time period. Payments are based on a notional principal amount the value of which is fixed in exchange rate terms at the swap's inception. Like any derivatives, cross-currency swap can be used either as a hedging instrument (against exchange rate fluctuations) or as a speculative instrument (to bet on movements in currencies and yield curves). Cross-currency swaps do not change the size of debt (principal) at the beginning of the contract. At the end of the contract, debt value can change or not change based on nature of the contract. Swaps do alter periodic interest payments depending on the relative movements of exchange rates and interest rates in reference countries.Swaps do not reduce the size of debt, just the costs of borrowing. So how were Greeks able to reduce debt using cross-currency swaps? The simple answer is because the Eurostat accountants allowed them to. ESA95, the accounting standards for government debt and deficit allowed "up-front swap payment" to reduce debt because it did not take into account the corresponding increase in payment at the end of the contract. Greece and Goldman Sachs took advantage of this accounting loophole to comply with EC's demands.
Starting 2002, Greece and Goldman Sachs entered into series of cross-currency swaps exchanging Greek's dollar-denominated and Yen-denominated debt for Euro-denominated debt. The transactions totaled about US$ 10 billion with tenor (maturity) of 15 to 20 years. Instead of using spot Euro/US$ and Euro/Yen exchange rates to swap debt, they used "off-market" rates whereby the reference Euro rates were lower than spot rates. This in effect was equivalent to one-time foreign exchange gains for Greece causing Goldman Sachs to make US$1 billion up-front payment followed by higher than otherwise periodic interest payments. As per ESA95, Greeks reported this up-front payment as a reduction in debt. The currency gain was going to reverse and Greeks were expected to payback Goldman Sachs at the end of the contract but they did not have to report that to the Eurostat. Goldman Sachs on the other hand hedged its exposure to the Greek transaction by taking off-setting positions with Frankfurt-based Deutsche Pfandbriefe Bank.
The bottom line is that Greece will not be able to roll-over its debt without some kind of international guarantee but what form that takes and who leads it (Germany or IMF) if at all is an open question. Lets see how this plays out!
Reference
Bank of America, January 2007. Introduction to Cross Currency Swaps
Bernard Connolly and John Whittaker. What will happen to the euro? (6-Nov-2002)
BMO Capital Markets. Cross Currency Swaps
Economist. Financial WMD? (22-Jan-04)
Gustavo Piga. Do Governments Use Financial Derivatives Appropriately? Evidence from Sovereign Borrowers in Developed Economies, International Finance, Vol 4 # 2 (16 Dec 2002)
Nick Dunbar, Risk Magazine. Revealed: Goldman Sachs’ mega-deal for Greece (1-Jul-03)
Vishal_Damor. Greece Soverign Debt Crisis, The Way Forward, if Any! (11-Feb-10)
Wolfgang Reuter. Greek Debt Threatens the Euro, Spiegel (8-Dec-09)
