After Dubai, will Greece be next?

By Wolfgang Münchau



After Dubai, will Greece be next? This question is technically a category error, since Dubai World is not a state but a state-owned company. But many investors rightly do not care about the difference. Last week investors started to fret about sovereign default in earnest. So what about Greece?

We were already wondering about a Greek default at the beginning of this year, when eurozone bond spreads suddenly widened. In February Peer Steinbrück, the former German finance minister, abruptly ended the speculation by saying the eurozone would act if someone got into trouble. There was no concrete action plan. No work had been done to amend European treaties. There was no budgetary appropriation. Just a sentence. Investors believed him and all was well - for a while.

The speculation is now back, but there is one difference. The eurozone will not come to the rescue this time, verbally or otherwise, unless Greece meets a number of conditions the European Union is likely to impose in the coming months.

The EU's authorities, rightly or wrongly, are more afraid of the moral hazard of a bail-out than

the possible spillover effect of a hypothetical Greek default to other eurozone countries. If faced with a choice between preserving the integrity of the stability pact and the integrity of Greece, they are currently minded to choose the former. To safeguard what is left of the stability pact, they are determined to link any help to a country's willingness to comply. Otherwise the EU fears it might lose all leverage over budgetary processes elsewhere in the eurozone. And no country in the eurozone has flouted the pact more than Greece.

Here are the numbers. This year, the budget deficit will rise to 12.7 per cent of gross domestic product - and this assumes there are no further accounting tricks to be uncovered. Deutsche Bank calculated in a recent research note that the country's public debt-to-GDP ratio is headed for 135 per cent. Gross external debt - private and public sector debt owed to foreign creditors - was 149.2 per cent at the end of last year. The real exchange rate has gone up by 17 per cent since 2006, which means the country is losing competitiveness at an incredible rate. Had Greece not been in the eurozone, it would be heading straight for default.

The government's 2010 draft budget foresees a deficit reduction to about 9.1 per cent of GDP. But the number is misleading. The lion's share of the total deficit reduction effort is earmarked to come from tax measures, and most of those from the fight against tax evasion. Tax evasion is always the item first on the list of desperate governments. The European Commission and Europe's finance ministers, who have heard this story before, are rightly asking for genuine deficit reduction. So is George Provopoulos, the Greek central bank governor, who demanded that two-thirds of the entire deficit reduction effort should come in the form of spending cuts. If the Greek parliament confirms the government's soft budget next month, the European Commission will almost certainly judge the effort insufficient and demand a supplementary budget. It might also ask for structural reform, including pension reform.

If the Greek government refused to comply, which is quite possible, the next step could be the penalty procedure under the stability pact. So instead of helping Greece, the EU might be asking Greece to pay a penalty. This in turn would aggravate Greece's financial position in the unlikely event that the government would agree to pay it.

The current strategy of the EU is to raise the political pressure - perhaps even provoke a political crisis - with the strategic objective that the Greek government might eventually relent. It is a dangerous strategy that could easily backfire. Even if George Papandreou, the Greek prime minister, were sympathetic to the EU's demand, he would face enormous political headwinds if he tried to implement draconian austerity measures. This would be the very opposite of what he promised during the recent election. The real problem is that the Greek people have not been prepared by their political leaders for what lies ahead.

So what happens if Greece cannot meet a payment on its bonds, or fails to roll over existing debt? About two-thirds of Greece's public debt is held by foreigners. According to calculations from Deutsche Bank, Greece is looking to raise some €31bn ($46bn, £28bn) in new borrowing and €16bn to roll over existing debt next year. In the absence of help from the eurozone, the Greek government would have to resort to the International Monetary Fund if it were to encounter difficulties refinancing the debt. Unlike Argentina, Greece cannot devalue, and leaving the eurozone is not a realistic policy option either. Latvian-style austerity could thus come one way or the other, with or without default. But it might be politically easier for the present government to have austerity imposed on it from the outside than from the inside. This is another reason why the EU would be happy to let the IMF take a lead.

Just as the Greek people are unprepared for austerity, investors are unprepared for what awaits them. I would still bet that outright default is unlikely. But I wonder whether the current Greek bond spreads reflect the true risks.