Text By PAUL HANNON
What was once unimaginable is now highly probable, and a member of the euro zone, the world"s second-largest economy, looks likely to default on its debt. It"s an outcome for which bond investors have been preparing themselves for some time, such are the stratospheric levels to which Greek bond yields have climbed in recent months, and certainly since the German government first began to acknowledge the possibility of a restructuring in October last year.
At almost every step of the euro zone"s fiscal crisis, the currency area"s policy makers have seemed unprepared for any but the rosiest of outcomes, despite the fact that actual outcomes have generally been the worst possible.
More protests, such as this in Lisbon, dispute the notion of shared obligations.
.Indeed, for many years, the behavior of bond investors wasn"t much different. Until August 2007, the yields they were prepared to accept on the debts of Greece and other governments that now face big fiscal problems assumed that those economies really were becoming more like Germany"s, even when it was clear they weren"t.
In essence, bond investors bought one of the euro zone"s basic sales pitches, and didn"t spend too much time checking whether it was true. The story was that those economies with what one might call a checkered past would be put on the straight and narrow by Germany, which, for reasons of history, had a deep aversion to fiscal irresponsibility and high inflation.
But since the crisis began, investors have become more and more focused on the particular situations in which countries find themselves, and are horrified by what they see.
..Another peculiar feature of the euro zone is that it has always been assumed that what binds its still-growing membership together is more than a currency, and that the obligations of one were the obligations of all, even though euro-zone members were explicitly barred from bailing each other out.
Because some of these assumptions may not be entirely false even now, Greece"s fate, should it default, is difficult to predict with confidence. Other members of the currency area may yet be prepared to finance its budget deficit for many years to come, or until the current and future governments do everything they say they will, including selling ¤50 billion ($72 billion) of state-owned assets.
But for how long will Greece have to rely on the European Union and the International Monetary Fund? There is a commonly held view that participants in financial markets have very short memories, and almost no sense of history. If that were true, Greece could restructure its debt and spend a few years relying on its friends while fixing its fundamental economic problems, before once again persuading investors to buy its bonds at an affordable yield.
It is true that some governments that have defaulted on their debts have quickly been welcomed back to the international bond markets— Russia is a relatively recent example. And it"s true that bond investors will lend again to a defaulter—if that weren"t the case, there would be no serial defaulters, and there are plenty of those.
It can make sense to lend to a government that has just walked away from its debts. For a start, if you suddenly decide that you owe 50% less than you did yesterday, your ability to service any new debt is much increased. And in many cases, such defaults are accompanied by a change of regime, a pledge to turn over a new leaf and a determination not to end up in the same mess again.
And yet, so many do. One of the reasons is that bond investors really do punish defaulters, and for a long time. In a paper presented to the Royal Economic Society"s annual conference, Juan Cruces of Argentina"s Universidad Torcuato Di Tella and Christoph Trebesch of the Free University Berlin looked at the precise losses —or haircuts—suffered by creditors in all 202 sovereign restructurings with foreign banks and bondholders between 1970 and 2007, covering 68 countries.
They found that "higher haircuts are associated with significantly higher post-restructuring spreads and much longer periods of market exclusion." Specifically, an increase in the haircut of 20 percentage points typically ensures that borrowing costs are 1.7 percentage points higher immediately after the restructuring, and still half a percentage point higher five years later.
For Greece, this would mean its borrowing costs would still be high in 2017, even if it did everything right.
And one interesting question in the case of the euro zone is who exactly would be punished? If what happened is that bond investors bought a story that turned out to be mostly untrue, shouldn"t their ire be directed at those that sold them the story? In other words, will the effect Messrs. Cruces and Trebesch observe be applied to all the euro zone"s borrowers, or just Greece?
Surely that"s something euro-zone policy makers will have to consider pretty carefully before allowing Greece to default.