July 22, 2011

US recession would follow a disorderly Greek default

Oxford Analytica

Against a background of rising public anger, the Greek government on June 28 secured parliamentary passage of a new austerity package. Failure to approve the package would have prevented the IMF-EU from continuing their loan disbursements to Greece, which would have resulted in a disorderly default on Greece's sovereign debt obligations. A Greek default would constitute the largest sovereign debt default on record. This would have serious consequences for the European banking system and global economy -- particularly the US economy, where economic recovery appears fragile.


  • Given current US vulnerability to exogenous risks, a worsening of the European crisis would lead to renewed economic contraction
  • While larger US banks are slowly rebuilding their capital, smaller banks remain highly vulnerable to external shocks.
  • If credit conditions worsen, it would accelerate the housing price contraction.
  • Net US job creation, currently anaemic, would turn negative in the event of a disorderly Greek default.

What next

A disorderly default in any of the peripheral countries would likely trigger a banking crisis in Europe, which, given the importance of Europe in the global economy, would have substantial ripple effects. While US banks are less exposed than their European counterparts, any potential disruption in wholesale credit markets would have a disastrous impact, pushing the US economy back into recession.


Financial markets are now convinced that Greek government has borrowed more than it can possibly repay and that sovereign debt default in Greece is only a question of time. This is now reflected in 2-year bond yield for Greece at over 25% and 10-year bond yields at over 17%.

Slide towards default

Pessimism about the Greek government's ability to honour its obligations turns on three considerations:

  1. Surging debt burden Although Greece made considerable progress in reducing its budget deficit in 2010 as part of its IMF-EU adjustment programme, the shortfall remains over 10% of GDP. Meanwhile, Athens's public debt-to-GDP ratio has risen to over 140%; IMF-EU programme anticipates that in the best of circumstances this ratio will hit 167% by 2013. Doubts about a country's solvency generally surface when this ratio approaches 100%.
  2. Severe recession Greece's efforts to redress its public finance imbalance are handicapped by the negative effects on output of severe budget tightening. Over the last 18 months, the Greek economy has contracted by around 9% while unemployment has risen to over 16%. Industrial production contracted by 7.8% year-on-year over the first five months of 2011. However, industry accounts for only 15% of Greek GDP (manufacturing accounts for 11%), and whether exit from the euro as many argue would help jump-start recovery is doubtful.
  3. 'Adjustment fatigue' Greece is now showing signs of 'adjustment fatigue' as dissent surfaces within the ruling PASOK party and demonstrators vent their frustration outside the Greek parliament. Yet the IMF-EU adjustment programme requires that Greece undertake further large scale fiscal austerity and embark on an ambitious privatisation programme over the next three years in order to qualify for future IMF-EU loan disbursements. Markets doubt that Greece has the political will to endure several more years of IMF-imposed austerity.

Fragile European banks

Greece's economy constitutes only around 1.5% of the EU economy. Yet its sovereign debt amounts to over 450 billion dollars with a large part of that debt owned by the European banking system. It is through its potential negative impact on the European banking system's balance sheet that Greece constitutes a potential risk to the global economy.

Recently, Juergen Stark, the European Central Bank's (ECB's) chief economist, warned that a Greek default could trigger a Lehman-style crisis for the European banking system.

A Greek default would be approximately four times the size of the earlier Russian and Argentine sovereign debt defaults in 1998 and 2001, respectively. The European banking system has yet to make adequate loan loss provisions for the eventuality of default.

Athens's default would almost certainly trigger defaults in Ireland and Portugal, which display similar public finance weaknesses. This would increase the total amount of sovereign debt that might need to be restructured to approximately 1 trillion dollars.

There is the distinct risk that defaults in Greece, Ireland, and Portugal could result in financial market contagion in Spain, which is highly reliant on foreign capital inflows to finance its balance of payments deficit. Spain's sovereign debt stands at approximately 1 trillion dollars.

Inadequate policy interventions

European policymakers are aware of the threat that a Greek default might pose to European banks. They also are fearful that Greek default could pose an existential threat to the euro and set back Europe's highly successful post-war programme of economic integration.

Mindful of the potentially damaging consequences of a default in any country in Europe's periphery, European policymakers have repeatedly stated that they will do 'whatever it takes' to avoid a default. To date the European strategy of large scale IMF-EU financial support to the European periphery has been successful in preventing a default in Greece, Ireland and Portugal. However, looking ahead, this strategy looks unsustainable.

There are increased signs of 'bailout fatigue' in northern Europe, which will constrain the ability of the European political elite to continue providing large-scale financial support to the periphery. Moreover, in the peripheral countries there are complementary signs of 'austerity fatigue' as electorates in those countries resist the stringent austerity measures attached to IMF-EU bailout loans.

US economic implications

Experience with the Lehman bankruptcy in September 2008 suggests that should a Greek default trigger a European banking crisis, that crisis would not be confined to Europe. The European economy accounts for around one-third of global output and the European financial system is highly integrated into the global financial system.

Indeed, in the event of a Greek default, the US economy would be materially impacted through several channels.

US exports to Europe could be adversely impacted by renewed recession in Europe and a weakening in the euro, as uncertainty intensified about the future of the currency.

A banking crisis in Europe would heighten risk aversion in global financial markets, which could see material declines in global equity prices and significant increases in global borrowing costs for corporations and households.

US financial markets could be materially unsettled by a European banking crisis in much the same way as the US banking crisis in 2008-09 sent ripples through Europe. While the direct exposure of US banks to the countries in the European periphery is very limited, the US financial system has considerable exposure to European banks. In particular, it is reported that the top ten money market funds in the United States have up to 50% exposure to the European banking system.

Follow up

This article is drawn from the Oxford Analytica Daily Brief® which analyses the regional and global implications of key geopolitical, economic, social, business and industrial developments. It provides government, corporate and financial clients with timely, authoritative analysis every business day.

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