Thursday 16 Aug 2018 | 02:24 | SYDNEY
Thursday 16 Aug 2018 | 02:24 | SYDNEY

Euro: Interest rates must reflect risk


Stephen Grenville

7 November 2011 14:03

Everyone now agrees that Greek debt is worth less than half its face value. The puzzle is why until early last year it was treated as being almost identical to debt issued by Germany. It's not as if Greek policy suddenly did something unexpectedly foolish, or even that its banks were found to be insolvent and in need of government bail-out (as was the case in Ireland).

Until Greece joined the euro, it had to pay double-digit interest rates to borrow, because the market understood that it was a dubious credit risk. Why did that change when Greece joined the euro? Whatever fiddling was done with the budget figures to meet the euro entry requirements, financial markets knew that Greeks were shy taxpayers with a generous welfare state, and it was no secret thereafter that the budget was continuously in substantial deficit.

Did this interest-rate convergence occur because the market reasoned that the euro countries would never let one of their members default? The euro rules explicitly precluded this.

Perhaps the market was betting that, despite the prohibition, the euro countries could be persuaded to bail out Greece. In this, they came very close to succeeding. During this drama, almost all the parties have been ready to endorse the idea that sovereigns always pay.

The other southern Europeans, under extreme threat themselves, are clear supporters. The creditors of these countries are loudly reminding the policy-makers of the dangers of contagion. The European Central Bank, with perhaps €50 billion of Greek debt on its balance sheet, has never supported debt rescheduling. The Greek Government has no interest in declaring default so long as they are receiving new funds from the bail-out package.

It might actually be in the interests of the Greek people to reschedule and start again with a manageable debt load. Iceland has demonstrated that a new government can quickly re-establish credibility after total default. It's also possible that a Greek default is in the interests of the world economy, accepting a once-off hit to confidence rather than the current (and prospective) death-by-a-thousand- cuts.

This would, at least, restore the market assessment of sovereign debt to a sensible basis. Rather than attempt to maintain the pretence that all euro sovereign debt is equally strong, markets could get back to where they should have been ever since Greece joined the euro. It had a common currency with Germany, but debt issued by the Greek Government was not the same as debt issued by Germany and would require higher yields. With this reality established, rescheduling would not seem so inconceivable.

Instead of this painful but feasible path, commentators are grappling with the idea of moving towards a fiscal union in which all debt would be backed by the euro area as a whole. Such as fiscal union seems decades away, and the Greek problem is here today.

Europe has, perforce, moved beyond the strange and anomalous convergence of interest rates that occurred as the euro was formed. This is a positive step. Now that Italy has to pay a yield that reflects the risks of default, the incentives for fiscal rectitude are in the right place.

Some are blaming the Basel II prudential rules for the anomalous market valuation of euro debt. This seems a lame excuse. True, these rules applied a zero-risk weight for all sovereign debt. But that was only because Basel didn't want to get into the business of rating sovereigns. The market has never had any trouble distinguishing between good and not-so-good sovereigns outside Europe. What happened with the market evaluation of euro debt has to be squarely blamed on the market itself.

Photo by Flickr user alles-schlumpf.