Jun 12, 2015

By 5th June 2015, Greece was expected to pay £216m (€300m) to the IMF (International Monetary Fund) or default on its debt obligations. This is just the first in a series of obligations that Greece has to pay to its creditors, which is why – once again, speculation has been raised across the market that Greece must not only re-negotiate another deal with its creditors, but also exit from the Eurozone. In doing so however, there are far-reaching consequences both across international politics and the financial markets. What happens in Greece – does not just stay in Greece! Yet to further understand this, it is imperative to look at the history leading up until today from the moment that Greece joined the Euro. Also this is not the first time that Greece has come to the wire on defaulting nor would it be the first country to do so.

Greece joined the Eurozone in January 2001 when Greece officials reduced the budget deficit enough to satisfy the joining criteria set out in the Maastricht Treaty. A boom in public sector spending ensued, not least on the 2004 Athens Olympic Games, fuelled by increased access to capital and historically low interest rates.

Now it should be noted that at the time, many believed that Greece’s risk of default was low. This was due to the Euro being tied into other Member States’ much stronger economies, Germany in particular. In fact, the rating agencies were criticised for the blanket rating given to all countries across the monetary union, which masked the true risk of investments. As a result, Greece’s risk was deeply underestimated and when the financial crisis of 2008 hit, the level of public debt became unsustainable.

Arguably, Greece suffers from the twin deficits cycle that has long plagued the U.S. economy, with a growing budget and current account deficit caused by a weak export sector and low tax revenue. It also has to be factored in that high levels of tax evasion and corruption across the public sector meant that Greece was unable to meet its debt obligations through taxation.

Now, previously – prior to joining the Eurozone, the Greek Government had devalued the Drachma. This had reduced costs and boosted an ailing export sector. Unfortunately, Greece’s Eurozone membership removed such sovereign powers and they were unable to devalue the Euro. Additionally it should be mentioned that, for a country heavily reliant on tourism, being bound by a strong single currency was a disadvantage as their debt problem grew.

In late 2009, Greece’s debt surpassed €300bn, amounting to 113% of GDP. Subsequently, Greece’s credit rating was downgraded to below investment grade. This meant that it was no longer able to access capital on the open markets. In response, the Greek Government introduced austerity measures and requested assistance from the European Commission (EC), the IMF and the European Central Bank (ECB) – known cumulatively as the “Troika” (set of three).

This was the first in a long cycle of downgrades, bailouts and austerity measures, which caused great social tension and distress within Greece. The people of Greece came together in protest at their Government’s handling of their debt crisis.

In 2011, as part of a debt restructuring agreement, private investors agreed to a 50% reduction in the value of government bonds. It was initially feared that this might be considered a “Credit Event”, which would trigger the termination and settlement of a critical number of Credit Default Swaps (CDS’) and other ISDA OTC confirmations and Master Agreements, and cripple the French and German financial institutions that had significant exposure attached to Greek bonds.

As it transpired this did not trigger a “Credit Event”, as accepting the loss was voluntary. Yet Greece’s woes were far from over, and one year later a “Credit Event” was declared by ISDA (International Swaps and Derivatives Association); Greece enacted a collective action clause forcing nearly 96% of its investors to accept a more than 50% loss on bonds.

Even prior to the past two months (when Greece’s potential default has taken centre stage once more) the situation in Greece was not hopeful. There may have been a fall in unemployment and a €2bn reduction in national debt in 2014, but mounting tensions within Greece contributed to the election of Syriza – this is a party vehemently opposed to austerity.

Right now, the Greek Government is implementing tax reforms to combat evasion. It is doing this in order to increase revenues, whilst negotiating with the pro­austerity Troika on lending terms. It remains to be seen whether this will be sufficient to restore Greece’s prospects – the outlook? Doubtful.

A new deal with creditors seems more than likely and will surely have been made known by the time most are reading this article, but it will, by most informed observers’ opinions, be just yet another short-term fix to Greece’s overwhelming debt burdens. Surely, their colossus of debt is not sustainable in the long-term? Is not a Greek default at some point inevitable?

Assuming, for one moment that it is, does this automatically equate to a Greek exit from the Eurozone? Many believe that it does, and that default and “Grexit” are one in the same, but of course it does not necessarily mean this.

A “Grexit“ is likely only to occur if the ECB and national central banks stop the Emergency Liquid Assistance (ELA) programme that currently keeps Greece somewhat solvent. If they stop this, then a new currency would have to be adopted. However, this would cause significant practical difficulties as well as potentially expose weaknesses in the common currency.

Currently, Greece is party to 39 Bilateral Investment Treaties (BITs), Agreements establishing foreign direct investment relationships between two countries. These agreements are enforced under international law, and typically contain provisions protecting investors against expropriation and unfair treatment.

Now in the event that Greece reverts to the Drachma, the country will prove unable to honour its BITs because adopting this new currency would adversely affect covered investments. However, as mentioned earlier, should Greece default they would not be the first country to do so. This means that they would not be the first to test these constraints. Greece isn’t doing anything a country before it hasn’t already done.

When Argentina defaulted back in 2002, it broke its currency peg with the U.S. dollar. To date, Argentina has not repaid many of its debts and has caused its creditors to sue for 100% of their losses in litigation battles that are continuing to this day. Conversely, Russia quickly bounced back following its Sovereign default in 1998. Although it is worth noting that this was largely due to a boost in oil prices.

Where Greece does differ though to the other countries that have defaulted before, is that it has more to consider than just its investment arrangements with other countries. Greece has already begun haemorrhaging capital over fears of insolvency within the Greek banking system. Sadly, these fears tend to be self-fulfilling. Also a Greek default, also brings with it fear of contagion.

If investors become truly concerned about Greece and the risk of a default, the absence of capital controls, they may withdraw their capital from Greek banks. This could lead to bank insolvency and the subsequent failure of Greece’s entire banking system. However, a run on Greece could just be the start of things. How strong is the Eurozone? That is the fear, that was the plague of contagion in 2010 – that sent the markets tumbling, and it’s the constant fear every time Greece nearly defaults.

In 2010, many feared that insolvency in Greece would lead to contagion. Contagion being the idea thought that should Greece default, it would cause other banking systems in countries with similar financial problems to also collapse. Now while the problems did indeed spread to Ireland and Portugal in 2011, the damage was relatively well-contained following assistance from the European Authorities and their removal from the market. In 2015, the risk of contagion is considered to be low. Yet the threat of contagion still carries a very real threat.

Beyond a collapse of its own banking system, a Greek default could be problematic for a number of EU member countries’ governments and international institutions as well. Greek banks do not hold much of Greece’s debt; instead the country’s biggest creditors are EU governments, particularly Germany, the ECB, the European Financial Stability Facility (EFSF), and the IMF. Should Greece default this would not only trigger a collapse of its own banking system, but it may contribute to significant losses for major international institutions.

Given the real possibility of a Greek default, a controlled, managed, exit would be essential to mitigate market distress and any “domino effect” that might arise. The Treaty of Lisbon provides the EU with a protocol for countries to exit the Union, although it has never been used. After Greece’s first exit scare, experts from the IMF, ECB, and the EC began planning for this scenario, so should we be faced with the realisation of a “Grexit”, all parties involved should be better prepared to handle a somewhat smooth transition.

Regardless of the outcome of Greece’s default today, many will again question the regulation and legislation surrounding the financial situation. How can this continue to happen? Is more reform needed or on the way?

One of the biggest issues at stake here, and has been from the beginning, is clearly capital adequacy. Whilst Basel III aims to ensure that banks have sufficient capital and liquidity to prevent capital flight and over­leveraging, and also provides for stress-testing in regards to a bank’s ability to take a loss and remain in business, one would question – is this is sufficient to reign in or manage a Government? Greece seems so far under a mountain of debt and poorly made legislative decisions right now, that further legislations and regulation may not be their way out of this crisis.

A question to consider is; should Greece default and then leave the Eurozone as a result – if not today then at some point in the not too distant future, what are the immediate consequences on other financial intuitions?

Most notably there will be paperwork – lots and lots of paperwork. For every financial institution, both buy side and sell side, there will be contracts and agreements that will need to be amended. The likelihood is that ISDA would rally quickly and come together to create a protocol, to avoid the entire market having to re-paper on this issue. The likely approach would be to concentrate on your Greek counterparties first, as they carry your largest risk, and then contracts with other counterparties that reference Greek entities, clauses or references to Greece. In terms of re-papering, speed is of the essence and the volume of paper is vast.

Arguably the most urgent updates would be to the legal agreements, such as ISDA Master Agreements (MAs). These are lengthy, heavily negotiated documents that set forth standard terms for all transactions between two parties. Currently, MAs for Eurozone countries have provisions establishing the Euro as the payment currency. Should Greece exit the Euro and adopt a new currency, these MAs would be unenforceable, leaving lawyers and financiers to renegotiate terms for settling trades under tight deadlines.

In addition, Credit Support Annexes (CSA) that establish terms between two parties for posting and/or transferring collateral would have to be amended to reflect the currency change. Similarly, Global Master Repurchase Agreements (GMRAs) for repurchasing transactions would have to be amended. However, many recent GMRAs typically define the Euro, potentially locking in Greece to using Euros even if the national currency has changed. Most of these legacy agreements remain in paper form, currently deep in filing cabinets, will need to be digitised to quickly access the data and terms within them and equally to regenerate new agreements.

Predicting the exact course that the Greek economy will take and whether it will or will not leave the Eurozone is difficult, but what is certain is that legal service providers across the globe will have a hand in clearing through the paperwork chaos that a default and/or “Grexit” will create. A forced exit will expose the weakness of the single currency and pave the way for other countries to either leave or renegotiate their membership. A default, on the other hand, leaves regulators with little choice but to look at further regulation. The implementation, processing and remediation, of all of the above will likely be highly burdensome for the banks.

Whatever happens, for the people of Greece you can only hope that the purgatory of a continued cycle of ever-increasing debt, a continued tumult of living in fear of default, and constantly having the eyes of the world upon you, comes to an end sooner rather than later.