Category Archives: Contagion

Contagion, Theory and Practice

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Here is a nice summary of the contagion factors in Europe. 

Contagion: Looking Ahead to Spain and Italy

The past week has been a busy one for people worried that the Greek debt
crisis will soon spread to other countries. Ireland and Portugal have
long been seen as susceptible to going the same way as Greece, but
recently Italy has joined the group of countries seen to be potentially
vulnerable.

So like many, I’ve been thinking a lot about
contagion this week. But even though it seems to be common knowledge in
the business press that if and when Greece defaults the crisis will
immediately deepen for other countries, cogent explanations for why that
might happen have been scarce. So I think it’s helpful to try to get
more specific about why we think the crisis might or might not spread
further to Spain or Italy. That will help us better understand whether
those fears are real or overblown.

Most of the economic
literature about contagion has focused on its applicability to currency
crises, such as the EMU crisis of 1992-3 or the “Asian Flu” of 1998.
However, the logic is similar when applied to sovereign debt crises. As
a reminder, here’s a list of some of the explanations that have been
put forward to explain previous episodes where financial crises spread
from country X to nearby and similar country Y:

  • a common external shock: whatever factor originally tipped country X into crisis has the same effect on country Y, so it will also push Y into crisis.
  • the “wake up call”: when
    country X enters a crisis investors suddenly reevaluate their
    portfolios for risk, and sell off assets related to any country similar
    to X, thereby precipitating a crisis for country Y.
  • liquidity concerns among common creditors: crisis
    in country X causes creditors (e.g. banks) to suffer losses that force
    them to sell off assets in country Y, precipitating a crisis in Y.
  • cross-market hedging among common creditors: crisis
    in country X means that the portfolio of creditors (e.g. banks) has
    suddenly become more risky on average, so they respond by reducing their
    risk exposure elsewhere in their portfolio, in part by selling off the
    assets of any similar country also seen as risky, such as Y.
  • political contagion: the
    actions taken to deal with the crisis in country X (e.g. dropping a
    fixed exchange rate, or in this case, default) make it less costly for
    country Y to do the same thing, and investors realize this, sell off the
    assets of country Y, and thus precipitate a crisis for country Y as
    well.

The thing that these mechanisms have in common is that
they all create a process of self-fulfilling expectations, where a loss
of investor demand or confidence causes a sell-off of assets, which
causes a crisis, which validates the original loss of confidence.

But
in the case of Greece, I don’t think that most of these sources of
contagion are of real concern, simply because the crisis has been drawn
out over such a long period of time now that investors and creditors
have all had plenty of time to expect and plan for a Greek default. So I
think that the only one of these possible sources of contagion that
might apply in this case is the last one, which for convenience I’ve
labeled “political contagion”.

If Greece is seen to default (and
it seems likely that however the EU chooses to package and label the
terms of the new Greek bailout, it will involve some sort of "soft
default"), then investors will have been provided a demonstration of how
a limited default could work for other euro countries. This poses an
enormous problem for European policymakers. Whatever new bailout and
debt restructuring they agree to for Greece — especially if it
substantially reduces the Greek debt burden going forward — could
prompt Ireland and Portugal to ask for the same terms. On the other
hand, if the terms of the Greek deal do not sufficiently reduce Greece’s
debt burden then the deal will have done nothing to resolve the
fundamental issue of insolvency, and policymakers will be right back
where they started at some point down the road.

But developments
in the financial markets over the past week have reminded everyone that
policymakers may need to worry less about Ireland and Portugal, and
instead be more far-sighted and consider first and foremost the impact
on Spain and Italy. Because when it comes to those two countries, it is
clear to everyone that if the debt crisis takes serious hold on them
then a financial crisis will become a financial catastrophe.

Paradoxically,
one way to help cut off the speculation in the financial markets that
Spain and Italy could at some point be candidates for bailouts and/or
debt restructuring would be for the EU and ECB to be relatively generous
with Greece. If the transfers to Greece from the core euro countries
are large – so large that they are difficult for France and Germany to
agree to – then investors will have to draw the conclusion that such a
deal could never, ever be applicable to Spain and Italy. Spain and
Italy are just too big, and the aid packages that worked for Greece
would never be feasible for them. While that wouldn’t necessarily stop
speculation that Spain and/or Italy might someday be unable to service
their debts, it would definitely stop speculation that they would ever
be candidates for a Greek-style managed default. And that might be
enough to help. 

Europe’s Big Fat Greek Default

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It seems tough to avoid.

First the facts,

1) The New York Times reports that "Eurostat, the European statistics agency, raised its estimate of the country’s budget deficit for last year to 13.6 percent of gross domestic product, above the Greek government’s recent estimate of 12.9 percent. The ratio of debt to G.D.P. stood at 115.1 percent, compared with the government’s estimate of 113.4 percent."

If the Greeks lost track of their accounts and this was an honest mistake that only Eurostat's forensic accounting uncovered, is is quite an indictment that the Greeks cannot even keep track of their debt. If they actually tried to hide more debts the situation is even worse. Either way, this turn of events does not look good. 

2)  The large debt immediately led to a lower debt rating. The same day "Moody’s Investors Service downgraded its assessment of Greek debt and suggested that more cuts might be on the way." Sure enough, only four days later Greek Bonds were downgraded to junk bond status and warned investors that "bondholders could face losses of up to 50 percent of their holdings" of Greek bonds. Government bonds as junk bonds is a novel concept in Europe. Lets just remind ourselves, a junk bond is a "non-investment grade, speculative grade bond. It has a high risk of default and pays a high interest rate to compensate speculators (not investors) to take on the extra risk. Stage 1 of a sovereign country's default is to have your bonds rated "junk" and be priced out of the normal investment asset market.  

3) Greece desperately needs a cash infusion. But there are two key problems: other countries, or even the IMF, are unwilling to help if they has a sense they'll never see their money again.  On the other hand strikes are shutting down the capital of Greece, as public services, schools and even hospitals were shut down to protest potential budget cuts or tax increases. While the airport is still open, the port near Athens is closed for days now. Not good for trade…

4) that was not the only news, Eurostat also reported that it has to correct its estimate of the Irish government deficit to 14.3 percent, compared with the 11.7 percent figure submitted by Dublin in December… The Spanish deficit for 2009 was projected to be in line with estimates earlier this year, at 11.2 percent of G.D.P., while the forecast for Portugal’s deficit was 9.4 percent. Another New York Times report suggests that "increasingly, investors wonder if Portugal, Spain and even Ireland may not be able to borrow the billions of dollars they need to finance their government spending." "As the European Union and the I.M.F. debate the politics of Greece’s laying off civil servants or persuading its doctors to pay income tax, it is becoming apparent that the international community may need to come up with a much larger sum to backstop not just Greece, but also Portugal and Spain. The number would be huge,” said Piero Ghezzi, an economist at Barclays Capital. “Ninety billion euros for Greece, 40 billion for Portugal and 350 billion for Spain — now we are talking real money. Mr. Rogoff says that the I.M.F. could commit as much as $200 billion to aid Greece, Portugal and Spain, but acknowledges that sum alone would not be enough."

5) Not having enough cash on hand for a bail out would signal the end of the Euro as we know it… 

Update 1: Martin Feldstein is willing to take bets

Update 2: Greek yields are through the roof. Here's the Financial Time quote:

Greece’s two-year borrowing costs are now higher than those of Argentina, at 8.8 per cent, and Venezuela, at 11 per cent, two countries that have been shunned by many international investors because of the mismanagement of their economies.

Investors said that the Greek bond market was now in effect pricing in a government default as two-year bond yields were trading more than 12 percentage points higher than German Bunds, Europe’s benchmark market.