MAF 306 - International Finance and Investment

Report on the Greek Debt Crisis

Executive Summary
This report was commissioned to examine the Greek debt crisis. It has been structured in three parts
the causes of the Greek debt crisis, the effects of the debt crisis on the wider Eurozone and
possible remedies for Greece, and a comparison of the current situation in Greece to previous
financial crises.
Part one includes background information on the events leading up to the Greek debt crisis, mainly
those surrounding Greece's entrance to the Eurozone. Likely causes of the crisis are detailed Greece's high levels of debt to GDP, high levels of inflation and irresponsible financial decisions.
Part two shows the impacts of the Greek debt crisis on the rest of the Eurozone. It examines the
historical value of the euro over the past 10 years and draws parallels between events of the debt
crisis and the fluctuation in currency value. The costs and benefits of the euro are evaluated, with
the lack of control of common monetary policy being highlighted as a major deficiency of using a
single currency. Pro-growth strategies for Greece are also suggested, including reforms to Greece's
labour market.
Part three compares the measures being implemented in Greece austerity measures, bailout
packages and debt swaps against the actions taken in during the Latin American debt crisis of the
1980s. The report concludes that austerity measures are ineffective at reducing a country's levels of
debt. Debt relief or debt rescheduling are recommended as a viable options for assisting Greece
with its debt management.

Table of contents
Introduction

pg.6

Part one: Background and causes of the Greek debt crisis

o Greece and the Eurozone
o What caused Greeces debt crisis?

pg.6
pg.6
pg.8

Part two: The effects of the Greek debt crisis on the Eurozone
o The European debt crisis
o The Greek crisis and the euro
o The result of a single currency
o Growth strategies for Greece

pg. 12
pg. 14
pg. 15
pg. 15

Part three: Historical comparisons between the Greek Debt Crisis

and the Latin American Debt Crisis
o Greece's latest bailout
o Latin American debt crisis
o Effectiveness of debt-reduction measures in Greece

pg. 17
pg. 17
pg. 18
pg. 19

Conclusion

pg. 20

References

pg. 22

Introduction
This report examines the debt crisis in Greece, from its beginnings in the early 2000s to the most
recent developments. The analysis conducted here is split into three distinct sections, with each part
examining a different aspect of the crisis. Part one provides background information to Greeces
entrance into the Eurozone, and investigates the initial causes of the Greek debt crisis. In part two,
the wider-reaching effects of the Greek crisis on both the euro and other members of the Euro are
explored and the strengths and weakness of the Eurozone are detailed. Potential economic growth
policies for Greece are also examined. Part three discusses the most recent developments of the
debt crisis, including the Euro summit in Brussels and the most recent bailout package. Greeces
current situation is compared to previous financial crises, and their economic repair measures are
critiqued. Finally, some recommendations are given for Greece heading into the future.

Part One: Background and causes of the Greek debt crisis

Greece and the Eurozone
In 2001, Greece entered the Eurozone. This action can be viewed as the starting point for Greek
debt crisis as, in order to join the Eurozone, Greece needed to meet the financial criteria given in the
Maastricht treaty (1992). The Maastricht Treaty outlines the requirements for European Union
member states who wished to become part of the Eurozone. These criteria include stipulations that
government debt could be no more than 60% of gross domestic product (GDP) and the government
budget deficit could not exceed 3% of GDP (Shapiro 2014). By entering the Eurozone, Greece
relinquished their use of the drachma and implemented the single currency of the Eurozone the
euro. The adoption of the euro gave the appearance of financial stability to Greece, counteracting its
historically high levels of inflation and lack of economic policy credibility (Ladvas, Litsas & Skiadas
2014). Most significantly, the adoption of the euro gave Greece greater access to private debt
markets (Kouretas 2010). Greece was able to increase their ability to borrow and lend at longer

horizons. This led to an increase in private investment and robust real growth rates of 3.9 per cent
per year over the period 2001-2008 (Robbins 2015).
In 2009 it was revealed that Greece had been hiding the extent of their budget deficit in order to
meet the criteria of the Maastricht Treaty. Prior to the election of George Papandreou on October 4
2009, the government of Greece reported what was considered a relatively modest fiscal deficit 3.7% of GDP (Tiersky & Jones 2014). However, following the election, it became clear that Greece's
financial situation was far worse than previously claimed. It was revealed that the 2009 deficit was
15.4%, well above the previous estimate of 3.7%. It soon became apparent that this data had been
misreported rather than incorrectly estimated, and Greece's government had been "cooking the
books" for some time (Kouretas 2010). At this point, Greece was burdened with debt amounting to
113% of GDP - nearly double the Eurozone limit of 60% (Fig 1.1)
Figure 1.1: Greeces deficit and debt as a percentage of GDP

Source: World Data Bank

The announcement that Greece had been understating its deficit seriously damaged the countrys
international economic reputation. The three largest Credit Rating AgenciesStandard and Poors,
Moodys, and Fitchrepeatedly downgraded their rating of Greek government debt. Greeces debt
5

dropped from a triple A debt rating to a C-; junk bonds (Phillips, 2015). Serious concerns were raised
about Greeces ability to service its debt (Krugman 2011) and speculation arose regarding a possible
exit from the Eurozone(Arghyrou & Tsoukalas 2011). On 23 April 2010, the Managing Director of the
International Monetary Fund (IMF) announced that Greece made a request for a Stand-By
Arrangement; a financial assistance package to assist Greece with their debt repayments. On 2 May
2010, after days of negotiations, the IMF, the European Commission (EC) and the European Central
Bank (EBC) informally known as the troika - agreed on a three-year 110bn bailout package to
rescue Greece. This package was to be the first of three bailout packages that Greece has received
so far.
What caused Greeces debt crisis?
Greeces inclusion in the Eurozone has long been considered a mistake. In 2004 it was revealed
through close scrutiny of Greeces budget figures that the country had never fulfilled the terms of
the Maastricht Treaty (Pascual & Ghezzi 2011). One of the major purposes of the Maastrich Treaty
was to ensure that all members of the Eurozone had similar financial policies, levels of debt and
inflation. Monetary policy for all members of the Eurozone would then be dictated by the ECB. But
by applying a common monetary policy to countries with widely varying fiscal policies, serious
financial issues arose, such as a large spread of inflation rates across the Eurozone countries (Fig.
1.2). For Greece in particular, inflation rates rose dramatically, which led to a decrease in
competitiveness. The normal counter to high inflation rates is currency devaluation, but due to the
use of a single currency, this was not an action Greece was able to take. The decrease in Greeces
competitiveness led to a decrease in exports, leading to an overall trade deficit account (Fig 1.3).

Figure 1.2: Spread of inflation rates within the Eurozone

Source: Pictet WM AA&MR Datastream

Figure 1.3: Value of imports and exports of Greece (in million )

Source: Bank of Greece, Trade Balance (annual)

Another significant contributing factor is Greeces government; its irresponsible fiscal policies and
poor macroeconomic choices (Arghyrou & Tsoukalas 2011). For a government with a large deficit,
social spending was high. Expenditures included: a generous public welfare system, with full pension
7

payments made to early retirees, and full benefits and subsidies available to the unemployed (Fig.
1.4); low tax rates and high levels of tax evasion; over-employment, low productivity and high wages
within the public sector (Labrianidis & Vogiatzis 2013). Up until 2007, the government's expenditure
increased by 87%, while revenues grew only 31% (Ari 2014). This led to a large push to implement
austerity measures, from both the Greek government and Greeces creditors. These consisted of
cuts to wages, employment and tax increases. These cuts have been cited as extensively contributing
to Greeces plummeting GDP (Fig 1.5) (Krugman) (Arghyrou & Tsoukalas 2011).
Figure 1.4: Greeces levels of unemployment

Source: Thomas Reuters Data Stream

Figure 1.5: GDP in the Eurozone

Source: Thomas Reuters Data Stream

The high levels of debt and uncertainty caused yields on Greek government bonds to soar. Prior to
2008, the spread between Greek and German 10 year government bonds - widely regarded as the
safest bonds within the Eurozone (Krugman 2011) - was very small, ranging between 10 30 basis
points. After the news of Greeces levels of debt became public, financial markets started raising
interest rates in the fall of 2008 to compensate for the heightened risk of default (Tiersky 2015). By
January 2012, the yield spread between German and Greek debt had increased by 3,300 basis points
(Figure 1.6.). These high interest rates, reflecting Greeces high level of default risk, effectively
excluded Greece access from the bond markets (Ari 2014). Faced with upcoming debt repayment,
the Greek government was forced to turn to the IMF and the Euro Commission for assistance.
Greeces bailout package was the first of many in what would become known as the European debt
crisis.

Figure 1.6: Yield on 10Y Greece government bonds v yield on 10Y German government bonds

Source: Atlas Data Bank

Part Two The effects of the Greek debt crisis on the Eurozone
The European debt crisis
Although Greeces GDP only made up 2% of the overall GDP of the EY, the concerns and lack of
confidence were still significant enough to impact other members of the Eurozone (Lapavitsas,
2012). After Greeces request for a stand-by arrangement, other heavily indebted nations in the
Eurozone - Portugal, Ireland, Italy and Spain, (known collectively with Greece as the PIIGS) came
under more intense scrutiny. Ireland, Portugal and Spain all received some form of assistance from
the EU (Tiersky 2015).
From looking at Fig. 2.1, it can be seen that Greeces ratio of government debt to GDP and budget
deficit to GDP were considerably higher than the other Eurozone nations. This data helps to explain
why even though all of the PIIGS had budget deficits, Greece was so severely affected.

10

Figure 2.1: Levels of government debt and budget deficit as a percentage of GDP

Source: Shapiro, 2014

The initial bailout package Greece received allowed them to make the necessary repayments to their
creditors on time and avoid a default. However, by 2012 Greeces debt was 152% of GDP and their
GDP in decline. It was becoming obvious that Greece had a level of debt that they would not be able
to repay, at least not within their specified time frames (Pascual &Ghezzi 2011). Although the 2012
bailout package included a haircut on their private sector bonds, removing approximately 107
billion from their debt total, it also gave them an additional loan of 130 billion (Robbins 2015). The
more assistance Greece received from the troika, the more their debt levels rose, and the more
unlikely it became they would be able to repay their debts.
Two alternatives existed: either forgive or reschedule some or all of Greeces debt, or allow Greece
to default. By forgiving Greeces debts, a dangerous precedent would be set for the other indebted
nations. However, by allowing Greece to default on its debts - making it the first advanced economy
to default on IMF loans - Greece would effectively exit the Eurozone. Either option would create
further instability and uncertainty in the already suffering Eurozone countries.

11

The Greek crisis and the euro

Figure 2.2: Historical valuation of USD per 1 EUR

Source: Atlas Data Bank

Looking at Fig. 2.2 above, it can be seen that while major events took place in Greece in regards to
its debt crisis, there was also a simultaneous adverse effect on the euro currency. Substantial drops
in value can be linked back to specific incidents with the implementation of the first and second
bailout packages having a significant negative effect on the euro. This was in no small part due to
growing concerns by investors regarding the future of Greece, its risk of default and its ongoing
place in the Eurozone. The most considerable decrease occurs at the end of 2014, with the euro
nearly reaching parity with the US dollar. This could likely be in response to the ECBs drastic rate
cuts (Detrixhe 2014). Along with the mounting fears that Greece would default and exit the euro,
investors and economists alike believed that this crisis was also an indicator of the lack of stability
within the Eurozone (Tiersky & Jones 2015). Many were wondering whether the creation of the
Eurozone and the use of a single currency was the right choice in the first place (Morley 2015).

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The result of the single currency

There are many benefits to the Eurozone and the implementation of a single currency: tax-free
trade among members, freedom of movement around the Eurozone, simpler and cheaper trade with
a single currency and a single market and the promotion of peace and unity between countries as a
condition of being a member (Ladvas & Litsas 2012).
As illustrated by the Greek debt crisis, there are also many disadvantages. First among these is the
binding of monetary policy to a single central bank, the ECB. By refusing countries control over their
monetary policy, but allowing them to dictate their own fiscal policies, problems arise of disparate
inflation rates, levels of debt and government expenditure arise (Ladvas, Litsas & Skiadas 2014). The
structural differences in how each country operates aggregate productivity, price and wage
competitiveness - impacted the effectiveness of the common monetary policy. Over time, this
created macroeconomic imbalances within the Union, which in turn directly affected levels of
employment and external balances (Ari 2014).
The ongoing events of the European debt crisis have also had a significant financial impact on the
stronger performing nations within the Eurozone, with the amount spent on debt bailout and
financial relief packages totaling billions of euros (Arghyrou & Tsoukalas 2011). As the economic
difficulties suffered by the PIIGS are seen as the result of years of reckless spending, fiscally
responsible nations, such as Germany and France are reluctant to spend their tax-payer dollars on
bailout packages (Mayeda & 2015). Yet the alternative - allowing nations to default on their loans
and exit the Eurozone - would have devastating economic consequences (Ari 2015). Thus far,
Greece's exit from the Eurozone has not been discussed as a viable option.
Growth strategies for Greece
If Greece is to stay within the Eurozone and attempt to repay their debt, options for economic
growth need to be considered. Traditionally, when a country is suffering the similar financial woes
13

as Greece - overvalued currency, high inflation, low economic competitiveness - the safety valve is
currency control. By devaluing their currency, Greece would be able to reduce their inflation,
increase competition and strengthen their economy (Krugman 2011). Given monetary policy is
shared by all countries and controlled by the ECB, this is not an option. Another alternative would be
to increase spending. Keynesian economics shows that in times of budget deficit, an increase in
spending will actually boost the economy, allowing for debts to be repaid faster (Blinder 2008).
However, as Greece's debt levels are already unsustainably high at nearly 180% of GDP, further
spending is viewed unfavourably by Greece's creditors (Gopal 2015). As Greece also has a low level
of tax collection - with tax evasion costing the Greek government at least 10% of GDP each year
(Gimein 2012) - attempting to raise revenue by increases taxes is unlikely to be successful.
The most successful strategy for growth within Greece is likely to come from major reforms to their
labour market. Although structural changes to an economy as a whole generally take a long time to
produce positive results, structural changes to labor market tend yield results relatively quickly
(Petrakis 2014). Greece's major problems with their labour market include high wages, low export
value and high tax evasion practices.
Between 2000 and 2011, the level of minimum wage was increased by almost 60% (Karamanis &
Naxakis 2014). High minimum wages affects youth employment, as employers are reluctant to
employ workers once they reach the level of minimum wage. This either results in employees being
terminated and replaced by younger and cheaper employees, or employers paying wages in cash to
cut costs (Petrakis 2014) Reducing wages will increase the involvement of youth and the long-term
unemployed in the labour force.
The increase in wages has also increased the prices of exports, reducing their overall
competitiveness and lowering Greece's net exports. The reduction of wages will also help to target
this. Analysis of the Greek economy shows there is excessive activity in sectors creating products
which are not internationally tradable, such as real estate, restaurants and construction (IMF 2013).
14

The Greek government needs to encourage people to move away from these non-tradable sectors,
which have historically been considered 'safe' investments, and instead create incentives for workers
and employers to invest in internationally tradable goods such as new technologies. This will boost
Greece's overall domestic growth, while effectively targeting their low export levels (Malliaropulos &
Anastasatos 2011)
Finally, Greece's taxation system needs to undergo significant reforms. Tax evasion in Greece has a
high value relative to GDP evaded taxes were estimated at nearly 25% of GDP in 2012 (Gimein
2012) and Greece has the lowest public receipts of all Eurozone members. This tax evasion
contributes significantly to the annual budget deficits and the extremely high level of public debt.
The primary source of this shortfall is personal income taxation (Mitsopoulos & Pelagidis 2011).
Rather than focusing on increasing taxes, as suggested by Greece's creditors, it would be much more
beneficial to Greece to make changes to their taxation system that reduce tax evasion. With
effective tax reform, Greece could recoup approximately 30 billion each year (Gimein 2012).
Greece has yet to effectively implement any strategies that are focused solely on promotion of
economic growth. Reforms that have been implemented thus far tend to revolve around fiscal
adjustment and debt reduction measures, such as cuts to spending and tax increases. The overall
result of these measures - generally termed austerity measures - will be examined in part three, with
reference to the Latin American debt crisis.

Part three: Historical comparisons between the Greek Debt Crisis and the Latin American
Debt Crisis
Greeces latest bailout
Despite the bailout packages received since 2010, Greece continues to fall into larger debt, while its
economy has shrunk by 25% in the last five years. On July 12 2015, Greek Prime Minister Alexis
15

Tsipras met with the International Monetary Fund (IMF), the European Central Bank (ECB) and the
leaders of the other Eurozone members to discuss the terms of a third bailout package for Greece.
The third bailout package was a direct result of Greece missing the deadline for a 1.5 billion
payment to the IMF. After lengthy negotiations, it was established that Greece would receive a
bailout package of approximately 80 billion in exchange for agreeing to implement further political
and economic reforms (Euro Summit 2015). The major elements of this reform included: reforms to
the value added tax (VAT) system and increasing revenue by broadening the tax base from 13% to
23%; restructuring the Greek pension program; and the ongoing privatisation of Greek assets ports
and airports - and the sale of broadcast and telecoms spectrum rights (Euro Summit 2015)
The Latin American Debt Crisis
Before evaluating the effectiveness of the debt reduction methods currently being undertaken in
Greece, it is worthwhile considering the details of the Latin American debt crisis:
Since the 1960s, US banks had been lending heavily to Latin American countries such as Brazil,
Argentina and Mexico. However, due to a worldwide recession, drastically increased oil prices and
reduced export prices, both Latin American current account deficits and net external borrowing
grew steadily from 1977 until 1982, until the Latin American region had levels of debt at 50 percent
of GDP (Pastor 1989). Following the realisation that they were unable to service their debts, many
countries implemented austerity measures, and cut spending on infrastructure, education and
health, froze wages and fired public sector employees (Sims & Romero 2013). The result was high
unemployment, steep declines in per capita income, and stagnant or negative GDP growth (Carrasco
1999). By 1989, it became clear to the US government that the Latin American countries would be
unable to simultaneously repay their debt and stimulate economic growth
In 1989, the new Secretary of the Treasury, Nicholas Brady, announced that the only way to address
the sovereign debt crisis was to encourage the banks to engage in voluntary debt-reduction

16

schemes (Carrasco 1999). Banks had a choice of three options, such as exchanging their existing
loans for 30-year debt-reduction bonds that would provide a discount of 35 percent of face value
(Vsque 1999). These debt-reduction schemes served as a vehicle for debt-relief, with over $60
billion in loans being forgiven between 1989 and 1994 (Sims 2013). In exchange for the debt relief,
the eighteen countries that agreed to the Brady Plan also agreed to economic reforms that would
allow them to service their remaining debt (FDIC 1997).
Effectiveness of debt-reduction measures in Greece
There are many similarities than can be drawn between the Latin American debt crisis of the 1980s,
and the current debt crisis in Greece (Sims & Romero 2013). The situation in Latin American was a
real-life example showing why austerity measures do not help a country in times of economic
downturn. Yet Greeces creditors still insist the strict implementation of austerity measures as a
condition of the bailout packages. Without the maintenance of government services and nationwide infrastructure, Greece's economy will increasingly shrink (Krugman 2013). This means Greece
debt burden increase over time, rather than decreasing. This is especially likely given the country's
GDP has already fallen by 40% since 2009 (IMF 2012). Furthermore, Greece has taken new debt in
the form of additional bailout packages while being told to reduce its existing debt by spending
significantly less. From this combination of factors, it seems highly unlikely that the debt will ever be
repaid.
A recent IMF analysis estimated Greeces debt will peak at close to 200% of GDP in the next two
years (Bloomberg 2015). The IMF admitted that that it massively understated the damage that
spending cuts inflict on a weak economy (2012) and that Greeces debt is currently unmanageable.
The most recent report from the IMF (2015) states that further concessions are necessary for debt
sustainability. The bond swaps of 2012 were the beginning of this, with approximately 107 billion
being removed from Greece's privately held debt approximately 30% of their overall debt (RBA

17

2012). As the bond swap coincided with a second bailout package, Greeces debt to GDP ratio
remained largely unchanged (RBA 2012).
The typical bond swap deal undertaken during the Latin American debt crisis led to about 30 to 35
percent forgiveness of a countrys debt (Vsque 1999). While the average debt of countries in the
Latin American debt crisis was approximately 50% of GDP, Greeces debt is nearly four times that
size. Despite their reservations, the troika, specifically the Eurozone leaders, need to start
considering debt relief as viable option.
Debt relief for Greecewhich has to mean a reduction in the face value of the debt owed, rather
than just another extension of repayment deadlineswould reduce the current pressure for
austerity by making Greeces debt load more sustainable. This would then allow Greece to pursue a
larger range of growth strategies, such as investment in infrastructure and creation of jobs. If any
lesson can be taken away from the Latin American debt crisis, it is the reality that no debtor can
continue paying its creditors without economic growth (Girn & Solorza 2015)

Conclusion
With hindsight, it can be seen that Greece's entrance into the Eurozone was a highly problematic
endeavour. Greece never truly met the required financial criteria and, once inside, their access to
cheap debt markets led to irresponsible spending and unsustainably high levels of debt. Greece's
debt crisis had wide reaching effects on Eurozone members, including drastically impacting on the
overall value of the euro and costing billions of euros in bailout packages.
Yet Greece's exit from the Eurozone would cause massive financial turbulence that would impact
financial markets worldwide. To this end, bailout packages are still being implemented.
Unfortunately, the austerity measures that accompany these packages serve only to slow Greece's
economic growth and increase their levels of debt. Greater emphasis needs to be placed on pro-

18

growth strategies, such as labour market and taxation reform, in order to assistance Greece's
economic recovery. Debt rescheduling and relief will also need to need to be reconsidered, as under
current conditions, it is unlikely that Greece will ever repay its debts.

19

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