During the past two years there has been an increasing interest in the so-called “spreads”, that is, the yield differences between long term (10 year) Greek and German Euro government bonds. The German bonds are considered the de facto benchmark bond for the European Monetary Union (EMU) member countries. This is mostly due to three factors: a) the German bonds have consistently had the lowest yields amongst EMU countries; b) the German economy has a disproportionate size vis-á-vis that of the economies of the rest of the EMU member countries; c) Germany has traditionally exhibited fiscal discipline (at least, during the past few decades). These stylized facts explain why credit rating agencies have rated the German bonds with the highest possible (positive) grade. In particular, the 10-year German government bonds have held stable AAA ratings for many years (S&P since 17/03/1983, Moody's since 05/07/2000 and Fitch since 10/08/1994).
Spreads provide a strong indication as to the servicing cost of government deficits and the (re-)financing a country's debt. As Greece is burdened with a high level of debt (over 100% of GDP), even a tenth of a percent spread (10 b.p.) could increase government outlays by more than 0.1% of GDP in the medium term. For example, the 2009 government budget estimated that payments for interests would require about 4,6% of GDP. In fact, 5,2% of GDP was required, mainly due to the increased yields of Greek bonds.
As far as the historic development of Greek-German spreads is concerned, it should be pointed out that these were particularly low during the first years after Greece joined the EMU. In particular, during the period 2001-2007, spreads were on average 27 basis points (b.p.). During this period, Greece experienced high GDP growth rates which provided a very positive prospect for the future. However, in 2008 spreads started to increase and gradually rose from roughly 40 b.p. (February) to about 100 b.p. (October). The worst came during the November 2008 - April 2009 interval, during which there were dramatic changes and spreads oscillated between 220 b.p. and 300 b.p. (i.e. 296,8 b.p. on 23/1/09; 299 b.p. on 17/2/09; and 300,3 b.p. on 12/3/09). However, this sharp increase was mostly the outcome of a sharp decrease in the yields of German bonds, and - to a lesser extent - of increases of the yields of Greek bonds. In particular, there was an unprecedented drop in the yields of the German bonds from roughly 5,5% to 2,5%. This fall has been attributed to the liquidity crisis which resulted in panic leading investors to place their fortunes in the seemingly safe German bonds, a phenomenon which was named “flight-to-safety”. This exaggerated demand led to a fall in the relevant German bond yields, while at the same time there was also a (smaller) rise in the yields of the Greek and Irish bonds as the first signs of budgetary troubles had made their appearance. It was unfortunate for Greece that during this period of high spreads, its lending program was in full effect, which meant that the majority of the annual government lending was done at a very high cost. Following these few months of panic, spreads fell to the 110 - 160 b.p. range. This tendency was not affected by the announcement that the government deficit for 2009 was officially appreciated in October to have risen to 12,7% of GDP from about 5,2% in the preceding months.
However, towards the end of 2009 there was another large and abrupt increase in the spreads which was due to the downgrading of Greece's credit rating by all three major international credit agencies (Moody's, Fitch and S&P). This time, the increase in spreads was due to the fact that markets estimated that Greece did not correspond to the requirements of the European Committee for the adoption of measures that would permanently reduce the fiscal deficit. In other words, the increase in spreads was not the outcome of the level of the deficit and/or the debt of the country (in nominal terms) but of the future negative prospects concerning these variables. However, in contrast to the first spread increase, the lending program had been completed and therefore debt service was not influenced (with the exception of 2 billion euros at the very end of the year). The year 2009 ended with a seemingly “positive” report by Moody's (a downgrade of one level instead of the expected two levels), which led to a small reduction of the spreads.
The study of the development of Greek spreads shows that their fluctuations are not necessarily connected with the absolute levels of government debt and deficits. The sharp (mostly in accounting terms) increase in 2004 did not influence the medium-term trend of the spreads, and neither did the statement as to the 2009 deficit of 12,7%. Spreads are set in the secondary bond market which focuses mainly on the future prospects of the repayment of loans instead of the past and present of a country. This is also proved by the reports of credit rating agencies that support their rating decisions based on their projections concerning the main aggregates of an economy. Market participants are neither “vengeful” nor are they interested in “punishing” a country or a government. The main objective of the majority of investors is to price and buy financier products (e.g. bonds) based on the risk they undertake.
Moreover, the unfavourable developments regarding the Greek spreads and the deteriorating macroeconomic environment are probably influencing the potential and cost of lending for Greek financial institutions. During 2009, there was an increased issuing of government bonds as in the first nine months the value of issued bonds was 66,4 billion against 35,4 billion in the correlative period of 2008. The result was an important drain of commercial banks’ liquidity towards the Greek state since they now possess roughly 16% of all government bonds currently in circulation. According to the Greek Public Debt Management Agency, Greek banks are the main investors regarding government securities, while important investments have been also made by mutual funds, insurance companies and pension funds.
However, the maturity of the securities held by Greek banks are mostly medium term bonds (3-5 years) with an important percentage in long term bonds (10-15 years). The average maturity of the existing Greek state securities (roughly 8 years) is larger than the corresponding means of other European countries. The recent country credit rating downgrades will also directly influence the credit ratings of Greek banks which will also be influenced by the high exposure of Greek banks to government securities, the unfavourable developments in the macroeconomic environment and the deterioration of the quality of their portfolio.
It is extremely difficult to forecast future trends (especially short-term ones) of spreads as nowadays both the domestic and the international financial environment is very uncertain. There could be a random event that would lead to a new “flight-to-safety” (i.e. Dubai) which would increase the spreads. However, in any case, Greece can influence the medium-term spreads levels through a prudent budgetary policy, fiscal discipline and increased reliability of official statistical data. Furthermore, it is essential for Greece to adopt measures that will not only lead its economy out of recession but will also produce sustainable medium-term levels of economic growth.
Dr. Nikolaos Georgikopoulos is a Researcher at the Center for Planning and Economic Research (KEPE) in Athens, Greece. He is a visiting scholar at Stern School of Business, New York University and a member of the OECD - Financial Markets Committee.
Dr. Tilemahos Efthimiadis is a Researcher at KEPE. He is also an external partner at STORM Research Centre, London Metropolitan University.
(The opinions expressed in the article do not necessarily represent opinions of the aforementioned institutions).
By: N. Peter Kramer
