Plunging prices for Greek bonds signal investors expect the debt-swamped country will be forced to restructure its finances, despite the government's assurances it is on track to meet its obligations.
Yields for government of Greece two-year bonds hit 20 per cent Monday, the highest level since the euro was born a dozen years ago, showing that investors see a high risk of restructuring - forcing debt holders to accept less than they are owed.
The prospect of losses on Greek bonds has ramifications far beyond the country's own fiscal health, since European banks are major holders of the country's debt and the continent's financial system remains fragile in some areas.
Greek politicians and the country's central banker, however, insist that a restructuring is not under consideration.
"Such an option is neither necessary nor desirable," Bank of Greece governor George Provopoulos said Monday in his annual report on the Greek economy. "It is not necessary because we can meet our goals if we apply policies correctly. It is not desirable because it would have disastrous consequences on the access of the government and of businesses to international credit markets."
Greek government officials had a similar message early last year, when they denied that Greece required a bailout. They were proved wrong in April, when the country accepted a €110-billion ($150-billion) rescue package from the EU and the International Monetary Fund.
While most economists think Greece's burgeoning debt load is unsustainable, some say Europe's political leaders would not allow a restructuring any time soon because European banks are not strong enough yet to absorb a "haircut" on their Greek debt holdings. Deutsche Bank economist Mark Wall said bank exposure to Greek debt, while falling, "is still significant enough for politicians to think twice about creating a capital shortfall around the European banking system."
At last count, European banks still held the equivalent of $154-billion (U.S.) of sovereign and non-sovereign Greek debt, according to the Bank for International Settlements. While estimates of the size of any Greek debt restructuring vary greatly, Standard & Poor's last week suggested bond investors would lose 50 to 70 per cent of their holdings.
German Chancellor Angela Merkel last year pledged that her government, the single biggest sponsor of the EU's sovereign bailout funds, would not force debt restructurings until after mid-2013. Other EU leaders have similar positions.
But the positions may not rule out a voluntary and relatively small debt restructuring, such as the extension of bond maturities, combined with deeper government spending cuts in exchange for additional bailout loans.
Fears about unsustainable sovereign debt loads roiled the markets on Monday, sending bond yields up and stock markets down. The fears intensified when S&P downgraded its U.S. government debt outlook and a populist, anti-euro Finnish party, called True Finns, won 39 seats in parliament, up from five in the previous general election.
The party's strong showing will make it harder for the Finnish government to approve the Portuguese rescue package, currently under negotiation. EU bailouts require the approval of all 27 EU countries.
London's FTSE-100 index fell 2.1 per cent while the euro lost 1.3 per cent against the dollar, sending it to $1.422. The Greek restructuring rumours infected other weak EU countries. The yields on Spain's 10-year bonds rose to 5.6 per cent, near a record, while Portuguese yields surpassed 9.3 per cent, a new peak.
Economists think Greece would have to wipe out roughly half its overall debt of €325-billion if its finances are to become sustainable. The country's ratio of debt to gross domestic product is expected to hit 150 per cent or more this year, up from 110 per cent in 2008, when the financial crisis hit. The average debt-to-GDP ratio in the euro zone, the 17 EU countries that share the euro, will be 86 per cent this year, according to the European Commission.
Greece's ability to pay its debt seems to diminish by the day. Deutsche Bank expects the Greek economy to shrink by 3.5 per cent this year as the austerity programs kick in, economic reform stalls, unemployment soars and Greek resistance to spending cuts gains momentum. On Monday, Greece's private sector umbrella union, with 800,000 members, called for a 24-hour strike on May 11 to protest the latest austerity measures.
Interest costs as a percentage of Greek GDP are expected to hit 9.2 per cent in 2014, up from 6.2 per cent last year. In Germany, interest costs are only 2.5 per cent of GDP.
On the weekend, Costas Simitis, the Greek prime minister from 1996 to 2004, said Greece had no choice but to restructure its debt. "A well-prepared restructuring will essentially improve our position," he said in an interview in the To Vima newspaper. "The longer it delays, the greater the debt that cannot be restructured."
Bond traders would agree with him. The cost of insuring Greek debt against default rose by 84 basis points (or 0.84 of a percentage point) to 1,220 basis points, according to Markit, a financial data company in London. That means it costs €122,000 to insure €1-million of exposure to Greek bonds. The high insurance price suggests that the chances of a default within five years are greater than 60 per cent.