The euro crisis and Greek debt

What you will learn

• Why a country inside the euro faces different debt risks from a country with its own currency
• The main stages of the crisis from 2009 to 2018, including rescue programmes and the 2012 Greek debt exchange
• How a nominal haircut on a bond is calculated
• Practical lessons on high yields, bank deposits and capital controls

Explanation

Bund yields and euro-area spreads are explained in the bonds course; this lesson uses them to read the history of the crisis.

Why the euro changed the risk

Sovereign debt is debt owed by a national government. A country with its own currency can, in an emergency, let its central bank create money or let the currency fall. Euro members cannot do either alone, because the European Central Bank (ECB) sets policy for the whole area. Debt in euros is therefore closer to debt in a foreign currency: if investors stop lending, the government can run out of cash.

A second problem is the sovereign-bank loop (often called the "doom loop"): domestic banks hold large amounts of their own government's bonds. When those bonds fall, banks weaken; when banks need rescue, government debt rises.

Key stages

What a haircut means

A haircut is a reduction in the amount a borrower must repay. A nominal haircut cuts the face value: New nominal = old nominal × (1 − haircut). In 2012, the new bonds also had longer maturities and lower coupons, so the loss in present-value terms was larger than 53.5%.

Lessons for private investors

• A very high yield is the market's price for a real chance of loss. It is not "extra income".
• Euro bank deposits are protected up to €100,000 per person and bank (see the personal finance course); Cyprus showed that amounts above that limit can be used to absorb losses.
• Capital controls can block payments and withdrawals for months; keeping all money in one bank and one country adds risk.
• Policy statements can change markets quickly: spreads fell after July 2012 even though the economic problems remained.

Worked example

Hypothetical example: a government must refinance €100 billion of debt. Assumption 1: it can borrow at 2%, close to a safe benchmark. Assumption 2: markets demand 7%. Fees and changes in debt size are excluded.

1. Spread = 7% − 2% = 5 percentage points = 500 basis points (1 basis point = 0.01 percentage point).
2. Annual interest at 2%: €100bn × 0.02 = €2 billion.
3. Annual interest at 7%: €100bn × 0.07 = €7 billion.
4. Extra cost: €7bn − €2bn = €5 billion per year on this debt alone, money that must come from tax rises or spending cuts, which can weaken the economy further.

Now a bondholder: a private investor holds €10,000 nominal of the old bonds. With a 53.5% nominal haircut, the new nominal is €10,000 × (1 − 0.535) = €4,650, before any further loss from lower coupons and longer maturities.

Common mistake

Practice activity

On paper: a hypothetical investor bought €20,000 nominal of a government bond at a price of 80 (80% of nominal). In a restructuring, the nominal is cut by 50%, and the new bonds trade at 40% of their new nominal. (1) What did the investor pay? (2) What is the new position worth? (3) What is the percentage loss? (4) Before the crisis the bond yielded 9.5% while the benchmark yielded 1.5%. What was the spread in basis points?

Key takeaways

• Euro members borrow in a currency they do not control, which makes a loss of market access more dangerous.
• Banks and governments can pull each other down through the sovereign-bank loop.
• Greek private bondholders accepted a 53.5% nominal haircut in 2012; a high yield was a signal of that risk.
• Deposit protection limits, bail-ins and capital controls are real crisis tools, so spread cash sensibly.

Next step

In the next lesson you will study the fastest crash in this course: the 2020 pandemic crash and its unusually quick recovery.