Should Greece Remain in the Spotlight?

The sovereign debt-driven volatility of the last week doesn't begin to approach the roller-coaster ride of the summer of 2011, let alone late 2008. But the market remains skittish and laser-focused on what is happening in Greece. Recently, it seems that as the picture in Greece darkens or lightens, so does the market.

But does that make any sense? Greece is a small economy, dwarfed by other members of the European Union. At this point, is anyone really shocked that Greece can't pay back its creditors 100 cents on the euro or that the European community is deeply conflicted about dolling out unlimited aid? No. The market isn't focusing on the fact that Greece is in trouble. Instead, the spotlight is on the precedent that Greece is setting and its impact on larger economies.

Will It Work?
Greek's eventual default had been a fait accompli for sometime now. There is just no way that the economy could grow fast enough in order to pay back creditors on the original terms. The big question that was hanging over the market was if the default would be a chaotic mess or an orderly, polite affair. The debt-swap deal reached this week was an important step in reducing the chance of the disorderly option. Private debtholders were asked to swap their original debt for a new Greek bond, a bond backed by the European Financial Stability Facility and a warrant on future Greek gross domestic product growth. All in all, bondholders were asked to take around a substantial haircut from face value. The debt swap also opened the door to the next round of bailout money from the troika--European Union, International Monetary Fund, and European Central Bank--that Greece desperately needs to meet its short-term obligations.

These moves eliminated a lot of near-term uncertainty. Particularly, Greece now looks almost certain to make it past March 20, the date that a large tranche of debt was due, without major issue. So if much of the near-term fear is gone then why should Greece matter anymore? It matters because long-term structural problems remain. To name just a few: The Greek primary budget deficit remains large, meaning that the country still has to borrow and issue new debt to keep the lights on. Pension and other public-sector obligations remain enormous. Political will and popular support are both diminishing for the major austerity plans that need to take place. The economy isn't very competitive on the world stage, and without being able to devalue the country's currency, it is hard to compete on price. There is growing resentment that Greece is being forced to hand over its fiscal policy decisions to Brussels and Berlin.

Given these problems, the deal sealed this week hardly precludes the possibility of another default down the road. Even the EU projects that if everything goes right--one can guess on the chance of that happening--Greece's debt will stand at 120% of GDP by 2020. That's better than it is today but hardly a confidence-inspiring number. Greece could very well still leave the euro or suddenly default on its new obligations. Investors were right to cheer the current swap. It is a step in the right direction, but Greece is far from out of the woods.

Why Greece Matters
Greece might be small--it's GDP of $312 billion is around that of Washington state--but what happens there has a big impact of the rest of Europe. Sovereign debt defaults are rare in the developed world. Greece could end up setting important precedent for the endgame in other heavily indebted countries.

With a corporate bankruptcy, the rules of the game are fairly clear. Creditors have a decent understanding of where they stand, how the process will work, and the steps along the way. No such road map exists for Greece. How will the multitude of domestic and international political forces play out? How far is the European Central Bank willing to go to keep Greece in the euro? Are German voters willing to accept huge transfer payments to keep the European project going? How will the Greek citizens react to years of cuts and austerity? Add in the complexity of Greece being part of the euro, and there are a lot of open questions about how the entire process will play out down the road.

As these questions get answered, the market will have a better clue as to how the world is going to react to problems in other heavily indebted countries such as Italy, Spain, and Portugal. If Greece is able to blaze a path forward, one that barely causes a ripple in the financial markets, then there will be more confidence that Europe has the tools to deal with the other laggards. However, if the country fails to make progress or ends up defaulting in a disorderly fashion, the contagion could quickly spread to other countries that will be much more expensive to clean up.

Certainly every country's situation is different, and the process in Greece won't be replicated exactly elsewhere. But investors would be well-served to look at the continued problems in Greece as a small-scale preview of what could come.