The risk of Greece destabilizing the euro is diminished, but not gone

21 Jan 2013 by Jim Fickett.

Since Draghi promised that the ECB will “do whatever it takes”, markets have become a good deal more optimistic on the euro, and sovereign bond yields have come down considerably. Maybe everything really is fine now.

Or maybe not. The fact remains that Greece, and very likely others, still have unsustainable debt, and writing off some of that debt while keeping interest rates low will present considerable challenges for some time yet.

On Friday the IMF released a state-of-the-nation report on Greece with the catchy title of Greece: First and Second Reviews Under the Extended Arrangement Under the Extended Fund Facility, Request for Waiver of Applicability, Modification of Performance Criteria, and Rephasing of Access--Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Greece. If you like to curl up with a cup of coffee and 260 pages of in-depth, honest reporting, this is the report for you.

The IMF shows that that there has been some real progress in some areas – for example real wages have come down, making Greece more competitive, and euro-area banks have reduced their exposure to Greece, lessening contagion risks. However there are also major areas which have seen almost no progress, for example attempts to reduce tax evasion, and the depth of the ongoing recession.

The IMF is straightforward in saying that contagion risks have come down, but remain significant.

Despite the evidence of reduced scope for spillovers, the potential euro area output cost of a Greek exit is fundamentally uncertain and of a very large magnitude in certain scenarios.

And again,

it is not possible to establish that contagion risk from euro exit would be limited and manageable.

The IMF points out that the ECB mechanism behind their promise to manage the markets has never been tested. The nightmare scenario is probably that (1) a combination of unsustainable interest costs, northern European resistance to further bailouts, and political difficulties at home could cause Greece to leave the euro, (2) the resulting loss to the European rescue fund (the ESM) would cause its borrowing costs to rise, (3) this would lessen faith in rescue mechanisms and cause sovereign borrowing rates to rise once again for Spain and Italy, once again putting them on the edge.

This is yet one more example of how the world's economic and financial health is dependent on central banks' ability to keep interest rates at irrationally low levels. Perhaps investor faith will continue as long as necessary. But the ongoing solution is fragile.