-Jane Foley is research director of Forex.com. The opinions expressed are her own.-
Germany’s Finance Ministry this week denied a report in Le Monde that Germany, France and other countries were working on a package to rescue Greece. It seems that for now the official line from the grandfathers of European Monetary Union is that Greece can sort out its own budget deficit. The official line from the Greek government is much the same; it continues to maintain that it doesn’t need a bailout.
The problem with this is that this lacks credibility. The blowing out of the yield spreads on Greek government bonds over bunds and the price of credit default swaps are evidence of that. In the months after EMU, the 5 year Greek-bund spread was less than 200 bps. This week it was over 400 bps. Unless the impact of bond yields can be contained Greece loses a major incentive to stay within EMU.
As with many of the less well fiscally managed countries in the approach EMU in 1999, Greece benefitted hugely from convergence trades. Technically, the spread between Greek bond yields and Germany’s should have closed only after budgetary reform led to a much smaller budget deficit.
In practice what happened with many countries is that the market pre-empted the convergence trade and the countries which had previously suffered from high debt maintenance costs saw the burden of financing their deficits decline markedly. In turn the savings made on financing the deficit hid the fact that true budgetary reform was in certain cases avoided. Years of strong growth allowed the government in Greece to get away with it. That the recession has uncovered the cracks is not really a surprise.