The Greek tragedy has taken another turn. It appears as though a new bailout package will be put in place so that Greece can continue to fund itself for the next two years. The new bailout will impose further restrictions on Greece; require deeper austerity measures, and greater privatization by the government.
When Greece got its first bailout, it was expected to more the sufficient to fund its deficits up to a point where Greece would be able to return to the markets to borrow. Unfortunately, Greece was not able to bring down its deficit as quickly as planned, and is still unable to borrow from the markets; current 2 year bond yields stand at 25%.
So why does Greece need a second bailout so soon after the first one? Why is the yield on Greek debt so high that the market practically expects a default to take place? In fact, the most recent S&P ratings downgrade puts Greece at one of the worse levels available. It is quite clear that the first bailout was a failure, and there is nothing to suggest the second one will succeed.
The reason the first bailout failed, and the second one will too, is that Greece is insolvent. For a bailout to work, they would have to be illiquid, rather than insolvent. An entity that is illiquid is one that is unable to raise funds in order to service its debt. But crucially, their debt level is not unsustainably high.
Greece, on the other hand, is insolvent. This means that its debt level is at an unsustainably high level. So it will not matter if they can borrow more in the form of a bailout, because it does not affect their overall debt level. A bailout is a case of using one credit card to pay off another.
The only way to solve this problem is to allow Greece to restructure their debts. If the debt is brought to a sustainable level, they will have an easier time servicing it, will not need further bailouts, and can get their economy out of recession. The Greek bondholders (i.e. European banks) have been extremely reluctant to allow this to occur.
The bondholders do not want to take a loss on their debt holdings; for fear that it will affect their own solvency. The European authorities also do not want this to occur because of fears that it could cause undue stress on their banks.
While these are legitimate concerns, there is unfortunately no other solution than for bondholders to incur some losses on their holdings. What the EU and IMF should be focused on is developing a debt restructuring solution for Greece that will cause minimal damage to European banks, while at the same time bring their debt down to a sustainable level. Restructuring will happen eventually, so the sooner this is done, the better.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!