What might happen in Greece?

Greece’s financial difficulties keep getting worse. Fitch has just downgraded its credit rating to BBB+, creating fresh jitters in financial markets. On Monday Standard & Poor’s warned it might do the same. The combined effect will be to raise further Athens’ cost of borrowing - and maybe accelerate the pace of events in one of the eurozone’s weakest economies, where the new Socialist government faces a massive challenge in bringing public finances under control. Remember, this is happening a eurozone country – so it is a big test, too, for European Union authorities.

A significant risk is that Greek assets become ineligible for use as collateral at the European Central Bank. Until October 2008, the minimum requirement was an A- rating. As the financial market crisis intensified, that was lowered to BBB-. The relaxation was meant to be temporary and, in theory, expires at the end of 2010. But my hunch is that the ECB governing council would not raise collateral requirements in full knowledge that its action would exclude the assets of a eurozone member state. Such a move would be seen as highly political.

So what happens next? Maybe other eurozone governments will rally around? This happened in February, when Peer Steinbrück, then Germany’s finance minister, admitted that in a worst-case “we would have to take action”. His comments indicated ways could be found to get around the eurozone’s supposed “no-bailout” clause, which prevents collective liability for debts incurred by a member.

But a lot has happened since then. Most importantly, the financial market crisis has eased and worries have emerged of “moral hazard” – rewarding bad behaviour. I wrote last week about the “game of chicken” that is going on. Other eurozone governments, the European Commission and the ECB appear keen to push Greece as hard as they can.

Would they, in an extreme case, push Greece into default or the hands of the International Monetary Fund? Again my hunch is that they will not, because the knock-on effects for the rest of the eurozone would be massive. The point is that nobody really knows.

One thing is clear: whatever the noises in financial markets, the eurozone is not about to break up. Even if it were possible practically, exiting the eurozone and devaluing would only multiply Greece’s problems by escalating the cost of servicing foreign debt.

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