Friday, September 16, 2011

Greece is heading toward default – but what kind?

Greece is almost certain to default on its debts, but the type of default – and its impact on the markets, Europe and the world – is yet to play out.

A default can come in three different forms:

A “selective default”. Under the terms of the second bail-out, some creditors can roll over their debt and take a “hair-cut”, or losses on the money they are owed. This is done to protect against the possibility of greater losses in the future. It is limited, controlled and understood. Crucially, it is expected.

The greater fear is that Greece defaults on a much greater scale. An “orderly default” would be one that is planned for, so creditors – and the markets - are prepared and have a plan to deal with losses in the value of their investments. While markets will be volatile, there will be soothing statements from eurozone leaders and it will be controlled.

The worst case scenario is that Greece defaults outright and without warning. This is what people are referring to as a "disorderly default,” and that is the big fear. This would be hugely significant because it will almost certainly lead to contagion. It will not necessarily lead to Greece being kicked out of the euro, nor the collapse thereof. It will however pose fundamental questions about the foundations of the euro project. Market reaction could be as bad as when Lehman Brothers collapsed in 2008. more