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How Greece's credit went south

- July 20, 2015

Pensioner talk with a bank employee as they wait outside the national bank of Greece to withdraw a maximum of 120 euros ($134) for the week in central Athens, Monday, July 13, 2015. (AP Photo/Emilio Morenatti)
The crisis between Greece and the euro zone appears to be reaching at least a temporary resolution. But if Greece finds itself back again in a year — as it has several times since the onset of the debt crisis — how might it raise funds outside the IMF and euro group?
If Greece tries to raise money by selling bonds to private investors, it is likely to find that its cost of borrowing is pretty high. Markets will demand a high premium, even though Greece has shown itself willing to pay back private investors before it pays back the euro-zone members. In part, this premium will come because Greece has lost a key advantage on bond markets. Investors used to give Greece favorable treatment because it was a member of the European Union and the euro zone. They used to treat Greece as though it was almost Germany. But since the debt crisis began in 2008, they’ve treated it as if it’s Greece.
People tend to think of portfolio investors as rationally evaluating countries based on their economic fundamentals.  But this isn’t always true. In my 2013 book, I show that particularly for middle-income countries, investors pay a lot of attention to the company states keep. When investors are trying to figure out whether a country is going to make good on its debt payments, they pay attention to the reputations of the other members of international clubs to which that country belongs.
As my research shows, the reputational boost that countries get from being in “good” international company has little to do with their actual track record of reform. Moreover, it isn’t that some international clubs are good at picking better performing countries to be members. Instead, some countries simply seem to get a reputational boost from hanging out with the right states, even if they may not be very good investment risks on their own merit.
Greece – like several other countries that joined the euro zone in the last decade – fits this pattern. Although some of the euro zone’s new members undertook substantial reforms to get their membership and often turned out to be strong economic performers, others botched or covered up the failures of their reforms. Hungary, for example, had a series of debt crises and scandals involving cooked books starting in the mid-2000s.
And yet throughout the 2000s, investors were willing to overlook these obvious shortfalls, asking for interest rates on Greek debt that were nearly as low as that of their European counterparts. It helped that the European Central Bank agreed early on to redeem securities from any country in the euro zone, which motivated investors to seek higher-yield debt in places like Greece and Italy, with the knowledge that they were all backed by the same ECB guarantee. And Germany and France themselves broke the rules of many of the mechanisms that they had set in place to ensure good behavior, such as the Stability and Growth Pact. Even so, Greece and many other euro-zone countries benefited greatly in the 2000s, simply because they were perceived as members in good standing of a prestigious club of states.
However, investors are now shedding that old presumption and assessing potential loans on the country’s merit alone. The turmoil in Greece today more accurately reflects the actual economic and political fundamentals of Greece’s situation.
The converse is also true: The reputations of creditworthy countries can also suffer when they associate with worse-performing countries. This may help explain why some European states seriously considered kicking Greece out of the euro zone. Germany fears the dilution of the euro-zone brand if it softens the line on economic reforms, even if those reforms might seem unrealistic. But middle-income countries have an incentive to try to stay in the club, as Greece’s abortive talks with Russia suggest. Even if Russia had given Greece money in the short run, it might have hurt Greece’s reputation in the long run to be associated with a regime with a dubious image among investors. The same reasoning could also help explain why Ukraine wanted to be associated with the European Union and not Russia.
This means Greece is in a bind. If it stays in the euro zone, which currently seems the more likely outcome, it will have to suffer through an extremely painful reform program in the hopes that its circumstances will improve. If it leaves, however, not only will it have damaged its own reputation since it will have to repudiate much or most of its debt, but it will also have given up any hope of regaining the luster of being a euro-zone member. Neither choice is especially appealing.
Julia Gray will be joining the International Relations department at the London School of Economics in the fall.
Read more about Greece and the euro at the Monkey Cage:
Matthew Gabel, What’s the matter with Greece? It can’t run the clean and effective government necessary for a healthy economy
Henry Farrell, The euro zone was supposed to strengthen European democracy. Instead, it’s undermining it
Henry Farrell, Other Europeans say they can’t trust Greece. The problem goes both ways.
Stefanie Walter, What were the Greeks thinking? Here’s a poll taken just before the referendum
Mark Copelovitch, Greece votes no. Is this the end for the Eurozone?
Nicholas Sambanis, Why the Greeks rejected Europe’s bailout 
Henry Farrell, Greece is less likely to get a deal after the referendum, but will get a better deal if it goes get one
Stathis Kalyvas: Why the Greek referendum is the referendum from hell
Amber Curtis, Joseph Jupille and David Leblang: Greece isn’t the first country to have a debt referendum. Does Iceland provide useful lessons?