You can only stretch a rubber-band  so much. At some point, it will give away and the point can be painful. The same applies to economies which run huge deficits and have to keep financing them by external debt. The debts are mostly perpetual – the old debt is refinanced by new and this can continue – so long as the gap between income and expenditure is under control (deficit of 3% is a good number according to EU norms). However, if you are running a deficit more than 4 times the norm – you will find yourselves in a hole, sooner or later.

Greece, which is a part of the Euro zone was supposed to follow the strict fiscal guidelines of the euro zone. However, corrupt officials, huge public spending and an outdated tax collection system meant that the deficit was well above 12%. On the top of that, the previous government misreported the figures giving the rest of Europeans a fall sense of belief that while things aren’t in shape, they will get better. As the new Government assumed office, the belief was shattered.

Greece today stands on a €300bn+ debt mountain and it will be a tall ask to get the house in order. For a start, it needs over €50bn before the 1st half of the year to avoid a default. The new Government has already started the so called reforms (by bringing down the 14,000 expenditure lines in the budget to 1000) and has promised to get back the deficit within the 3% limit by 2012. However it is easier said than done.

The tremors of Greek debt crisis are being felt all across Europe. Euro continues to slide and has touched $1.38 to a euro. Its getting weaker against the yen and other currencies as well. The same is happening to Swedish and Norwegian currencies. The reason is simple – lack of credibility, lack of confidence that all is right with the eurozone countries. Greece is having to borrow at pretty astronomical rates by European standards. The yield has touched 7.25% and the premium over German Bund is the highest since Greece adopted the Euro. The Greek PM may blame the “malicious forces” for the problems in the bond markets, but that doesn’t solve his problems. Also, the confidence in the oversubscribed €8bn issue seems to be misplaced as first its too small a amount in comparison to what he needs and secondly the rumors about Chinese buying into Greek debt may gave a hand in it.

The question then is what happens next? Will Greece default? Or will someone come to the rescue! The rest of the Eurozone countries are capable enough to help Greece, but they need to do it with caution. Definitely, the Germans and the French don’t want their people to believe that they have to save while others squander. Also, they don’t want other countries to feel that they can keep running their socialist agendas as the French and Germans will come save them when its needed. At the same time, the choices are limited. IMF as the lender of last resort can help Greece, but none in Eurozone want that. IMF help comes along with their own terms and conditions and IMFs interference in Eurozone is not acceptable to any. China with $2.5 trillion of forex reserves is another option, but they are clearly not interested. Chinese are conservative and Greek debt at this point is too risky. It serves none of their political ambitions as well. Chinese exposure to euro is about 20% or less of its total portfolio and they would like to keep it that way. Some analysts have also said that if the rest of Eurozone decides against doing much, Greece might become the 1st country to drop out of Euro. That’s one scenario everyone wants to avoid.

The problem however isn’t limited to Greece alone. Portugal, Ireland, Spain and a few others are running huge deficits as well and need to cut spending drastically to get to the 3% level. Anything that happens in Greece will have a domino effect in these countries and will impact the euro. That’s one disadvantage of tying so many countries with different growth rates to one common currency.

The confidence in euro is at an all time low and it will be an interesting next few weeks to see how it all pans out.

This article is authored by Saurabh Bagrodia. Saurabh is based in Amsterdam and handles Business Development (Banking and Capital Markets space) in Netherlands and Nordic countries for a global IT major. He had done MBA (Finance) from a top B-School in India.  He likes to follow the financial markets and is also interested in derivatives. You can contact him at saurabh.bagrodia@gmail.com