The Greek Saga


06/08/2011 By Dr. Harald Malmgren

In June, Eurozone finance ministers continue to be engaged in desperate efforts to reach consensus on how another bailout of Greece should be designed.  One might ask why it is so hard to reach agreement, and if it is so hard, why not simply let Greece default?

The simple answer is that a Greek default would put into doubt the sovereign debt of other Eurozone governments.  The ECB is totally opposed to any form of “restructuring” of any sovereign debt, as this would imply some kind of “haircut” for holders of all sovereign debt.

The primary sovereign debt holders are most of the banks in the Eurozone and the ECB itself.  Eurozone banks are already undercapitalized relative to the standards being devised under Basle III.  Eurozone governments have lately been vigorously resisting implementation of tougher capital standards generated by the designers of Basle III.  The same governments have resisted mark-to-market valuations of sovereign debt held by banks in EU stress tests imposed on European banks.

When some Germans argue that “investors” should share in the burden of further bailouts, it should be understood that the principal “investors” are Eurozone banks and the ECB.  Moreover, the German, French, Italian, and other banks own not only the sovereign debt of their own governments, but also the debt of other Euro member governments.

For several years many Eurozone banks became eager buyers of sovereign debt of any Euro member that provided higher yields, on the assumption that default would simply not be allowed for any Euro member sovereign debt security.  When Euro cash was needed, Eurozone banks could provide sovereign debt securities of any Euro member country as collateral for short-term lending by the ECB, making such securities almost as good as cash (a small haircut would be imposed on cash loans).  In effect, the ECB generated Euros on the backing of dubious sovereign debt.

This would not be such a problem but for one distinctive feature of the Eurozone financial market:  European businesses are far more bank-dependent than businesses in the US and a number of other countries.

If Eurozone banks are confronted with deep cuts in the value of their holdings of sovereign debt they would have to be recapitalized.  Raising capital would be costly and would have to be undertaken in direct competition against Eurozone governments with substantial capital raising requirements of their own.

Crowding out would damage many Eurozone banks.  If capital could not be raised, the alternative would be to shrink the loan book, halting lending and calling in outstanding loans, so as to reduce the ratio of capital to assets.

In other words, a default of any sovereign debt security would set in motion a massive requirement for recapitalizing the entire Eurozone banking sector.  That would likely require more than a trillion Euros.  Even then, a fall into recession would most likely be accompanied by massive contraction of lending.

Having that horrific alternative outcome in mind, topping up bailouts of Greece and other peripheral Euro member states with another €100 billion or more in the near future seems to European politicians as less risky and far less costly than a trillion Euro recapitalization of the entire Eurozone banking system.  “Kicking the can down the road” continues to be preferred over a Eurozone-wide recapitalization of all banks and the ECB.

Following the global market financial crisis of 2007-2008, Eurozone governments chose to avoid needed recapitalization of its banks and of the ECB.  While the US and UK governments went ahead with significant restructuring of financial institutions, the Continental Europeans avoided any meaningful action out of fear that recapitalizing banks would drag the Eurozone bank-dependent economies into deep, prolonged recession.

Now in June a frantic effort is under way to craft yet another bailout of Greece.  A likely bailout would include additional conditions that the Greek government must meet, including substantial privatization of major government enterprises and services (with deep job cuts) under the scrutiny of non-Greek advisors; toughened tax collection, also to be monitored by non-Greek advisors; further government spending cuts; and other draconian austerity measures.

The providers of funds would include the EFSF (which might float EFSF-issued bonds to help fund its assistance), other Euro member governments, the IMF and other multilateral financial institutions, and “voluntary” commitments by banks to buy new Greek sovereign issuance under “favorable terms” as their existing holdings of debt securities mature.

“Voluntary” is a critical ingredient to avoid legal interpretation that stretching out repayment and below market rates not be interpreted as “default.”

In the early days of June world capital markets have been optimistic that the Greek bailout will ultimately be agreed by all Eurozone member governments and by the IMF by the end of June, and that the Greek parliament will have no choice but to approve the package.

However, many challenges lie ahead.  Prime Minister Papandreou and his cabinet will agree, but lately he has had only has a tiny majority of 6 seats in the parliament.  With rioting in the streets intensifying, some 50 of his backbenchers are now threatening to resign their seats rather than support further cuts in public sector jobs, increase taxes, and sell off state enterprises to foreigners.

Street demonstrations against “subjugation of Greece to foreign decision makers” may block parliamentary approval.  In that case, elections may be needed, which would mean delay, even while the government must raise additional capital just to get through the summer.  A newly elected government would likely be resistant to the EU/IMF bailout requirements.  With further delays, markets would demand even higher interest rates to cover growing risk of default.  Financial markets throughout the Eurozone would be roiled once again.

The role of the IMF may not be as unhesitatingly supportive of Eurozone bailouts in the future as it had been in the past.  Some members of the IMF have evidently been miffed by the defiant demand of Eurozone governments that the next head of the IMF must again be a European.  While French Finance Minister Lagarde is well qualified, some IMF members may wish to demonstrate their irritation at being sidelined.

They may demand further “clarification” of how Greece is performing and the extent to which its achievement of IMF targets is being credibly monitored.  Delay in IMF approval cannot be ruled out; or future delays in disbursement may prove problematic.

Then there remains the question of whether all Eurozone member governments can agree to the terms of a new bailout.  Even German parliamentary approval is not guaranteed, with growing discord about further bailouts emerging within the Merkel-led governing coalition.

If Merkel’s final decisions prevail for now, they may not be sustainable over the summer and through the remainder of the time prior to the next round of German national elections.  The German courts may still challenge whatever assistance is crafted.

Even if the new Greek bailout is implemented, there can be little doubt that the ensuing decline in Greek economic growth and the high cost of servicing Greek debt will together result in yet another crisis before the end of the year.

In the background, finance ministers throughout the Eurozone are assuming that German economic growth will continue strong and provide an engine for Eurozone economic growth.  They are assuming that European and global economic recovery will gain momentum.

These assumptions are little more than wishful thinking.  The German economy is export-dependent, particularly dependent on continued strong growth in China and the rest of Asia.  World trade growth is not robust.  China’s economy is likely to grow less vigorously than in the last several years.  The undercapitalization of private banks, which remains hidden under the continuing Eurozone sovereign debt crisis, has yet to be addressed.  Austerity budgets throughout the Eurozone will put brakes on Eurozone economic growth for the next few years.