Tuesday, 11 October 2011

Inching closer?

It could very well be that we are in the last weeks before the Greek debt restructuring. At least we hear more and more noise from the Euro-group about the terms of the haircut private sector bond holders will have to take.

On 21 July the Euro-group members presented an agreement whereby the Greek debt would be written down by 21 per cent. It did not take long time to calculate that even with the economic reforms agreed by Greek government at that time, it would not be enough. Greece needs a combination of spending reductions and debt reduction in order to get back from the dead.

With the 21% debt write-off, it would take very optimistic assumptions about future Greek economic growth in order believe that the “primary” surplus (government revenue minus expenditure ex debt service) could be sufficient to cover the servicing of debts to the tune of 170 per cent of GDP.

Several sober estimates have consistently pointed to a haircut between 50% and 70% in order for Greece to get a fresh start. That matches exactly what we now hear from the Euro-zone, namely that “more than 50%” of the debt will have to be written off. It is a great step forward that the truth is finally being tabled.

But, it is not over yet. ECB apparently is against the idea of a Greek haircut of 66%. Instead ECB insists that the 21% “voluntary” haircut must be implemented. One could wonder why, given that a haircut of 50-70% is the only thing that makes sense. Probably it has a lot to do with politics (I will not be so mean as to suggest it could have something to do with the Greek bonds held by ECB itself!).

Let us assume that the banks take the 21% haircut. In that case they would probably need only a minor capital increase, and it would possibly be possible to find that money in the market. Shareholders would be happy and the interbank market would unfreeze rapidly. No wonder the banks endorse this strongly. It would be a carbon copy of the US “money-for-nothing” program, called TARP.

The problem is that in order to arrive at a debt reduction of 66%, EFSF and the Euro-zone countries somehow would have to finance the difference between the bank’s losses and the necessary debt reduction. One could imagine that EFSF simply would underwrite difference or take over the Greek government bonds at artificially inflated prices. This would amount to a de facto gift to Greece and/or the banks.

That would be just about the worst thing that could happen for Chancellor Merkel and the other European leaders. Their electorates could rightly claim that their governments had just rewarded Greece and the banks for their recklessness.

Let us instead assume that the haircut is fixed at 66%. The banks for sure would need capital injections from their governments. In that case the governments will be able to present the expenses as a help to domestic banks and not as a rescue of the reckless Greek. The governments would for an extended period of time take control of the banks. That would be far more palatable for the electorate.

Either way, Europe’s governments will end up having to foot the bill. The difference is in the resulting relationship to the banks and the electorate. It is easy to see why politicians prefer the larger haircut. It is equally easy to see why the banks prefer the 21% haircut. 

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