It’s All Greek to Me

The Greek Prime Minister spoke of a choice between “austerity” and “disorder”. He got both, as the Greek Parliament based the European Union (“EU”) agreed to severe budget cuts and outside rioters protested the plan.

In great dramas, sub-plots support the main story. The story of “hairshirts” (the Greek economic plan) and “haircuts” (the writedown of Greek debt or PSI – Private Sector Involvement) are little more than an intriguing side show in the broader European debt crisis.

With Greece increasingly doomed, the real significance of the negotiations is that they provide a template for future European sovereign restructurings. No one buys the oft-stated European leaders’ position that Greece’s position is unique or exceptional. Portugal is first in the line of fire, with the Irish, Spanish and Italians watching anxiously.

In July 2011, the Institute of International Finance (“IIF”), a lobby group representing major banks and investors, proposed a complex plan entailing investors suffering a loss of around 21% on the value of their Greek bond holdings. On 27 October 2011, banks and investors were “invited” to accept a 50% write down under threat of larger losses if they did not agree. The write-down was structured as a “voluntary” exchange of maturing Greek bonds for new bonds, to avoid triggering credit default swaps (“CDS”) contracts, a form of credit insurance.

Greece has around Euro 350 billion in debt including Euro 70 billion in bailout loans and around Euro 80 billion in bonds held by the European Central Bank (“ECB”). A 50% haircut of the remaining Euro 200 billion equated to reduction of Euro 100 billion. As around Euro 85 billion is held by Greek banks and pension funds, the reduction of Euro 100 billion was less than 30% of outstanding debt, as only private investors are covered and bonds held by official institutions such as the ECB are excluded.

Following protracted negotiations, the Greek government has agreed on a new austerity package. The bond exchange is likely to proceed with bond holders’ writing off 53.5%, equating to losses of over 70-75%.

The Troika – the European Union (“EU”), European Central Bank (“ECB”), the International Monetary Fund (“IMF”) – needs to reduce the level of Greek debt to a “sustainable” 120% of gross domestic product (“GDP”) by 2020. The bond deal and the latest budget cuts are designed to achieve this paving the way for a second financing package for Greece to enabling Greece to repay a Euro 14.5 billion bond on 20 March 2012. Deterioration in Greece’s finances required the bigger writedowns and greater budget cuts.

But even the greater austerity and larger losses to lenders will probably leave Greek debt above the target level, requiring delicate financial engineering to at least cosmetically reach the target. In the end, the fancy footwork yielded an irrelevant 120.5% of GDP.
The 120% level is largely meaningless, being a political construct designed to avoid drawing unwelcome attention to Italy whose debt levels are around this level.

There is no certainty that the agreement reached can be implemented. The IIF represents around 50% of banks and investors.

Investors with Greek bonds naturally want to minimise losses. Investors who have hedged by reinsuring the Greek bonds prefer default to a voluntary restructuring, allowing them to trigger their insurance and cover losses. Hedge funds who bought into Greek bonds, at prices around 30%, want a result which gives them a profit.

The deeper losses will increase resistance to the deal, especially from hedge funds who may prefer to take their chances in a default.

One option is to unilaterally insert collective action clauses (“CACs”) into existing bond contracts, allowing a supermajority of lenders to bind the minority.

A complicating factor is the ECB’s refusal to take losses. With direct holdings of Greek bonds of Euro 40 billion as well as additional loans to banks secured over Greek bonds, the ECB’s capital of Euro 5 billion (scheduled to increase to Euro 10 billion) is insufficient to absorb losses. As the CAC would force the ECB to share in losses, a special arrangement will exempt them from the effects of any CAC to the further detriment of already resistant private lenders.

The special treatment of the ECB means that commercial lenders are effectively subordinated to official lenders, a position which has been avoided to date. Given that after any restructuring, the bulk of its debt will be held by official lenders, such as the ECB and IMF, it is unlikely that Greece will be able to return to financial markets for a long time, which probably in reality was always the case. But this will discourage commercial investment in risky European debt, such as that of Portugal, Ireland, Spain and Italy, adding to the contagion pressures.

Any agreement is also likely to face legal challenges from lenders, which would complicate proceedings.

Another complication is the extremely tight timetable that must be followed to ensure the arrangements are implemented in time. There is little margin for error.

If the new agreement cannot be implemented, then the Troika could extend the necessary money to meet the March maturity and continue negotiations, although this would be difficult. Alternatively, they could arrange an orderly default. Another outcome is that Greece unilaterally declares a debt moratorium and leaves the Euro.

Voluntary or involuntary default, large voluntary losses, and/or CACs all increase the risk that credit insurance contracts may be triggered with increased threat of contagion.
This agreement is unlikely to be the definitive resolution everyone seeks.

Greece has consistently failed to meet economic forecasts. Despite measures by the Greek government, debt continues to increase. According to the EU statistics office, Greece’s debt reached 159.1% of GDP in the third quarter of 2011, up from 138.8% a year earlier and 154.7% in the previous quarter.

Greece may get through the March 2012 maturity but the arbitrary 120% debt to GDP ratio, the best case under the plan, is unsustainable, even in the unlikely case that it is met. The Greek economy, which has been in recession for years, shrank by 7% in later part of 2011. Budget revenues for January 2012 fell 7% from the same time last year, a fall of Euro 1 billion. This compares to a budget target for an 8.9% annual increase. Value-added tax receipts decreased by 18.7% in the same period compared to January 2011.

Greece’s financial position will deteriorate and it will miss key milestones – debt levels, budget deficits, growth, asset sales and structural reforms. The projected reductions in debt are based on optimistic assumption of growth which are unrealistic given the severity of the income cuts and shrinkage in government spending.

With elections due in April 2012, government support for the austerity plan cannot be assumed, in face of a serious recession and increasing social unrest.

A similar pattern is already evident in Portugal, Spain and Italy with debt, budget and growth targets, largely unrealistic, being missed. Popular resistance to reforms and austerity is also predictably rising. Prime Minister Maria Monti has made it clear that Italy cannot take more austerity, which has barely started to be implemented.

Even if the Greek “rescue” is agreed, the Euro-zone still need to finalise the Euro 500 billion rescue system by April 2012’s IMF meetings. The fund is designed to create the much vaunted firewall to prevent Euro-Zone instability from spreading.

There are suggestions that the size of the bailout fund could be increased. But Germany, Finland and the Netherlands, the only remaining AAA rated members of the Euro-Zone, are reluctant to increase their commitments. The credit ratings downgrade of many other member nations, including France and Austria, has increasingly highlighted the risks of increasing their exposure.

The IMF is trying to marshal additional funds from members to support a European bailout. At the World Economic Forum, IMF head Christine Lagarde said that she was attending “with my little bag, to actually collect a bit of money”.

Following direct approaches by Lagarde, China and Japan have mouthed platitudes about “help”. Any support has been made conditional upon the Euro-Zone members increasing their commitments, in the knowledge that it is presently unlikely. Tellingly, China Investment Corp (“CIC”), the country’s sovereign wealth fund, and influential Chinese central bankers have rejected suggestions of purchasing European government debt. One official stating that: “We may be poor, but we aren’t stupid”.

The US has ruled out contributions, though is shouting encouragement from the sidelines. The US Congress still hasn’t approved the previous round of additional IMF commitments.

Everyone knows the amount of money available is insufficient to deal with the problems.
History suggests that a write-down of debt for distressed borrowers is frequently followed by others.

The entire trajectory of discussions, plans and negotiations largely ignores Greece. There is no longer any pretence of “assisting” Greece. It is about ensuring that German and French banks minimise their losses. It is probable that no funds will be released to Greece but rather placed in a special account from where it will be used to meet the country’s debt obligations.

Germany and the Netherlands has suggested that the EU assume control of Greek finances and elections be suspended in favour of a technocratic government, having the confidence of Berlin, Paris and Brussels. In the end, the communique required Greece to pass a humiliating law giving priority to debt repayment over other government obligation. The Trioka will establish a permanent presence in Greece to oversee the process. The loss of Greece’s sovereignty has not been well received, at least in Athens.

Subplots connect main plots in thematic terms or provide minor diversions or comic relief. The light relief in this instance come from a group of hedge funds who have threatened to take action in the European Court of Human Rights alleging that Greece has violated bondholders “rights”.

In the end, Greece may live to default another day. Other embattled European nations will be scrutinising the Athenian sub-plot extremely closely as to clues as to their future as they await the battles that lie ahead.

This post originally appeared at naked capitalism and is posted with permission.

7 Responses to "It’s All Greek to Me"

  1. Bob Misko   February 21, 2012 at 2:17 pm

    Thank you.
    Again, more insight to the European debt crisis. How much longer can the world economies teeter on the edge of the cliff?

    • Christopher Dobbie   February 21, 2012 at 8:25 pm

      A little while longer I will hazard.

  2. Oupoot   February 22, 2012 at 1:41 am

    It struck me last week that in effect Greece has already defaulted. It is not a technical default, but Greece is exhibiting all the features of a default. I mean, it is already in negotiations with its creditors about restructuring debt and allocating losses. It has been in negotiations with other international institutional creditors (ECB, IMF, etc) to provide it with a special credit lines that are exempt from losses (for now), etc. Without these, there is no doubt Greece will have a technical default.

    If there was a "chapter 11 bankruptcy for governments", this would be the precursor.

  3. diatoo1   February 22, 2012 at 7:09 am

    Heaven knows whether any valid arguments exist against the analysis of Mr. Das. Aggravating the situation are a few things like the fact that the Greece government has already burdened its people extremely heavily, that still all mile stones have been missed, that the base problem of lack of competitiveness of Greek economy is unaddressed and finally that Greece has a longstanding record over the centuries to default.. I think Greece has to go the very hard way of defaulting and leaving the Euro; otherwise its base problem cannot be solved. And Euro countries will have to struggle to ringfence the Euro with Portugal in or out. The only and easiest option left in my opinion is not government sponsored rescue funds ( because government debt cannot be expanded sufficiently) nor Euro bonds (because the AAA countries cannot take the risks or the role of being the buyer of last resort for all European government and bank bonds) but it is the ECB splashing unlimited amounts of money over the Euro members. In the medium and long term this means inflation, aka robbing the working class, the retired people, those who have savings. Only the very rich will find ways to escape that robbery.

  4. Aegean1972   February 23, 2012 at 1:29 am

    What Greece (and the rest of the periphery needs) is growth. Growth growth growth.
    But especially Greece, since they ve had this hard recession for over 5 years now. They ve been underwater for way too long.

    Frankfurt is frantically trying to pressure Greece to even more hard core austerity, so they can get their finances in order before Italy blows the gasket. Because Italy WILL blow the gasket in less than two years. And when Italy starts falling, then it is going to be very difficult for europe to manage the situation. So they re buying time and kickin the can as much as they can. Italy is the next Greece, multiplied by 5.

    As for Greece, it would be VERY VERY advisable not to go to elections, because the measures of the last 5 years have boosted an anti-troika movement and leftist parties will take 43% of the vote, if elections happened today.In such a senario, the conservative coalition gvmnt wont be able to pass any laws and a disorderly default will be almost inevitable. Mr Papademos must stay for another 2 years minimum!

  5. Deva Sagayam   February 25, 2012 at 4:18 am

    Greece is finding its real economic level.
    What existed was because of manna from heaven.
    There is no possibility of growth as nothing to grow exists.

  6. Simon   March 7, 2012 at 4:59 am

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