Don't Shoot the Messenger

For Whom the Bailout Tolls

“On an optimistic view, that a deal was struck implies that neither side was ultimately willing to risk a Greek exit because they recognise that no one fully understands all the ramifications of such a decision. Under this scenario, when pressure again builds, the authorities will do the same: let Greece remain in the euro, even if it fails to keep to its adjustment programme. So, the reality of “bail-out II” means that, if the situation becomes critical, there will be a bail-out III”. Sushil Wadhwani, writing in the Financial Times

 So Greece has finally been awarded a second bailout. One may wish the country will live to tell the tale.

According to IMF DG Christine Lagarde, speaking at the post agreement press conference, “It’s not an easy (program), it’s an ambitious one,”. Never a truer word was said, and certainly not in jest. Not only is the program an ambitious one, it is more than probably a “pie in the sky” one too. The objective of 120% for Greek debt in GDP is totally unrealistic, not only because it won’t be attained (it won’t), but because even if it were the country would still be in an unsustainable situation in  2020. So this is hardly something to be proud of, or look forward to.

And then there is growth. Ah yes, growth. Noone really has any idea how this will be achieved, and of course without it even the (un)ambitious 120% goal is way out of reach. But beyond the details, I have serious doubts whether Greece itself is now rescuable. I don’t mean the financial dimension, I mean whether or not the country will even raise its head again. The social fabric and the country’s reputation is being so destroyed, that it is hard to see serious investors getting back into the country again, with or without that much needed internal devaluation.  At the end of the day the Greek bailout is not for the Greeks at all. Certainly they will see very little of the money, and there will be none whatsoever to help restart their withering economy.The Greek bailout is to protect the rest. It is a vain attempt to let Greece go its course (or even die) while preventing the contagious smell from reaching Spain or Italy. The only real creditors now are the official sector. This is not a bailout, it is a “cordon sanitaire”.

The outcome is already almost guaranteed – young people tired of continually being unable to find work commensurate with their skills will simply vote with their feet and leave, leaving an ever more unsustainable pension and health system for the Troika to manage. A common story these days along Europe’s periphery, but still, Greece definitely seems destined to be the worst of worst cases scenario.

Perhaps the best simple summary of what just happened was written by Annika Breidthardt and Jan Strupczewski in their Reuters report:

“The complex deal wrought in overnight negotiations buys time to stabilize the 17-nation currency bloc and strengthen its financial firewalls, but it leaves deep doubts about Greece’s ability to recover and avoid default in the longer term”.

We have just bought some time for the rest of us, while Greece is sent off to default and beyond. The Troika representatives didn’t “sign off” on the new deal, they effectively washed their hands of the whole messy situation. Naturally Greece won’t be able to comply with the conditions, and at the next review, or the one after, the country will be face to face with the inevitable.

The Details

  • Greece has agreed to be placed under permanent surveillance by an increased European presence on the ground, and it will have to deposit funds in an escrow account to service its debt to guarantee repayments. effectively this will rule out future defaults against the private sector. This is why Europe’s leaders think this agreement will end contagion, there will be nothing to “contage”. But the problem simply becomes worse, since any default now will be against the official sector, and they are not nice, friendly people to default on.

  • The European Central Bank agreed to help the process by distributing its profits from bond-buying. A Eurogroup statement said the ECB would pass up profits it made from buying Greek bonds over the past two years to national central banks for their governments to pass on to Athens “to further improve the sustainability of Greece’s public debt.”  The bond holdings of the ECB and national central banks from their investment portfolios (about 12 billion Euros) and the Security Markets Programme (around 40-45 billion Euros) are to be swapped for instruments that appear to be exempt from any future  Collective Action Clauses. They will be repaid at face value, albeit with an understanding that the profits accruing from this repayment plus coupon payments will be transferred to governments via the various  National Central Banks. This money can then be passed to Greece in the form of a transfer. The importance of this arrangement is that it reinforces the subordination of private sector bond holders to central bank buying. Moreover, it is not clear that there is any obligation for the national governments to give these income flows from Greek restructuring back to Greece, and if this proves to be the case this outcome would simply amplify the subordination of private investors.

  • Private bondholders are being asked to accept more losses than originally postulated. Private sector holders of Greek debt will take losses of 53.5 percent on the nominal value of their bonds. They had previously agreed to a 50 percent nominal writedown, which equated to around a 70 percent loss on the net present value of the debt. This being said, all is still far from clear. The IMF document detailing the underlying economic assumptions for Greece assumes a 95% participation rate in the PSI. This outcome seems unlikely, especially in light of the increased haircut for private investors in the new deal, which was implemented in order to reduce Greek debt/GDP to the targeted 120% by 2020 from the 129% it would reach according to earlier PSI assumptions. What this implies is that those dreaded Collective Action Clauses may still be needed sometime early next month to ensure no hold-outs, and if this happens it is quite possible that CDS will trigger. So we are not out of the woods yet, it seems.

  • The latest IMF document reaffirms its view that Greece is unlikely to be able to access the market in its own name during the programme period until at least 2020, “and it is assumed that financing needs are met by Greece’s European partners on standard EFSF borrowing terms”, if good policies are maintained. One problem  the IMF mentions here is important, and that  is the fact that future debt issuance would be subordinated to the currently being restructured pool of debt. This would obviously make it hard to sell bonds to new investors even in the most favourable of circumstances.

  • As if this wasn’t enough in the way of headaches, the latest IMF document also suggests that  Greece is likely to need additional funding well before 2020. The Fund outlines two scenarios: a “base” case whereby Greece may need an additional 50 billion Euros during the period 2015-20 given that the new 136 billion Euro support package will only meet Greece’s funding needs until 2014. They also cite a more bearish case involving slower-than-targeted growth and fiscal consolidation, whereby debt/GDP only declines to 160% by 2020 rather than the targeted 120%, in which case Greece would require a further 109 billion. Hence far from having put Greece off the EU radar, the new debt deal only marks the end of the beginning, and we still need to get through to the beginning of the end.  

  • In terms of timescale, the private creditor bond exchange is expected to be launched on March 8 and complete three days later, according to Greek sources. That means a 14.5-billion-euro bond repayment due on March 20 would be restructured, allowing Greece to avoid default.

    In fact the important point to note is that the vast majority of the funds in the current program will be used to finance the bond swap and ensure Greece’s banking system remains stable; some 30 billion euros will go to “sweeteners” to get the private sector to sign up to the swap, and 23 billion will go to recapitalize Greek banks. A further 35 billion or so will allow Greece to finance the buying back of the bonds. As Annika Breidthardt and Jan Strupczewski point out in their article, next to nothing will go directly to help the Greek economy.

    The main purpose of exercise – apart from trying to close off contagion – was to reduce Greece’s debt to a level that the IMF would be able to continue funding. It will be recalled that the whole second bailout issue was put on the table when the IMF reported that it would be unable to continue with the first bailout since its own regulations stipulated it could not continue to make programme payments to a country whose debt path was not sustainable. Their economists must have had to swallow some to be willing to sign off on the sustainability of this one. But such are the political pressures people are facing.

    The Sacrificial Lamb

    It is hard to remember a time when such an important decision was taken with so many of those involved expressing the view the solution was not going to work. Thus conservative leader Antonis Samaras, a strong contender to become next prime minister, stressed that the rescue package’s debt-reduction targets could only be met with economic growth. “Without the rebound and growth of the economy … not even the immediate fiscal targets can be met, nor can the debt become sustainable in the long-term.”

    Hardly inspiring words from the person who is most likely to have to take responsibility for all of this, especially since he appreciates perfectly well that all that growth simply isn’t coming. At some point the economy will strop contracting, be we will certainly not see a significant rebound, but rather a dead cat bounce.

    Europe’s leaders, on the other hand, are more concerned about their own backyard than they are about what actually happens to the Greeks. “It’s an important result that removes immediate risks of contagion,” Italian Prime Minister Mario Monti is reported as telling a news conference.

    Swedish Finance Minister Anders Borg effectively summed the cynicism of the whole position up like this: “What’s been done is a meaningful step forward. Of course, the Greeks remain stuck in their tragedy; this is a new act in a long drama. “I don’t think we should consider that they are cleared of any problems, but I do think we’ve reduced the Greek problem to just a Greek problem. It is no longer a threat to the recovery in all of Europe, and it is another step forward.”

    But as Sushil Wadhwani suggests, rather than overcoming contagion, what the agreement does is give a whole new twist to the issue. In particular, the general impression that has been generated is that Germany’s leadership will now make almost any concession in order not to have to look for the Euro exit door, and the others, starting with the highly intelligent Mario Monti, are beginning to sense this. Even Spain’s Mariano Rajoy has caught-on, and seen he can negotiate a relaxed deficit target for 2011, despite the fact that the country missed last year’s target by a large margin. So we may well now see a chain of events were one country after another sets out to test the patience of the “core”. And in addition (see below), even the Greek contagion problem is a long way from being over.

    Eternal Life on LTRO “Cool Aid”?

    Meawhile, the impact of recent policy changes at the central bank should not be underestimated, in terms of the durability of this tragedy in multiple acts . In particular, the latest decision to implement two 3 year Long Term Repo Operations has been very important. Indeed it is a short term game changer.

    Distressed sovereigns can, for the time being fund themselves, even if the commercial banks are only really inclined to bid at the short end, and may well be exaggerating the extent of spread relief provided by buying short term bonds in an attempt to store liquidity to meet their own future wholesale financing needs.

    Basically, the liquidity provided, in conjunction with the all important flexibilisation of the collateral rules, has enabled banks to make provision for their wholesale funding needs right through from now to 2015, at which time there will doubtless be another round of LTROs, and who knows, they could even have a longer term than a mere three years  now that the distinction between capital and liquidity has become totally blurred. The days when banks saw it as a stigma to have recourse to ECB liquidity, and when journalists entertained themselves making fun of packaged used car loans being offered as collateral in Ireland by the Australian bank Macquarie are now long gone, as are the times when anyone really imagined that any sovereign bond from a country losing the minimum rating qualification of at least a single A from one agency would not be available for use as collateral at the central bank.

    What the LTROs won’t do is stimulate credit in countries where there is little solvent demand for borrowing. Countries like Greece, for example. Crashing the economy without restoring competitiveness means that Athena does not rise from the head of Zeus out of the ashes of created destruction.

    But this liquidity policy does knock yet another of the “old chestnut” endgames straight out of the window, since it makes deposit flight within the Euro Area as a whole a much smaller problem. German and other core country deposits can be recycled – via wholesale finance provided at the ECB – as a substitute for the missing peripheral ones. As I say, this measure does not unblock the credit crunch problem, but it does reduce immediate systemic pressure. So, if the Euro system is inherently unstable, and unsustainable, a mire from which no one wants to exit since fear of the unknown always trumps hatred of the known, how does it all finally unwind?

    The implicit market assumption the markets are making that Portugal will follow Greece into default comes as no surprise. If Greece is to be given an ongoing debt pardoning programme then surely in Portugal is going to want one too. And then there will be Ireland, and so on. Yet all of this is contemplatable, what is not contemplateable is that the people who live in these unfortunate countries will continue to accept whatever is thrown at them, and then some, come what may. You only need to look over in the direction of Hungary to see that these no-growth austerity programmes have a sell-by date. But what will follow will surely please no one.

    The Club No One In Their Right Mind Would Leave

    But what about Greece itself? Logic suggests that they will be unable to meet the terms of their new agreement, and that we will soon be back to where we started, …….or will we?

    Feelings that what we are seeing today will only constitute a short interlude in a pretty atonal concierto are based on an appreciation of three important factors: a) a recognition that even a reduction of debt to GDP to 120% by 2020 is still not sustainable; b) a recognition that after the formal bailout is awarded there will still be ongoing programme reviews, and the country will struggle to comply with the conditions; and c) the fact that the implementation of the Private Sector Involvement debt swap will probably mean changing the jurisdiction under which Greek debt is denominated from mainly Greek law in the majority to international law in the totality, and that the only creditors left on whom the country can effectively default is now the official sector. This latter point is undoubtedly the most important, although being able to grasp its full implications implies an understanding of the first two.

    Essentially, if the unsustainability of the Greek debt path and the inability to comply with conditionality are accepted, then a further default will be inevitable, but such a default will undoubtedly be a very, very hard one, and most likely an uncontrolled one. In the first place if the country were to leave the Euro after the debt swap, then the new Greek bonds could now not be converted to New Drachma (or equivalent) by a weekend session of the Greek parliament, and the country would have to default on bonds denominated in Euros, which would presented them with all kinds of problems.

    Secondly, given the terms of the debt swap, and the condition of an escrow fund to protect the interests of private bondholders, then the only liabilities on which the country could still default would be those commitments it has with the official sector, which means defaulting on the IMF, the ECB, the EU and Germany. These would not be especially nice people for the country to default on, since if Greek reaches such a point the country would almost surely be made an example of, which means effectively establishing a pariah state.

    The EU certainly wouldn’t be sending in the social workers and psychologists to help them cope with this massive tragedy, which would evidently create such social and political chaos that investors generally would be inclined to steer clear. Realising this, and having taken the decision not to default now, faced with the alternative of seeking allies among other rogue states (the North Korea path) the country’s leaders have probably taken the decision to stay in as long as they can. But then it is worth remembering the old Greek saying that “whom the gods would destroy, they first make mad”, by which I mean we could well eventually see extreme factors at play in Greek politics – the extreme right, the extreme left, and the military – before they then all go rolling off the cliff together.

    Or maybe Greece will decide to default and stay in the Euro, printing its own Euros at the national central bank along the lines of the Emergency Liquidity Assistance precedent. That would surely create a mighty mess, (they could even carry out the internal devaluation by subsidising Greek wages) and would leave the onus of kicking them out on their European partners.

    Whichever the appointed path, such a scenario would have important geopolitical implications, since surely the EU could not let Greece become a nice place, given that then Portugal would immediately say “I want one of those”, and so on and so forth along the daisy chain. In the meantime private capital will be steadily forced out of periphery sovereigns like Spain and Italy, and the ECB will ultimately have to provide. But we have already crossed the Rubicon on this, and there is no real turning back. Ongoing debt restructuring will continue, as none of the really troubled economies can either grow or sustain their existing debt. I mean, who can now really believe that Spain won’t be asked in six months time to prepare another set of reforms (the latest batch have “destined to fail” written all over them), and six months later another one, and so on, until eventually the country is where Greece is now?

    And if the private sector either can’t, or won’t accept the degree of involvement being asked of it, then the ECB will be taken out of the official sector, and somehow or other find a way to swallow the losses. At least that’s the way things could work for the time being.

    Destroying European Democracy?

    The principal issue impeding exit is not the one of the presence of sunk costs from years of membership, but rather existence of non-linear credit and currency impacts – in either one or the other direction – impacts which could not be envisaged in the pre-Euro era during which most of the critics of the common currency cut their theoretical teeth.

    The only conceivable way a deliberate decision to leave could actually be taken would be as a result of one or more of the respective agents being actually driven “insane” by the constant painful efforts involved in trying to retain the pin in that grenade they are holding as they are driven to ever more desperate efforts in a vain attempt to try to stop it going off in their face. Could, for example, Hungary’s leader Viktor Orban be about to offer us an early prototype for the kind of road map which some of the participants might need to follow in order to reach the point whereby they actively decide to leave? In Hungary’s case, of course, the departure would be from the EU, not the Euro, but the point is effectively the same, since the farewell party would most certainly acrimonious, where the possibility of regulating the exit would be limited, and where the end product would almost certainly be the creation of a pariah state.

    For the inevitably defaulting participants, given the total determination not to have official sector restructuring, leaving the Euro would more or less automatically mean a sharp break with both the EU and the IMF and in all probability the United States. If we take Greece as an example, and assuming the currently proposed PSI debt swap goes forward, the country will almost certainly see the jurisdiction of its debt shifted from national to international law, making converting sovereign debt instruments into New Drachma (or whatever) impossible, and given the creation of an escrow account to pay the private sector creditors, the only meaningful possibilities for default would be against the official sector – the ECB, the IMF and the EU member states – and clearly such a development would not be well received, among other reasons due to the precedents which could be created for other struggling countries who might wish to follow the same path.

    So the list of probable allies for an exiting country – Venezuela, Bolivia, and North Korea come to mind, or nearer home Serbia, Belarus and Ukraine – would not be entirely alluring. The difficulty is that after the ending of the cold war, the world is rather short of role models for developed economies who want to pursue unorthodox policies, especially if they are engaged in a disorderly default causing considerable discomfort for most of their “first world” peers at the time in question.

    On the other hand, those with more stable, internationally competitive economies will not readily wish to surrender this condition, and since they have clearly benefited significantly from membership of the currency union they will be unlikely to offer themselves as candidates for departure. In a post Euro world they would face the likelihood of trying to export their way forward while labouring under the constraint of a substantially over-valued currency. They need only look over in the direction of Japan to discern the outline of the future that would await them.

    So with no one leaving, and each elbowing the other in the rush to say “I’m not going”, there really only is one way all this can end, isn’t there?

    9 Responses to “For Whom the Bailout Tolls”

    Brian HanleyFebruary 21st, 2012 at 11:49 pm

    Yes. But I think the EU needs to think further than that to one of the reasons why the IMF and World Bank were created in the first place.

    Creation of pariah states has been done more than once in history. Such punishment has been popular in times past. It makes perfect sense to an accountant sitting cozily in a nice office. Can't let them get away with that!

    But crushing a state is also the foundation for dictatorship and war. Once started, that particular snowball is quite self-sustaining. The human race when pressed to the wall will do things we don't consider civilized.

    Since the EU is such a dysfunctional union of money without a real federal system, I think that development is probably inevitable. Nobody alive today remembers war. And since the pension system of Greece is local but the economy of Greece is that of a state which is part of a union, the nation, as Edward points out, cannot sustain those payments.

    There is, however, a simple cure for much of this which I don't believe is politically feasible. That cure would require federalization of all pensions systems, health care, etc, and federalization of most taxes. Then it becomes straightforward. The liability of Greece becomes the liability of all and decisions fall out of that which can work, even though the children of Greece will still leave.

    john gladwynFebruary 22nd, 2012 at 8:51 am

    sadly agree. However it is worth noting the LTROS have had more benefit than you give credit. The yields at the 10 year have come in c.200bps, which is not just banks playing the lazarus/carry trade. If there is some kind of solution it will be a hotch potch of different policies that somehow make the whole stable. The LTRO is a good example. It incentivises the short end, but starts to stabilise the long end as it alleviates the real-money buyers' strike.

    Edward Hugh Edward_HughFebruary 22nd, 2012 at 3:29 pm

    "There is, however, a simple cure for much of this which I don't believe is politically feasible. That cure would require federalization of all pensions systems, health care, etc, and federalization of most taxes. Then it becomes straightforward. The liability of Greece becomes the liability of all and decisions fall out of that which can work, even though the children of Greece will still leave".

    Agreed Brian. It would not be the whole solution, but it would be an important part of it. I just don't see it happening, at least I don't see it happening soon enough to save the thing from its own destruction.

    Edward Hugh Edward_HughFebruary 22nd, 2012 at 3:35 pm

    I agree about LTROs John, although I don't know where they lead. I think they now become a permanent part of the structure, which is going to make opening the normal commercial interbank markets even more difficult, since people will have a subordination problem. So they hold the thing together, and enable it to stumble forward, but we need the kind of mechanisms Brian is talking about plus some way of subdidising a substantial internal devaluation to really make progress, and while this sort of thing may not be impossible in a much longer term given how far we have already come, my feeling is we are now definitely working against the clock (as well as the demographic "time bomb").

    The real test of the LTROs will come when we see what happens to the Italian ten year spread the next time global risk comes "off".

    TomFebruary 27th, 2012 at 3:59 pm

    The "simple cure" didn't work with the now-defunct Soviet Union, and a European Union of Socialist States would also fail.

    The real problem is that democratic governments of the present and the past, have made unsustainable promises about the future and the present, respectively.

    Deep cuts in (real) government spending are inevitable. Best disguised by Greece printing bonds, and paying its local promised of wages and pensions and health costs, with these locally printed Drachma bonds (1 year, 0% interest, bearer-bonds), which it promised to accept at full par value for payment of taxes.

    The 120% of GDP should more accurately be called 120% of reported (& taxed) GDP, with the likely 20-40% of gray-black economy being unreported and untaxed. The Greek gov't, perhaps with EU (esp German) help, will likely reduce the gray and increase the GDP that way.

    HenryFebruary 29th, 2012 at 2:13 am

    "Simple" cure would require federalization of all pensions systems, health care, etc, and federalization of most taxes.

    Who are you going to put in-charge of this "federalization" and tax collecting.
    and who are you going to put in-charge of this "federalization" tax auditing.
    How are you going to implement the pension, health care on the ground.
    French have different pension & health needs then the Italians and Finland. How could one standardize/ "federalization" all these changes.

    Could one country cheat the others ?

    There are too many Q? to that simple cure……..

    billhopenMarch 1st, 2012 at 1:43 pm

    Edward thankyou for a well thought out analysis. From what I know of Greeks and modern greek culture, they are not cut out to fit the mold of "paryaih state", they would rather exist as a well thought of and proud nation, perhaps impoverished and dependant but respected.
    The youth have always left greece, but many come back with money. It would be tragic if they fall back under a corupt and despotic Junta again, that could lead quickly to "pariahville"