The euro crisis

The euro crisis

Bazooka or peashooter?

Greece’s new bail-out helps, but should have gone further

WHEN Henry Paulson, America’s then treasury secretary, readied a plan to prop up Fannie Mae and Freddie Mac, two teetering housing agencies, in the summer of 2008, he spoke of having a “bazooka” in his pocket. In their response to the sovereign-debt crisis, Europe’s policymakers have tended to favour the peashooter. Their latest salvo in defence of Greece on July 21st produced some favourable initial reports, but the bang has faded. In a strange inversion of the crisis to date, the new bail-out plan seems to have helped the weaker peripherals and hurt the stronger ones.

The latest Greek bail-out consists of two main elements. The first is the promise of an extra €109 billion ($158 billion) in official lending to Greece from other members of the euro zone (apart from Ireland and Portugal) and the IMF. Greece will get more time to repay its loans; Europe is also cutting the interest rate it charges Greece, to about 3.5% from 5.5%. In effect, the euro zone is allowing Greece, its flakiest member, to borrow at rates similar to those paid by Germany, its most creditworthy one.

The second element of the plan involves asking Greece’s private creditors to shoulder some of the rescue burden. Bondholders are being asked to choose from a bewildering menu of options under which they can sell bonds at a discount or swap them for 15- or 30-year bonds, either now or when they mature. Under the proposals, which were negotiated with the Institute of International Finance (IIF), a club of the world’s biggest banks, €135 billion in Greek bonds are meant to be exchanged between now and 2020. Combined with official support the plan could allow Greece to steer clear of bond markets for the rest of the decade.

The IIF reckons the plan will cut the value of the bonds held by banks and insurers by 21%. That number is a little misleading: the plan neither reduces Greece’s debt burden to private-sector creditors by 21% nor does it necessarily imply a 21% write-down on the value of the debt by those who hold it. The menu of options seems to have been tailored to suit the accounting regimes of various creditors. Some holders of Greek debt may even be able to write its value back up as a result of the deal. “Now the negotiations are with the auditors,” says a banker who was close to the talks.

These accounting debates could mean the difference between all of the equity in the Greek banking system being completely wiped out (and a recapitalisation of €10 billion-15 billion from the bail-out pot) and more manageable hits to capital of €3 billion-6 billion. “The package is on balance pretty good for the Greek banks, although shareholders could be diluted down by 30-50% if the accounting treatment is harsh,” says Alexander Kyrtsis of UBS.

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Although European leaders no longer seem too bothered about avoiding a verdict of default from the ratings agencies, signing up to the plan is still “voluntary” in order to avoid payouts on credit-default swaps. The IIF is targeting a participation rate among Greece’s creditors that would affect 90% of the country’s privately held debt. Such participation rates have been achieved on similar swaps in the past—Uruguay reached 93% participation in a 2003 exchange—but mainly because the alternative seemed to be certain default.

In the case of Greece, smaller investors with soon-to-mature bonds may be tempted to hold out if they reckon Europe’s leaders wouldn’t dare impose a forced restructuring. Even so, enough big institutions seem to have signed on to get close to the 90% figure, according to senior bank executives involved. “Institutions are big enough and connected enough that they can see the big picture,” says one. “Whether they were subject to enough political pressure or it was from enlightened self-interest, both arrows point in the same direction.”

The second bail-out will improve Greece’s debt burden, although improvement is an elastic concept. The new package will stabilise Greek debt at about 150% of GDP over the next ten years (see chart 1), according to Barclays Capital. Many assume that a third bail-out or another restructuring will be needed to reduce Greece’s debts to 80-90% of GDP, although some are more sanguine. “There is at least a fighting chance now that there won’t be another bail-out,” says Gilles Moec of Deutsche Bank.

In cutting the interest rates paid by Ireland and Portugal on their bail-outs, the new rescue package also reduces the risk that these two economies will need more help. Ireland reckons it will save €900m a year on interest payments, for instance. Irish and Portuguese bond spreads came down after the summit (although Cyprus, whose banks are heavily exposed to Greek debt, is heading the other way).

The plan allows the European Financial Stability Facility (EFSF), the euro zone’s bail-out fund, to offer precautionary lines of credit to countries that are not yet on life support, and to recapitalise their banks. Given that most investors worry about Spanish banks more than about the Spanish government, that may help the country insulate itself. But the EFSF’s new powers still need to be ratified, and its lending capacity, currently €250 billion and soon to be €440 billion, was not expanded. It would be stretched if Spain really lost the confidence of markets, overwhelmed if Italy did (see chart 2).

The region’s bigger bond markets remained unsettled this week (America’s debt-ceiling wrangle will not have helped, of course). The spreads, or extra interest, paid by Spain and Italy to borrow compared with Germany inched back towards their highest levels in more than a decade. American money-market funds, an important source of short-term borrowing for European banks, are stealing away. Banks are losing their nerve: Deutsche Bank has cut its net exposure to Italian government debt to less than an eighth of its 2010 level, mainly by insuring against default.

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So are governments. Italy has cancelled a scheduled auction of long-term debt in mid-August, saying it doesn’t need the money (and, anyway, most people are on the beach). Bond traders think it was more about avoiding a poor result. “We would have preferred the auction to go ahead,” says one senior Italian banker, who frets that postponement has rattled nerves. More weaponry looks necessary.

The euro crisis

The euro crisis

A substantial problem

by Charlemagne | BRUSSELS

AS ministers, officials and journalists stagger out of the Justus Lipsius building tonight, the unofficial word is that European leaders will be summoned here on Friday to finalise the deal that finance ministers could not conclude.

The statement issued last night was a study in vagueness (see my earlier post), but the outlines of a compromise are becoming clearer: in exchange for a willingness by private bond-holders to support some form of debt rollover for Greece, euro-area members will have to support Greece in buying back its bonds from the secondary market.

The basis for this deal is the position taken by the banks, as set out by the Institute of International Finance, which said “it would be important to consider possible debt buyback proposals, which could, along with further fiscal adjustment, begin to reduce the stock of debt and help pave the way toward improved debt sustainability.”

The idea of allowing the main European bail-out fund, the European Financial Stability Facility, to buy bonds on the secondary market—whether directly or, more likely, by lending money to Greece to do it—was ruled out earlier this year. But now it is at the heart of the package deal to be discussed by leaders.

Yet although the principle of such a compromise has been hinted at, the details are yet to be worked out. How much finance can be raised “voluntarily” from the private sector? The Netherlands, in particular, insists the contribution must be “substantial”, even at the cost of having the move labelled a “selective default” by credit-rating agencies. The European Central Bank is adamantly opposed to this, and the numbers so far have been unimpressive.

And how much debt needs to be bought back to make a real impact on Greece’s burden? Diplomats say the numbers start at €60 billion ($84 billion) and go up. And if Greece gets extra money to buy up its loans, Ireland and Portugal will ask the same.

In other words, the amount raised from the private sector may turn out to be insubstantial. And though buying bonds at a discount will crystallise the losses of those who sell them, the money paid to private bond-holders is likely to be substantial indeed.

On Friday, the day leaders are expected to meet, the European Banking Authority will publish the results of its latest bank stress-tests. Many question the credibility of the tests, particularly whether they fully reflect the danger of sovereign-debt default. But German banks, in particular, say (paywall) they are worried that the revelations will open them up to attack in the markets. European finance ministers said today that transparency about the state of the banks will reduce nervousness in the market, and promised to take any "remedial action" needed to strengthen banks found to be vulnerable.

European policy is thus oddly discordant: on the one hand finance ministers want financial institutions to take a hit over Greece; on the other they are preparing to shore up financial institutions weakened by, among other things, the Greek crisis. Jacek Rostowski, the Polish finance minister who holds the rotating EU presidency, says there is no contradiction: the two policies involve different banks. The proposition is about to be tested.

The euro crisis

The euro crisis

If Greece goes…

The opportunity for Europe’s leaders to avoid disaster is shrinking fast

THE European Union seems to have adopted a new rule: if a plan is not working, stick to it. Despite the thousands protesting in Athens, despite the judders in the markets, Europe’s leaders have a neat timetable to solve the euro zone’s problems. Next week Greece is likely to pass a new austerity package. It will then get the next €12 billion ($17 billion) of its first €110 billion bail-out, which it needs by mid-July. Assuming the Europeans agree on a face-saving “voluntary” participation by private creditors to please the Germans, a second bail-out of some €100 billion will follow. This will keep the country afloat through 2013, when a permanent euro-zone bail-out fund, the European Stability Mechanism (ESM), will take effect. The euro will be saved and the world will applaud.

Time to stop kicking the can

That is the hope that the EU’s leaders, gathering in Brussels as The Economist went to press, want to cling to. But their strategy of denial—refusing to accept that Greece cannot pay its debts—has become untenable, for three reasons.

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First, the politics blocking a resolution of the euro crisis is becoming ever more toxic (see article). Greeks see no relief at the end of their agonies. People are protesting daily in Syntagma Square against austerity. The government scraped through a vote of confidence this week; the main opposition party has committed itself to voting against the austerity plan next week and a few members of the ruling Socialist party are also doubtful about it. Meanwhile, German voters are aghast at the prospect of a second Greek bail-out, which they think would merely tip more money down the plughole of a country that is incapable either of repaying its debts or of reforming itself. As the climate gets more poisonous and elections approach in France, Germany and Greece itself, the risk of a disastrous accident—anything from a disorderly default to a currency break-up—is growing.

Second, the markets are convinced that muddling through cannot work. Spreads on Greek bonds over German bunds are eight points wider than a year ago. Traders know that Greece, whose debts are equivalent to around 160% of its GDP, is insolvent. Private investors are shying away from a place where default and devaluation seem imminent, giving the economy little chance of growing. The longer restructuring is put off, the more Greek debt will be owed to official lenders, whether other EU governments or the IMF—so the more taxpayers will eventually suffer.

The third objection to denial is that fears of contagion are growing, not receding. Early hopes that Greece alone might need a bail-out were dashed when Ireland and Portugal also sought help. The euro zone has tried to draw a line around these three relatively small economies. But the jitters of recent weeks have pushed Spain and even Italy back into the markets’ sights again. The belief that big euro-zone countries could be protected from attack has been disproved. Indeed, far from fears of contagion ebbing, the talk is of a Greek default as a “Lehman moment”: like the investment bank’s bankruptcy in September 2008, it might unexpectedly bring down many others and devastate the world economy.

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While the EU’s leaders are trying to deny the need for default, a rising chorus is taking the opposite line. Greece should embrace default, walk away from its debts, abandon the euro and bring back the drachma (in a similar way to Britain leaving the gold standard in 1931 or Argentina dumping its currency board in 2001).

That option would be ruinous, both for Greece and for the EU. Even if capital controls were brought in, some Greek banks would go bust. The new drachma would plummet, making Greece’s debt burden even more onerous. Inflation would take off as import prices shot up and Greece had to print money to finance its deficit. The benefit from a weaker currency would be small: Greece’s exports make up a small slice of GDP. The country would still need external finance, but who would lend to it? And the contagion risk would be bigger than from restructuring alone: if Greece left, why not Portugal or even Spain and Italy? If the euro zone were to break up it would put huge pressure on the single market.

The third way

There is an alternative, for which this newspaper has long argued: an orderly restructuring of Greece’s debts, halving their value to around 80% of GDP. It would hardly be a shock to the markets, which have long expected a default (an important difference from Lehman). The banks that still hold a big chunk of the bonds are in better shape to absorb losses today than they were last year. Even if Greece’s debts were cut in half, the net loss would still represent an absorbable proportion of most European banks’ capital.

An orderly restructuring would be risky. Doing it now would crystallise losses for banks and taxpayers across Europe. Nor would it, by itself, right Greece. The country’s economy is in deep recession and it is running a primary budget deficit (ie, before interest payments). Even if Greece restructures its debt and embraces the reforms demanded by the EU and IMF, it will need outside support for some years. That is bound to bring more fiscal-policy control from Brussels, turning the euro zone into a more politically integrated club. Even if that need not mean a superstate with its own finance ministry, the EU’s leaders have not started to explain the likely ramifications of all this to voters. But at least Greece and the markets would have a plan with a chance of working.

No matter what fictions they concoct this week, the euro zone’s leaders will sooner or later face a choice between three options: massive transfers to Greece that would infuriate other Europeans; a disorderly default that destabilises markets and threatens the European project; or an orderly debt restructuring. This last option would entail a long period of external support for Greece, greater political union and a debate about the institutions Europe would then need. But it is the best way out for Greece and the euro. That option will not be available for much longer. Europe’s leaders must grab it while they can.