As the European Union dithers and the Germans temporize at least until their May 9 election,1 financial markets (and belatedly even Standard and Poors) have awarded junk bond status to Greek debt and made a Greek default their central forecast scenario. Europe appears headed down the road of an abrupt, chaotic default proceeding or a more organized debt restructuring agreement in which creditors take a haircut on their Greek debt, possibly in return for further austerity measures by the Greeks.
Who, other than the people of Greece, will be stuck with the biggest bill in either of these scenarios?
As I pointed out earlier, financial markets can act rationally—even after being asleep for years over Greece. When they predict a Greek default, and an inverted yield curve suggests major reductions in the principal on Greek bonds, they will head for the exit. Fortunately for them, the European Central Bank offers a way out by permitting loans to European banks with Greek debt as the collateral. But if this arrangement leads Europe's biggest creditors to share their all-but-inevitable haircut with the European Central Bank (ECB), which is a theoretical possibility for now, who becomes the biggest loser?
First, a word of explanation about the ECB's role in helping banks cope with the Greek debt crisis. The ECB continues to accept Greek government bonds as collateral in its open market operations—acting as a de facto "secondary market lender of last resort" for Greece through repos with private banks. The way this works is as follows: a private bank holding Greek debt temporarily sells that debt at face value to the ECB with a promise to buy it back [PDF] at full value—or to "repurchase" it; hence the term "repo."
In theory, European banks that carry out such repo deals are liable for the full face value of the Greek debt used as collateral, even if that debt plummets in actual worth. But in practice it is not clear who will be left holding the bag if Greece defaults. For now financial markets expecting default will try to dump as much exposure to Greece with the ECB as possible. As a practical matter, the national government owners of ECB will thus more than likely end up sharing the bill from a Greek default in a way that reflects the paid-up capital structure of the ECB. Hence in the event of an ECB loss resulting from a restructuring or default, Germany would get hit in accordance with its 28 percent of the eurozone's capital share. France would take 21 percent of the loss, Italy would take 18 percent, and Spain would take 12 percent. These countries would stand to lose the most money from the undermining of the ECB balance sheet through a Greek default.
Compare these losses to those of the private banking sector in light of their exposure to Greece. Their money on Greece has already been lost because of the decline in value of their assets, which is why the private banking sector has acted to offload its exposure to Greece that leads to the ECB's potential future losses.
But the distribution of the non-Greece eurozone paid-up capital structure of the ECB is very different from eurozone members' private banking sector exposure to Greece. One could argue, then, that European procrastination and buck passing could involve very substantial transfers of wealth between eurozone countries. This is illustrated in table 1.
|Eurozone member||Share of paid-up ECB subscription (percent)||Implied loss from a $150 billion write-down on Greek debt held by the ECB, $US billion||End-2009 Q4 private banking sector exposure to Greece, $US billion||Implied losses averted From a 2/3 reduction in private exposure via ECB collateral route, $US billion||Net implied gains/losses from Greek default via ECB collateral and averted private losses in country's banking sector, $US billion|
Source: ECB, BIS, Author's estimates
Note: 1) The $60+ billion exposure of Luxembourg to Greek debt relates to the 2009 Q4 shift of residence of the European Financial Group (EFG) SA, ultimate owner of EFG Eurobank from Switzerland to Luxembourg. Correspondingly, the Swiss country exposure to Greek debt as reported in Bank for International Settlements (BIS) consolidated banking data by ultimate risk basis declined by ~$60 billion in 2009 Q4. It can be debated whether EFG Eurobank should be treated as a domestic Greek bank. I am grateful to Carlo Bastasin for providing me with this information.
Column 2 in table 1 shows the distribution of paid-up capital to the ECB among eurozone members, excluding Greece. Column 3 illustrates the implied loss from a hypothetical future $150 billion write-down of Greek debt held by the ECB through its collateral policy, distributed by eurozone membership. The amount of $150 billion as a write-down is used here for illustrative purposes, and would imply a very steep reduction of the principal on foreign-owned Greek debt. As such it should be regarded as close to a worst-case scenario outcome for Greece's foreign creditors. In this scenario, the ECB's largest member countries suffer the biggest losses: Germany $42 billion, France $32 billion, Italy $28 billion, and Spain $18 billion.
Column 4 shows the latest consolidated foreign claims of reporting banks on Greece on an ultimate risk basis. Here we can see that French banks—with $79 billion—have the largest exposure to Greek debt (mostly through ownership of Greek domestic banks, such as Crédit Agricole's controlling share of Emporiki Bank), while German banks with a $45 billion exposure are the other principal eurozone creditor (see table note 1 for the special case of Luxembourg). It is noteworthy how Portuguese banks with almost $10 billion in exposure to Greece are more at risk than banks in the far larger eurozone members Italy and Spain. Lastly, it is clear that a Greek default would further compound the problems of already troubled Irish banks with their $8.5 billion exposure.2
Column 5 illustrates the reduction in exposure to Greece of eurozone members' private banking systems, should these succeed in offloading a conservative two-thirds of their total exposure to Greece on to the ECB balance sheet. The amount of two-thirds is again arbitrarily chosen for illustrative purposes to closely resemble the $150 billion in assumed losses to the ECB. Obviously, highly exposed French and German banks benefit disproportionately by this shifting of Greek debt onto the ECB balance sheet by being able to offload $52 billion and $30 billion, respectively, in exposure.
Column 6 finally computes the difference between the cost to individual eurozone members from the "Greece loss" through the ECB balance sheet channel and the "Greece loss averted" by these eurozone members' private banking systems via the ECB. This way it is possible to discern which eurozone members would benefit from taking losses through the ECB as opposed to through their private banks.
Column 6 shows how France—via the much reduced Greek exposure of its private banking sector ($52 billion saved)—would actually end up with an implied gain of more than $21 billion from letting national "Greek losses" occur via the ECB (where France's share is only $31 billion), as opposed to through its private banking sector. Similarly, the ultimate "Greek losses" of Germany are much reduced by the $30 billion in private losses averted via the ECB, although the country still suffers a $12 billion net loss.
However, at the other end of the spectrum, column 6 shows how Italy and Spain are the principal losers from the "no policy action taken" European crisis management that would lead bigger losses as a result of their share of ECB capital. The banks in these two large countries have very little exposure to Greek debt (and hence have little to offload to the ECB). But through their substantial share in the ECB paid-up capital they would suffer sizable implied losses. Italy would be Europe's "Greek loss" leader with an implied $23 billion loss, while Spain would suffer $18 billion in implied losses via the ECB route.
Ironically, Europe's inability to take action on Greece, and a resulting default or restructuring, would end up penalizing countries like Italy and Spain for having well-managed banks with limited risk exposure to Greece if the ECB ends up absorbing the brunt of the costs. France, whose banks took far higher risks, would benefit.
While President Sarkozy will thus likely be pleased with letting Greece's debt write-down occur via the ECB, Prime ministers Berlusconi and Zapatero have reason to feel aggrieved if Europe cannot agree to do something soon.
Finally, it is important to realize that an organized debt restructuring now represents the best possible (or least bad) outcome of this crisis both for Greece and for Europe. Hopefully, German parliamentarians will therefore demand from their eurozone partners, the European Commission, the IMF, and the Greek government that debt restructuring be part of the joint agreement now being negotiated. Anything else would simply be irresponsible.
1. Particularly the junior ruling coalition partner, the Free Democratic Party (FDP), which has dropped dramatically in the opinion polls since its record showing in last year's federal elections, faces a tough vote on Greece. Despite the unclear immediate fiscal implication for Germany of any aid to Greece, the FDP will in a political sense be asked to prioritize between its principal economic demand for German tax cuts or to provide aid to Greece. If the party wishes to remain fiscally responsible, it cannot demand both.
2. The total US banking sector exposure to Greece in the Bank for International Settlements (BIS) data at end-2009 Q4 is $17 billion, the United Kingdom $15 billion, Switzerland $4 billion, and Japan $7 billion.