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In Europe, bond markets are more powerful than voters in intimidating politicians to make faster and different decisions. So, in a manner uncomfortably close to the chaotic Lehman Brothers meetings over a single weekend last year at the NY Federal Reserve, the eurozone last weekend finally offered more clarity to financial markets about its earlier commitment to take "determined and coordinated action, if needed."
We thus learned several things about what the eurozone is prepared to do:
1. Enter into a three-year standby program with the International Monetary Fund and agree to a commitment of €30 billion during the first year (2010). Additional financial support for the following two years to be decided upon agreement of the joint program with the IMF.
2. Provide Greece financial assistance through a mix of fixed- and variable-rate loans with the former priced at Euribor (Euro Interbank Offered Rate) swap rates1 for the relevant maturities, plus 300 basis points and a one-off service fee of up to 50 basis points.2 Variable-rate loans will be based on three-month Euribor.
3. Eurozone states will activate their support when needed and disbursements will be decided by eurozone members who commit themselves to take the necessary national level steps to deliver swift assistance to Greece.
But several questions remain.
Question 1: How much, and is it enough? Certainly, the amount—€30 billion, plus any IMF cofinancing during 2010—is larger than what the markets anticipated. (The sum is estimated at up to €10 billion to €15 billion, based on earlier announcements of an intended two-thirds to one-third split and Greece's quota based access to IMF funds.) This money could cover Greece's most immediate short-term refinancing through May and likely most of 2010.
Question 2: At what price? The price offered to Greece—Euribor plus more than 300 basis points, or approximately a 5-percent yield on a 3-year maturity—is significantly below last week's implied market yield of 7.5 percent. These terms will lower Greece's cost of capital and function as "subsidized lending," notwithstanding the eurozone leaders claim to the contrary.
Although eurozone loans will be more expensive than IMF loans, they are below the market cost that Greece would have had to bear. Accordingly, Prime Minister George Papandreou won this round and Chancellor Angela Merkel of Germany retreated, recognizing that subsidies to the Greek government now would be less expensive than the cost of recapitalizing German banks in the wake of a Greek default or debt restructuring. (The same is true in France3).
But there is a longer-term risk for the German government, and perhaps others. German economists, for example, plan a legal challenge at the German Constitutional Court over this measure.4 Their action may not block the initial German disbursement in 2010, but it might impede German participation in the next two years. The aid could thus turn out to be a gun loaded with just this one bullet.
The fact that regional eurozone aid has proved more costly than IMF assistance highlights the limits of "European solidarity" in the absence of a strong rules-based multilateral European institution like the fund. Proponents of other regional replicas of the IMF in Asia should take note.
Finally, it is ironic that—having spent months deploring financial derivatives as destabilizing—eurozone leaders are linking their aid to Greece to the price of a widely traded financial derivative—Euribor swap rates.
Question 3: Triggered by what? Nominally, the eurozone aid requires unanimous agreement, but in reality the trigger is in the hands of the Greek government. As the eurozone group chairman Jean-Claude Juncker said in a press conference, Athens will decide when the aid is disbursed. Here the eurozone commitment to preempt parliamentary approvals in favor of a Greek request for aid is designed to facilitate timely assistance.
The German government has very likely gotten an unofficial agreement from the Greeks to delay their aid request until after the German regional elections on May 9. It remains to be seen, of course, if financial markets remain settled for that long.
But what about the longer term, or even just a few months from now?
Since Greece is expected to add to its already daunting debt mountain until at least 2012, even after implementing the announced austerity measures, it is a glaring omission that the eurozone agreement fails to address how or when Greece will pay its debt back.
Because eurozone aid is front loaded, assistance during 2011 and 2012 will most likely come from the IMF, subject to joint agreement. But there are constraints on IMF funding for individual countries. This restriction suggests that the sums available for Greece in 2011–12 will be smaller than in 2010—even though Greek debt will be larger.
The engineers of the aid package obviously hope that financial markets will place more faith in Greece's solvency and offer it lower interest rates down the road. In light of this week's Greek government auction of short-term bills, however, their hope appears misplaced.
The fact that Greece had to sell 6- and 12-month bills at a high 4.5- to 5-percent yield, twice what it paid for similar maturities in January, despite having now gotten a de facto eurozone guarantee for this short-term paper during 2010, was a devastating market verdict on Greece's long-term prospects. If the eurozone package did not impress the markets, such confidence may be a long way off indeed.
Compounding Greece's prospects is the determination of Greece's official sector creditors in the eurozone, the European Central Bank (ECB)5 and the IMF6 to force deflation on the country, which will further drive up real interest rates paid by Athens. For a country as highly indebted as Greece—both Ireland and Latvia had far lower debt stocks when they began "legislating deflation"—this route will be extremely painful.
As Keynes said, when the facts change, one must change one's mind. The latest facts indicate that the Greek government cannot likely implement more austerity measures sufficient to generate a government surplus needed to meet its debt service obligations. The eurozone and IMF, for their part, show no signs of willingness to commit the required substantial additional resources. As Greece faces ever fewer prospects for lowering its capital costs, an increasingly panicky market, and higher debts than Ireland and Latvia, a Greek default appears increasingly inevitable.
If a credible commitment of €30 billion from the eurozone didn't sway markets, will the eurozone and the IMF conclude that it cannot throw more of its good money after bad?
European taxpayers might well conclude that the effects of an immediate Greek default, provided it does not produce a contagion, could be no worse than pumping billions of euros into a hopeless situation. Since so much of Greece's debt is already owned by other eurozone banks, many of them state guaranteed, one could argue that the difference for taxpayers would actually be minimal. The money would be lost through bad loans to Greece or losses in their state-guaranteed banks, some of which might fail as a result. Pick your poison!
If eurozone governments and the IMF do disburse bilateral loans and direct IMF loans only to see Greece default, they would no doubt politically seek to acquire a rank of "super-preferred creditors." An ensuing squabble among Greece's creditors over who has a superior status is not in anyone's interest. But that is what would be ushered in by an increasingly likely Greek default.
The only good news this week, which ironically is actually bad news for Greece itself, is that the immediate contagion risk has lessened for other weaker eurozone members whose bond rates have become increasingly disconnected from Greece. Seemingly markets are increasingly betting that while Greece cannot be saved, at least the fallout can be contained.
Notes
1. Euribor rates are based on the average interest rates at which a panel of banks active in the eurozone borrows unsecured funds from one another. See the panel of banks. Swap rates are used for "Euribor rates" of longer maturities above 12 months.
2. An additional 100 basis points will be charged for funds not repaid after 3 years.
3. See comments by Bank of France President Christian Noyer.
4. See Joachim Starbatty's comments.
5. ECB president Trichet answered with an unambiguous "Yes!" when asked if uncompetitive eurozone countries must accept a period deflation to restore long-term economic growth prospects.
6. IMF Managing Director Dominique Strauss-Kahn stated to an Austrian magazine that "The only effective solution left to Greece is deflation. Exactly that has also correctly been recommended by the European Commission."
