Greece—The Gun Was Loaded with Blanks

So today (Friday) Greek Prime Minster Papandreou formally fired what he has called the "loaded gun" aimed at speculators in the financial markets and formally requested that the promised aid package of up to €45 billion from the European Union and IMF be activated.

The IMF announced its willingness to "move expeditiously on this request," while unsurprisingly Europe—in the form of a joint statement by the European Commission, the European Central Bank (ECB) and the eurozone—"take[s] note of the request." They further declare that "Euro area member states will decide upon the activation of this mechanism…based on the [program] that is currently being prepared by the Commission, the ECB, and the IMF together with the Greek authorities." Even if European officials say that these negotiations will be finished in a matter of days, bond markets have again shown their ability to dictate events, as European policymakers struggle to keep up with the rapidly escalating crisis.

There is little doubt that the speed of this Greek request has caught European decision makers off guard. They would clearly have preferred to have the joint European-IMF program with the Greek government negotiated and agreed ahead of a formal activation of the program. The German chancellor, Angela Merkel, announced after the official Greek request—in a clear effort to buy time—that the German government will only begin considering the Greek request once the joint eurozone-IMF program has been negotiated. The German government still appears to reserve the right to agree or disagree with the content of a future joint program, which clouds the prospects of the German commitment to the earlier eurozone plan.

Regrettably for the Greek government and European leaders, the market reaction to the latest developments has called their bluff. Bond spreads on Greek debt hardly moved after the announcement, and they even started to rise again toward the end of Friday's trading in European markets, with spreads on the benchmark Greek 10-year bond staying above an unsustainable 500 basis points.

Considering that the earliest IMF money is likely to flow to Greece only in a fortnight or so, it seems likely that spreads on Greek government debt will continue to rise in the coming weeks. Meanwhile the fact that Greece's yield curve is now inverted (shorter-term 2-year yields are higher than longer-term 10-year yields) suggests continued market belief that a debt restructuring will be required.

The verdict on the eurozone-IMF program is very clearly "too little, too late and still too uncertain." There are two principal reasons for why this very negative market reaction makes sense. First, the Greek decision to trigger the program early complicates political approval, particularly in Germany. The Merkel government will now have to put the law authorizing the disbursement of the German share (€8.4 billion) of the eurozone aid to a vote in the German parliament right before crucial regional elections in the German state of North Rhine-Westphalia on May 9. With public opinion in Germany overwhelmingly opposed to any German taxpayer assistance to Greece, there is a considerable risk that the German parliament might lose this vote, throwing the entire eurozone aid component into doubt.

These political complications will likely generate bitterness in Germany (and other eurozone governments) toward Greece.

Second, even with a rapid disbursement of aid, Greece's longer-term sustainability problems have not gone away. A full €45 billion would only cover Greece's refinancing needs until late in 2010, after which Athens will once again have to raise money in the private markets or ask for additional concessionary funds. Private financial markets are not interested in lending to Greece at rates it can afford. The Greek prime minister, George Papandreou, said earlier in the crisis that the Greek government could not afford to pay even 6 to 7 percent yields on its long-term debts, far below the levels demanded by markets today.

The prospects for such additional official aid after 2010 seem distant, and in any case another aid package would violate the political rule that elected politicians should not be asked for two bailouts in a row. Today's Greek request to activate the eurozone-IMF financial assistance plan therefore has made no difference for the Greek outlook. The country still needs to go through a debt restructuring. In fact, by accelerating the timetable in this unexpected manner, the Greek government may have increased the likelihood of a debt restructuring in an unorganized manner, posing a danger of spillover effects on to other eurozone countries as well as the European banking system.

Since markets are assuming Greece will default, even as European politicians seem to think it won't, it is useful to speculate on what will take place in rational markets if a default is inevitable. What would be the "choice architecture" for European policymakers if no new actions are taken?

Greek government debt remains eligible as collateral for ECB open market "reverse transactions,"¹ and with the market expecting a default, rational market participants will deposit their exposure to Greek government bonds with the ECB. Hence, it is not unreasonable to assume that in the coming days, outstanding Greek government debt will land on the ECB balance sheet.

This outcome could prove useful for a Greek debt restructuring. As rational investors expecting a default seize the opportunity offered them by the ECB collateral policy, only one outstanding creditor for Greece would emerge—namely the ECB. So far, so good.

On the other hand, the ECB would single-handedly have to take the entire loss from a Greek haircut. Ultimately, of course, such a loss would be passed on to the "owners of the ECB," namely eurozone governments, distributed according to the ECB paid-up capital ownership.

Assuming no policy action is imminent, €300 billion in outstanding Greek government debt (assuming that both domestic and foreign financial institutions find a way to dump their entire exposure with the ECB), combined with a 50 percent haircut, would yield the following losses by eurozone members.²

Table 1 shows how in the "rational markets, passive politicians" scenario for a Greek debt rescheduling, Germany becomes the loss leader with a paper loss on Greece of €45 billion, while it costs France €32 billion, Italy €28 billion, Spain €18 billion, and so on.

Of course, since the ECB need not mark-to-market its balance sheet, European leaders could, in theory, literally paper over a Greek default. Although this is highly unlikely to be accepted by European publics.

Notes

1. An ECB "reverse transaction" is a repurchase agreement (or repo) where the ownership of the asset is transferred to the creditor, while the parties agree to reverse the transaction through a retransfer of the asset to the debtor at a future point in time. ECB main refinancing operations have reverse transactions with a one week maturity, while ECB longer-term refinancing operations have reverse transactions with one month maturity.

2. This assumes that Greece itself and non-eurozone members do not participate.