What the Latest Euro Area Debt Market Instability Tells Us

April 20, 2011 12:45 PM

While much commentary in recent days have been focused on Standard & Poor's  (S&P) "shot across the US Congressional bow" with its negative outlook on US federal debt, it was actually euro area policymakers who received the most serious recent "market reminder" about the still perilous state of their plan to stabilize euro area peripheral governments.

Just how fragile the euro area financial circumstances remain is amply illustrated by the fact that a few speculative media reports about an imminent Greek debt restructuring managed to create the kind of euro area debt market contagion to Spain and Italy that the recent Portuguese request for a financial bailout did not.

Greece's enormous current debts are well known, so that an un-sourced story in a Greek newspaper1 about a "senior IMF" official had confirmed that Greece had already requested a maturity transformation of all Greek debt (e.g. involuntary restructuring), plus an equally un-sourced story from Reuters2 about "German government sources'" discussion of the need for Greece to restructure by the end of the summer, could cause such a market trauma and contagion suggests several things;

First of all of course, financial markets, when they are in a state of uncertainty as with the euro area today, react excessively to rumors. In a euro area, where "message discipline" among many elected officials and institutions is simply not possible (or even democratically desirable), this adds additional risks to the politically necessary prolonged muddling-through strategy.

Secondly, and far more importantly though, is to look at what the content of those rumors were. Evidently mere un-sourced rumors about a potential Greek debt restructuring has far more weight in the financial markets for Spanish and Italian debt that the actual bailout application of fellow Southern periphery country Portugal. That should tell euro area policymakers something about the makeup of their sovereign debt markets, where the verdict seems pretty obvious; talk about default = immediate contagion across all peripheral countries. This again illustrates how the major buyers of euro area government debt do not differentiate between the individual peripheral euro area members and talk about default in one immediately affects all, including euro area members of systemic importance.

Not without irony, and perhaps counter intuitively this observation should actually make Greek debt safer to hold for private bondholders. This is so, as recent days' events illustrate beyond doubt how Jean Claude Trichet and the ECB is right to consistently warn euro area policymakers about the debt market mayhem that imposing involuntary haircuts on all Greek bondholders would cause. Given the reaction to even unsubstantiated rumors, it is easy to imagine what chaos would engulf countries like Spain or Italy if euro area leaders actually implemented this "haircut solution" to the euro area sovereign debt crisis. Contagion would be uncontrollable.

Given how in reality the "insurance policy" EU leaders have created during the crisis (in the form of the EFSF and the ESM) does not hold sufficient capital to, in addition to Greece, Ireland and Portugal, rescue both Spain and Italy simultaneously, it should consequently now be even more obvious to EU leaders that alternative solutions without involuntary haircuts will have to be found to especially the Greek debt problem.

In sum, since the euro area does currently not and from the long-term institutional response envisioned in the recent EU Council Decisions will not in the medium-term be able to deal with uncontrolled financial market crisis affecting Spain or Italy, EU leaders for their own sake should not trigger one by thinking they can just proceed with haircutting Greek private debt holders. In many ways, policymakers are now trapped by their own earlier assurances to markets and their own voters that no across-the-board haircuts would be imposed pre-2013 and that no default will be allowed to occur.

From the perspective of moral hazard among national euro area taxpayers and their elected representatives, this will undoubtedly be an uncomfortable conclusion.

In searching for "alternative solutions" without involuntary haircuts, it is though informative to try to decipher the one set of recent on-the-record comments by a policymaker that has direct influence on the outcome, namely Germany's Finance Minister Wolfgang Schauble. In his – frequently by the way misrepresented – interview with German newspaper Die Welt3, Schauble makes the observation that in the hypothetical future event that Greek debt sustainability is in doubt, "further measures must be taken". He then proceeds to repeat the euro area decision that only after 2013 will creditors face possible haircuts on new debt, while before that only voluntary rescheduling would be possible.

It is worth noting that while it is often assumed that the term "rescheduling" entails deferred payment of the amount of the debt, and the provision of debt relief solely through the delay in repayment (protecting the NPV of the debt), the adoption of "concessional rescheduling" results in the reduction of the debt-service obligation4. In principle therefore, the German finance minister could well in Die Welt have referred to "voluntary reductions" in the Greek debt burden before 2013.

Considering that it now looks increasingly unlikely that Greece will be able to access the financial markets in 2012 and according to the current IMF program raise about $25bn at anything close to the interest rates at which additional EFSF money would be available (e.g. at yields around 5 percent of so), this potentially matters a lot.

At some point in 2012, Greece would need more money to avoid default and as a result of the contagion discussed above would with near certainty certainly get it from the other euro area countries. This raises the issue of what the political conditionality attached to such additional loans would be for the Greek government and the broader circumstances in which such additional euro area taxpayers money would flow to Greece.

In the March 2011 agreement with Greece, the euro area leaders proved perfectly willing to restructure their existing loans to Greece in exchange for additional political conditionality in the form of an expanded Greek privatization program5. However, since in 2012 additional money must be sent to Athens, additional political cover for the authorizing euro area leaders will likely be needed. But what type of political cover will it be?

Here it should be kept in mind that the European banking system by 2012 will have had an extra year in which to continue its ongoing recapitalization, and that the euro area economy as a whole at current projections would have had an additional year of quite solid growth behind it. As such, even as soon as 2012, there might be a somewhat improved real economy situation for the euro area and in its banking system especially. Consequently, euro area governments will likely in 2012 have less reason to continue their current strategy of "regulatory forbearance" (e.g. lying about the true health of many euro area  banks) vs. their banks and instead bring these into the solution of the Greek situation.

Enter the type of pre-2013 "voluntary and potentially concessional debt reschedulings" mentioned by Wolfgang Schauble.

In 2012, euro area leaders will need political cover for giving more taxpayers' money to Greece. What better way to get such political cover than by doing it in concert with "private sector participation" in the form of voluntary concessional rescheduling of Greek debt held by those European banks, which at that point in time have sufficient capital reserves to withstand such write-downs? Surely in such circumstances, where bankers and their shareholders share the costs, the political obstacle to granting Greece more taxpayers' money would be far lower.

Several options look possible; Similar to the process seen during the Brady Bond exchanges after 1989, all European banks holding Greek debt could be offered a suite of different "concessional rescheduling options", or individual banks could be identified by their regulators and behind closed doors arm-twisted into participating.

Given the stakes at risk for the euro area in 2012, market participants probably make a mistake in underestimating the willingness of euro area governments to "force banks into voluntarily sitting down at the negotiation table" in whatever form the process will take. As such, Greece's need for additional taxpayers' money from the euro area will mark the point at which the current regulatory forbearance vs. euro area banks shifts towards something more akin to financial repression.

But would banks agree to some kind of concessional rescheduling and/or related debt swaps without various credit sweeteners, and even if the management would like to, could they do so without the risk of shareholders lawsuits? Again, while the precise form of coercion relied upon by euro area governments at this point in time is difficult to predict, the width of and willingness to use innovative tools to such ends should not be underestimated.

The use of "credit sweeteners" implies that a creditor would get some sort of positive financial incentive to enter into a "voluntary concessional rescheduling". However, as the "Lord giveth and the Lord taketh away", it is also imaginable that an incentive for euro area banks to voluntarily enter into such negotiations is created not by giving them a new position incentive to do so, but by the regulatory threat of taking something of value that they already enjoy away from them. The ECB to give an example – which it should be recalled was instrumental in pushing both the Irish and Portuguese governments to give up their resistance to bailouts – would have plenty of opportunities through creative and coercive use of its collateral framework to give sufficiently healthy euro area banks "an offer they couldn't refuse".

Given how the ECB Governing Council has repeatedly stressed "that, if required, the Eurosystem has the possibility to limit or exclude the use of certain assets as collateral in its credit operations, also at the level of individual counterparties."6, recalcitrant euro area banks might suddenly find themselves and some of their otherwise eligible lower-rated assets – such as for instance all their existing Greek government bonds – partly excluded from Eurosystem market operations.

Making continued full access to the Eurosystem's various liquidity provision facilities in 2012 "conditional" on involved banks' willingness to a negotiate concessional rescheduling with Greece would moreover suggest a healthy introduction of the "IMF/ESM principle of conditional aid" into the realms of monetary policy and liquidity provision. A desire to keep its options open in 2012 may also be one of the reasons the ECB at its latest meeting declined to introduce a new conditional "medium-term liquidity" facility7.


1. http://www.enet.gr/?i=news.el.politikh&id=268301

2. http://www.reuters.com/article/2011/04/18/germany-greece-debt-idUSLDE73H17P20110418

3. The entire interview is now available (in German) on the German Finance Ministry webpage at http://www.bundesfinanzministerium.de/nn_122544/DE/Presse/Reden-und-Interviews/14042011-WELT.html?__nnn=true

4. See IMF Glossary of External Debt Terms at http://www.imf.org/external/pubs/ft/eds/Eng/Guide/file6.pdf

5. /realtime/?p=2082

6. http://www.ecb.int/press/pr/date/2010/html/pr100728_1.en.html

7. http://www.ecb.int/press/pressconf/2011/html/is110407.en.html

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