As euro area members jockey over who will pay to keep Greece afloat in the next two years, political grandstanding by elected leaders is to be expected. A lively display of those tactics is under way ahead of the euro area and European Union (EU) meetings later this month, from June 20 to 24. So are the various countries’ maximalist negotiating positions, outlined for domestic consumption, in discussing possible new terms for the EU-International Monetary Fund (IMF) bailout program.
The German Finance Minister, Wolfgang Schauble, went down the maximalist route, for example, in his June 6 letter to the European Central Bank (ECB), the IMF and the euro area finance ministers. Germany demands a "fair burden sharing between taxpayers and private investors" and a process that "has to help foster the Greek debt sustainability," he wrote. Specifically, Schauble outlined in his letter that as far as Berlin was concerned:
"This means that any agreement on 20 June has to include a clear mandate -- given to Greece possibly together with the IMF -- to initiate the process of involving holders of Greek bonds. This process has to lead to a quantified and substantial contribution of bondholders to the support effort, beyond a pure Vienna initiative approach. Such a result can best be reached through a bond swap leading to a prolongation of the outstanding Greek sovereign bonds by seven years, at the same time giving Greece the necessary time to fully implement the necessary reforms and regain market confidence."
The "Vienna Initiative approach1" rejected by Schauble refers to the move by European banking authorities to persuade European banks to permit Eastern European countries facing insolvency in 2008 to roll over their debts. The clear message is that Germany is demanding a genuine bond restructuring that will merely make Greece’s default orderly as opposed to "the first unorderly default within the euro zone."
On the other side of the table sits the ECB, which explicitly opposes the demands for haircuts to private bondholders at least for the time being. The central bank has clearly stated a maximalist pre-meeting negotiating position that in the event of a Greek default, i.e., a restructuring, Greek government bonds will no longer be eligible as collateral with the ECB. Such an occurrence would inevitably trigger a collapse of the Greek banking system, as the Greek government does not have the resources to recapitalize their banking system to the extent that Greek banks can. The government thus lacks the ability to regain access to private market liquidity. The ECB will only accept a purely voluntary bond rollover, which it clearly does not view as a restructuring. Banning any Greek collateral after a restructuring is ultimately another way to achieve "the first unorderly default within the euro zone."
As usual, such talk makes a Greek collapse and a crisis in the euro zone seem inevitable.
But there is another possibility that actually seems more likely, raising doubts about the euro-bear scenario. After all, underestimating the EU’s ability to reach a compromise in a crisis has so far been a losing bet. A closer look at the positions of Berlin and the ECB reveals some room for maneuver.
First, it is not clear what Schauble means by a "beyond a pure Vienna Initiative approach." Presumably an agreement that was 95 percent Vienna Initiative (e.g. mostly involving private creditors through voluntary bond rollovers) and just 5 percent something else, could be acceptable. Similarly, Schauble’s proposal for a bond swap into 7-year maturities is merely the way that private sector participation "can best be reached," as he put it. This presumably opens the way foralternatives.
Second, it is a mistake to interpret the ECB’s current fierce resistance to a debt restructuring as outright rejection. Indeed, the ECB Governing Council member Lorenzo Bini-Smaghi made this very clear in a speech in Berlin earlier this week, when he stated that such restructuring:
"…should only be the last resort, i.e. when it is clear that the debtor country cannot repay its debts. Incidentally, this is the way the international community has functioned and cooperated since the Bretton Woods agreement, which set up the IMF. Countries are never encouraged to default or restructure their debts unless they are in a desperate situation and have no alternative."
The ECB thus appears willing to contemplate a future Greek restructuring when all other options are exhausted, as determined by the euro area membership, the IMF and ECB.
This author believes that Germany will and should lose the argument ruling out a restructuring later this month. The necessary private sector participation in the financing for Greece in 2012 and 2013 will likely come in the form of a pure voluntary Vienna Initiative rollover approach without what the rating agencies call a "credit event" requiring a downgrade to default status of Greek government bonds. There may, on the other hand, be a minuscule face-saving measure to placate Germany. The final deal will probably largely fund Greece until the end of 2013 and maintain a sizable private sector exposure to Greek debt until that time. Implicitly, the stage will then be set for a comprehensive Greek Brady-style debt restructuring not much later than the end of 2013, when the current IMF program is scheduled to expire with Greece remaining highly unlikely to have regained normal market access.
This outcome would follow the previous playbook of this crisis in which Germany in the 11th hour backs down, and makes its financial contribution to the official sector bailouts in return for deep economic reforms in recipient countries, and partly the ability to dictate longer-term EU institutional reforms, as it has demanded since May 2010.
Despite the surrounding bombastic rhetoric, this resolution would be a good outcome for Berlin. German arguments for a Greek debt restructuring now, rather than a voluntary debt rollover, are unconvincing. Assuming that a debt rollover is effectively implemented and many private sector creditors with maturing medium and long-term bonds2 are unable to exit Greek exposure at par3 in 2012 and 2013, these private bondholders will remain vulnerable to losses in a future Greek restructuring.
Just as U.S. banks were forced to participate in the Latin American debt crisis in the 1980s, however, mainly euro area banks and other private creditors will have had an additional two years – by 2013 – to build up reserves against which Greek restructuring losses can be counted. If they use the time wisely, it will reduce the risk of a contagion resulting from an eventual Greek restructuring.
Similarly, the risk of "country contagion" to other euro area members from a postponed Greek restructuring will be significantly reduced with time, if the projected fiscal consolidations and policy proposals are implemented. By late 2013, for instance, Spain is projected to have a deficit of 3 percent of GDP and will likely have completed the reform/recapitalization of its troubled Cajas sector. As a result, considerably more market clarity about the long-term solvency of Spain should exist by then, again reducing the scope for contagion.
Other arguments brought forth in this debate4 include attacks on the ECB for opposing restructuring based on concerns about its own balance sheet. The bank already holds tens of billions of Greek government bonds purchased through its Securities Market Program (SMP), so the ECB might want to avoid losses in any restructuring.
It is worth asking an obvious question here. Who owns the ECB? Euro area governments do. It is they who would be asked to make up any losses according to the ECB paid-up capital key. Unlike in a private bank, where stock-owning management would surely have a self-interest in not recognizing losses, ECB bureaucrats have no such conflicts of interests, but would simply pass the bill along to euro area taxpayers.
It is nonsense to argue that the ECB leadership should be greatly concerned about the losses to the bank’s own balance sheet from an imminent Greek restructuring. Such losses might not even warrant a recapitalization, because the ECB enjoys a sizable income from its other assets. The real concern of the ECB is not from what they have already bought, but from bonds they might have to buy in the future, should a Greek restructuring spread financial contagion to Spain or Italy.
At the same time, it is unlikely that everything will go the way the ECB wants. Assuming that there is a deal between the euro area governments and the IMF that will finance Greece for 2012 and 2013, including a voluntary "Vienna Initiative debt rollover" of sovereign Greek debt that is declared a "credit event" by the rating agencies5, the ECB— like Germany—will back off from its maximalist pre-negotiation position and continue to accept Greek collateral in its open market operations.
If Greece’s fiscal position is endorsed by "the international community" and the country gets most of the new money it needs from euro area governments, the IMF and debt rollovers, it would be unthinkable for the ECB to block the use of Greek collateral in an open market and thereby blow up the European economy.
It would unthinkable because it would mean that the ECB would allow unelected and unrepresentative credit rating agency analysts with a poor record of predicting credit crises to hold a gun to Europe’s head by characterizing a sound political compromise as a "credit event" necessitating a downgrade to junk status. That would amount to handing credit rating agencies the power to destroy the European economy— an absolutely unacceptable position for the ECB. Faced with Greece being funded by new Greek austerity, privatization proceeds, the euro area, the IMF and rolled-over private sector bonds for 2012 and 2013, the ECB is certain to once again "change its rule book" for these issues, just as it did in April of last year when it suspended the application of a minimum credit rating threshold for Greek collateral.
Another plausible scenario would unfold if the euro area governments agree to pour more money into Greece, while demanding in return "private sector participation" in restructuring Greek privately held debt, as opposed to Greek sovereign or government-guaranteed bank debt. Such a step would reduce the risk of contagion into the sovereign bond markets of other euro area members and hence make it more palatable for the ECB. Faced with such a solution, the ECB would never press the nuclear button and exclude Greek sovereign (and sovereign guaranteed) debt from its acceptable collateral. The problem, on the other hand, is that it is not clear that there is enough non-sovereign Greek debt to shield euro area politicians from eventually having to send more taxpayers’ money to Athens.
When designing a solution to Greece’s financing problems, one thought must remain upper most in the minds of policy makers: "It’s the Contagion, Stupid!" It may be hard, but the situation requires Germany and the ECB to compromise.
1. The European Bank Coordination "Vienna" Initiative (EBCI) was launched in 20008 to provide a framework for coordinating a solution to a threatening financial sector collapse in Eastern Europe. The initiative aimed to prevent a large-scale and uncoordinated withdrawal of foreign bank groups from the region, ensure that parent bank groups publicly commit to maintain their exposures and recapitalize their subsidiaries, ensure that national support packages of cross-border bank groups benefit their subsidiaries in emerging Europe and avoid a home bias in dealing with Europe’s banks, and agree on basic crisis management and crisis resolution principles in the region. The principally involved institutions were the EBRD, IMF, EIB, World bank, European Commission, ECB, national central banks in Eastern Europe and all major private banks operating in the region. See http://www.ebrd.com/downloads/research/factsheets/viennainitiative.pdf .
2. The latest IMF review states that Greece has €35bn in 2012 and €29bn in 2013 in maturing medium and long-term bonds. As such, a debt rollover of these bonds to "ensure private sector participation" need not be 99.9 percent of private creditors, but can instead be only a subset hereof. See 3rd Review of the IMF Program (table 13 ).
3. Note that all private creditors are always free to sell their Greek bonds, but would given current extremely low secondary market prices then have to take a sizable loss hereon.
4. See for instance http://www.economist.com/node/18681980.
5. Several credit agency representatives have stated that they likely would rule a Vienna Initiative type solution for Greek debt rollovers would constitute a "credit event. See http://www.bloomberg.com/news/2011-06-09/moody-s-says-voluntary-participation-on-greece-s-debt-is-hard-to-imagine.html.