Greek actors seek divorce from reality

Greece, Germany and the European Central Bank appear to be petitioning for a divorce, not from each other, yet, but from reality, citing irreconcilable differences.

As in all such divorces, reality will get by far the best end of the settlement and it will be the children, or should that be the citizens, who suffer.

Greece, shut out of the capital markets, needs money, and soon, and is willing to play along with the fiction that the next tranche of aid, perhaps 90 billion euros, from the European Union, International Monetary Fund and ECB will buy them enough time.

The ECB, which is up to its eyeballs in exposure to Greek debt, steadfastly maintains that it won’t countenance a soft restructuring, or default, presumably because it fears this will be too much for it, the banks, and the global financial markets to bear.

Germany, however, is insisting on just that; it maintains that the private sector will have to bear some of the costs, and while there is much discussion about “soft” restructurings featuring debt repayment extensions, no one has credibly explained how the private sector can take its lumps without it being considered a default.

Standard & Poor’s on Monday slashed Greece’s debt rating to CCC, the lowest rating it currently has on any nation, saying what is obvious to everyone outside this particular marriage, which is that it just isn’t working any more.

“In our view Greece is increasingly likely to restructure its debt in a manner that, under the conditions of any package of additional funding provided by Greece’s official creditors, would result in one or more defaults under our criteria,” S&P wrote about its move.

“We are also of the view that risks for the implementation of Greece’s EU/IMF borrowing program are rising, given Greece’s increased financing needs and ongoing internal political disagreements surrounding the policy conditions required by Greece’s partners.”

The ECB has perhaps 40-50 billion euros’ worth of Greek bonds on its balance sheet, and has lent about another 90 billion or so to Greek banks. It has threatened, in the event of a restructuring, to stop accepting Greek debt as collateral, a move that would be tantamount to cratering the entire Greek banking system at once. This would also deal sharp losses to the many euro zone national central banks which are exposed, potentially causing some to need additional capital.

By destroying the Greek bank sector, the ECB would, quite possibly, effect the exit of Greece from the euro zone. Depositors in Greek banks understand this, and have been withdrawing funds. Two-year deposits fell 8 percent from a year ago in April, and savings deposits fell by 16 percent, according to Bank of Greece data.

Playing Chicken

Given all of this, it seems likely that the ECB will relent, though in doing so they will seriously impair their credibility.

Even if the ECB relents and decides that it will not be the one dealing death to Greek banks in the event of a default, what then? This is the problem with Germany’s position, which rightly demands private sector participation but isn’t nearly radical enough to actually get Greece out from under.

A Greek default, under the terms currently being debated, may turn out to be the worst of outcomes. It will raise the possibility of global market fragility without putting Greece on a sound footing. For example, though most direct exposure to Greece is held by European banks, there would be a high price to pay for U.S. institutions which have been selling default insurance on Greece. Economist Kash Mansori estimates that U.S. institutions would actually bear more of the total losses than German ones, a state of play which perhaps partly explains German hardball tactics.

The terrible irony is that even if the parties can agree a course, none of the courses they seem likely to agree will leave Greece able in two years’ time to fend for itself. That mooted 30 billion euros of private sector burden sharing is just a down-payment. And of course, as soon as Greece defaults, the eyes of the market would immediately turn to Portugal, Ireland and even Spain.

The problem with the European approach to its weak states is that the scope has been too narrow. Rather than figuring out how to keep Greece upright without knocking over the banks, they would have been far better off figuring out how to actually make the banking system solvent and sound given Greek insolvency. That would involve huge private sector losses, inevitably, but might just have laid the groundwork for sustainable growth.

Instead we will have a sinking euro and waves of deflationary force coming out of Europe.

[Source: By James Saft, Reuters, London, 14jun11]

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