Could Cyprus leave the Eurozone but stay in the EU?

Now, we're not necessarily saying that Cyprus should leave the eurozone.

But with eurozone finance ministers set for a pretty long and rough night of talks, trying to reach a compromise that will allow Cyprus to live another day inside the eurozone, the question is, if it came to it (i.e. if a deal can't be agreed and ECB turns off the taps), could the country leave the euro but stay in the EU? As we note here and here, due to Cyprus' geopolitical importance, if it did ditch the Single Currency it would be vital that it stayed in the EU.

Leaving aside the question of how Cyprus would be ring-fenced and given a reasonable chance of bouncing back with its own currency (a big one to leave aside admittedly), what would the legal and political mechanics look like?

There is currently no mechanism for a country to leave the eurozone. However, there is a provision (article 50 TEU) that allows for a negotiated exit from the EU. This has lead some analysts to conclude that a country has to leave the EU if it left the euro. We disagree.

As so often in the EU, this will come down to political negotiations. The below analysis is based on our paper from last year on a possible Greek euro exit (which, incidentally, we said was unlikely to happen in the short-term). The line of reasoning very much applies to Cyprus. 

Given the absence of a specific euro exit article, there are two ways in which a country can leave the Single Currency.

• Changing the EU treaties to allow for a euro exit mechanism, perhaps modelled around article 50 (possibly even simply extending the article to refer to a euro exit) or the idea – floated by German politicians – to automatically trigger an exit if a state is unwilling or unable to comply with the rules governing the single currency. This would require agreement amongst all 27 member states and would essentially be a treaty renegotiation (making it complex and long winded). 

• Using existing articles in the treaties which provide flexibility to address a number of issues, such as article 352, to legally facilitate withdrawal from the euro but not the EU. This would also require agreement amongst all 27 member states and the European Parliament. Per definition, a decision for Cyprus to leave the euro has to happen essentially overnight (some estimates have put the real time available at 46 hours). This is problematic as a treaty change could take months, even using the fastest track (the simplified revision procedure, which needs to go through at least some national parliaments). 

Historically, political expediency has trumped EU law. Although it would not be clear cut or easy – and involve a legal stretch – we believe that in order to take a swift decision and avoid a Treaty change EU leaders could (and most likely would) use existing provisions in the EU treaties to allow for a Cyprus euro exit. In particular Article 352 TFEU – sometimes referred to as “the flexibility clause” – allows member states to take measures to achieve EU “objectives” (subject to unanimity and consent of the European Parliament but not ratifications in parliaments), when those are not already provided for in the EU Treaties. Article 352 states,

“If action by the Union should prove necessary, within the framework of the policies defined in the Treaties, to attain one of the objectives set out in the Treaties, and the Treaties have not provided the necessary powers, the Council, acting unanimously on a proposal from the Commission and after obtaining the consent of the European Parliament, shall adopt the appropriate measures."

This article could be used to provide a legal temporary avenue for Cyprus to leave the euro within the framework of the EU treaties. This would be far from an easy process; there would likely be numerous legal challenges against the move, while the negotiations would be hazardous and subject to domestic political constraints.

Precisely for this reason, a full treaty change would almost certainly be necessary very soon after the actual Cyprus exit (and use of article 352), which would change Cyprus status under the EU treaties from a euro member to a non-euro one and recognise, at least in retrospect, that there is a way for a country to leave the euro (under an expanded article 50 for example). Such a Treaty change would, at least in theory, go some way to counter some of the political uncertainty and legal ambiguity around the status of Cyprus’s EU membership and therefore reduce the risk of legal challenges. However, a full treaty change would come with its own set of political and legal complications. As with Article 352, a treaty change could only happen if all member states agreed. In addition, the changes would most likely have to be ratified in national parliaments.

So far from straightforward, but still plausible.  

Cyprus crisis shows Europe cannot perpetually move in one direction only

In an op-ed yesterday's Times, Mats Persson argued that:

No matter how the nail-biting drama in Cyprus ends, the eurozone has never been this close to waving goodbye to a member. Yesterday afternoon the deputy leader of the ruling party claimed that his country was hours away from agreeing an emergency package of tax rises and spending cuts to secure the EU’s €10 billion rescue loan.

If no deal is struck by Monday, the European Central Bank, on whose cash Cypriot banks depend, will pull the plug. With a banking sector seven times the size of GDP, Cyprus would default and probably crash out of the euro. The big question is whether a country can exit the euro without taking all Europe down. In the case of Cyprus the answer is straightforward: it could leave without causing a crisis, but it wouldn’t be pretty.

For Cyprus it would be extremely messy. To avoid massive capital flight there would have to be strict controls on financial movements, with border guards ready to stop people taking cash out of the country. After that would come a decree establishing a new Cypriot currency and a series of defaults on foreign debt. This would probably all have to be done in a weekend to avoid panic and contagion. A new central bank in Nicosia would fire up the printing press, which could trigger inflation. Cyprus could limp on with the help of external cash, possibly from the EU and the IMF or Russia — but it would be painful.

 For the rest of Europe there is a fear that a Cypriot exit could bring down Greece, Portugal, Spain or Italy. There are three ways in which contagion can spread: direct losses for banks or governments elsewhere in the EU start a chain reaction; depositors in other countries panic and cause a bank run; or nervous international investors fearful of losing out to the “next Cyprus” push the cost of borrowing up for other indebted governments.

But this is unlikely. Cyprus accounts for only 0.2 per cent of eurozone GDP, and vulnerable countries have little exposure to its economy. Greece would take a hit, but is already ring-fenced via EU bailout funds. Depositors in other countries have so far been unfazed by Cyprus’s troubles and even markets have been relatively calm. This suggests that Cyprus is a special, and financially marginal, case. In addition, the ECB’s promise to “do what’s necessary” to save the wider eurozone will provide extra reassurance to markets.

Instead the risks of a Cyprus exit are mainly geopolitical. The fear is that Nicosia turns to Russia for aid in return for, say, a Russian naval base on the island. Given its location, this would be a strategic nightmare for Europe.

To avoid such a scenario, it would be vital for Cyprus to stay in the EU, even if it left the euro. While life outside the EU may sound appealing to many Brits, it is different for a small open economy such as Cyprus. To complicate matters, EU treaties currently provide only a way to leave the EU (Article 50 of the Lisbon treaty), not the eurozone.

However, the EU specialises in legal acrobatics and there are articles in EU treaties that can be used for all kinds of purposes. One such clause provides a general legal base to achieve the “objectives of the treaties”, which include protecting the EU itself. It will be wrapped in a cobweb of legal jargon, but will effectively come down to a political decision by EU leaders.

And this is where it gets interesting for Britain. A Cypriot euro exit would have wide political ramifications: one of the founding principles of the EU — “ever closer union” — would be history. A swift, “Band-Aid” solution would almost most certainly have to be followed by a reworking of the EU treaties to recognise that the direction of travel is no longer only towards greater integration. The EU will have become a two-way street in which powers can be passed back to member states and its laws and institutions will have to reflect that.

Even if Cyprus does not leave the euro — and a revised bailout deal remains the most likely outcome — this episode signals that Germany and the other northern European countries are no longer willing indefinitely to foot the bill alone. At the same time the eurozone continues to lack the tools to deal with an acute crisis. This makes change almost inevitable for the way the eurozone is governed. Some governments have already called for a formal mechanism to allow a country to exit the euro. Europe cannot, perpetually, move in only one direction. And, in one way or another, Cyprus may be about to prove that.

A euro exit may benefit Greece eventually but it won't be an easy ride

Over the weekend, we published a new briefing looking at the implications and likelihood of a Greek exit from the euro. We argued that an imminent Greek exit isn't inevitable, nor that it would solve Greece's problems - though, if managed, leaving the single currency could potentially be beneficial for the country in the long-term. Over on Telegraph blogs, we argue:

"if Greece defaulted and left the euro – perhaps following a failure to reach a compromise after the Greek elections on 17 June – it would be bad news all around:

• The Greek banking sector – woefully undercapitalised since the losses it took as part of the second bailout – would instantly collapse. Pensions would take a massive hit too. In order to avoid a complete economic – and social – meltdown, between them, banks and pension funds would need an instant €55bn injection of fresh capital. At the same time, full nationalisation of Greek banks – which has been mooted by the ‘radical left’ Syriza party – could prove pretty disastrous. The balance sheets of the six largest Greek banks are equal to 113pc of the country’s GDP – taking on all their liabilities would send Greek debt to GDP skyrocketing once more, potentially eliminating the benefits of the debt write-down.
• The new Greek Central Bank would also need to create at least €128bn worth of the new currency (63pc of Greek GDP) in liquidity to help keep Greek banks afloat as the Eurosystem withdraws its support. Hello inflation.
• Contrary to popular belief, a euro exit wouldn’t mean the immediate end to austerity for Greece either – the country would still have to find savings of at least €12bn to pay various bills, including hospital and social security expenditure vital to uphold social order.
• At the same time, the new Greek currency could devalue by around 30pc, which in theory increases chances of growth in the long-term (as the country is no longer stuck with a hopelessly over-valued currency), including a potential boost to exports equivalent to 10pc of GDP. But in reality, any potential export gain could be diminished if the ‘stub euro’ weakens (Spain springs to mind) or demand in Europe decreases further. Unlike previous devaluations in Argentina and Iceland – often used as comparisons – Greece has few natural resources or industries to fall back on, which may limit the benefits of devaluation. And remember, devaluing or removing a currency peg is not remotely the same as introducing a whole new currency. The latter is far more challenging.

So where does that leave us? Well, if Greece left tomorrow, we estimate that it could still need between €67bn and €259bn in external short-term support just to stay afloat. This could be split between the IMF, the Eurozone and non-euro countries.
The UK could potentially be involved in such a rescue package, via its IMF participation. In addition, the EU’s so-called ‘balance of payment’ fund – designed to help non-euro countries (which Greece technically would be) and in part underwritten by Britain (to the tune of 13pc) – could be activated. If the UK can get away with underwriting between €4bn to €6bn, which would be one scenario, it should count itself lucky. These would be loans, not up-front cash gifts, and if it served to stem contagion from a Greek exit, such loans would be justified.
To minimise the need for external support and risk of contagion, two steps need to be taken before Greece should even contemplate a euro exit: first, the banking sector should be recapitalised, shrunk, consolidated and restructured. Second, a primary surplus should be achieved to allow the Greek state to fund its day-to-day running costs without external help. Though this would make an exit far more appealing and – with a lot of luck – potentially beneficial for Greece in the long-term, the truth is that for Greece, whether inside or outside of the euro, the road ahead looks very rough indeed.
This is also why a new government in Greece – no matter what such a government would look like following the Greek elections – will likely reach a deal with its creditors, allowing it to remain inside the euro for now.
In European politics, the safest money is always on another fudge."

Spanish banks...Mañana, Mañana...?

The Spanish government held a press conference this afternoon finally laying out its plans for dealing with its significantly troubled banking sector. As usual Spanish Prime Minister Mariano Rajoy dodged the limelight and left the unenviable task of presenting the proposals to his Deputy, Soraya Sáenz de Santamaría, and Finance Minister Luis de Guindos – despite this being par for the course with the new government we still can’t help but feel that it fails to inspire confidence.

That fact aside, the plan did include a few concrete details on how Spain plans to deal with the Spanish banking sector, below we outline the key points and give our take:

·         Two independent auditors will carry out an evaluation of all the real estate assets held by Spanish banks – the Deputy PM termed this “an exercise in transparency”.

Open Europe take: We have been calling for this for some time, so believe it is a positive step. However, we have seen that similar tests have been fudged in the eurozone and Spain before, so it is very much wait and see. Taking an adverse scenario and ensuring these assets are written down to their real values is key – if they start posting falls in the future it will reignite the uncertainty surrounding the banking sector. The Spanish government also failed to mention that, at least according to the Spanish press, de Guindos was going to be asked to hire independent auditors by his eurozone counterparts at the meeting of eurozone finance ministers next week.

·         By the end of 2012, provisions to cover against losses on real estate loans considered as ‘non problematic’ will have to increase from 7% to 30%.

Open Europe take: This seems far too low. Given comparisons to Ireland we expect real estate prices could fall by another 35% in Spain. Additionally, this move seems to be skipping a step – Spanish banks already have €136bn in ‘doubtful’ loans against only €54bn in provisions, surely provisions against these very risky assets should be increased first or at least in tandem.

·         In absolute terms, this means an increase of around €30bn.

Open Europe take: Again, far too little. We predict that Spanish banks would need to at least double their provisions, taking them up to around €100bn. Similar estimates abound, with RBS calling for an additional €100bn and Roubini Global Economics suggesting it could go as high as €250bn over the next few years. Meeting the Basel III capital requirements will put further strain on the sector.

·         Banks will be allowed to get money from the FROB, but will have to pay 10% interest on it – Spanish Economy Minister Luis de Guindos stressed that this money cannot therefore be seen as state aid. Suggested maximum use of public funds would be €15bn. Heavy use of ‘contingent convertible capital’.

Open Europe take: This seems to be poorly thought out and based on an ideological reaction. Clearly the government is keen to avoid being seen to bail out banks, and rightly so. However, the banks tapping these funds will be those locked out of the interbank funding market (due to high rates), punishing them with 10% interest will make this recourse worthless. Any use of public funds should come with strong conditions but better to focus on letting some banks fail and be wound down in an orderly fashion, while forcing those that take funds to produce ‘living wills’ and give the state equity warrants. Contingent convertible capital can be useful but does not fundamentally solve the problems facing the banks, again it simply delays dealing with the problems and kicks in as a last resort safety mechanism – will do little if provisions are shown to be woefully small or valuations far too high.

·         Spanish banks will be obliged to transfer real estate assets into ad hoc societies tasked to sell them on the markets – i.e. the ‘bad bank’ that dare not speak its name.

Open Europe take: Potentially a large burden for the state, but given the breadth and depth of the problems across the sector some form of ‘bad bank’ scheme looked hard to avoid. The key here will be transferring the assets at realistic values so that they are sellable or can be written off. The Irish experience with NAMA makes this point clear – a bad bank stuck with uncertain assets can be a huge burden to the state. Furthermore, it could also distort the recovery of the sector as a whole, if the overvalued assets pile up on state books it will be hard for the remaining market to adjust – something which is necessary if the Spanish economy is to rebalance and recover.

The market response to the proposals has been lukewarm at best with Spanish borrowing costs rising slightly and the shares of many Spanish banks falling sharply.

There are some positive steps in the proposals and we will reserve full judgement until the complete package is announced and the stress tests have been detailed, however, it again seems to be a step short of what is needed. The key to tackling these banking sector problems is doing so decisively and in one swoop, rather than pushing the problems to tomorrow. Incremental adjustments increase uncertainty and expose the state to a longer and more volatile burden than needed - given the size of the Spanish economy, that is something which the eurozone cannot afford now or in the future. 

A credible Greek threat?

The Greek Public Debt Management Agency put out an interesting press release (PR) yesterday. We won’t go over all of it, since it’s been heavily covered in the press, but it did raise one interesting point:

“The Republic’s representative noted that Greece’s economic programme does not contemplate the availability of funds to make payments to private sector creditors that decline to participate in PSI.”

This is widely being seen as a warning to those who hold Greek bonds governed by foreign law and who therefore may be more inclined to hold out due to the extra protection offered under foreign law (they are also subject to higher CAC threshold, meaning CACs are harder to use). Greece essentially says that any bondholder who doesn’t take write downs will be defaulted on (except the ECB).

So, is this a credible threat?

Well, firstly we won’t find out until 11 April since that is the settlement date for foreign law bonds under the restructuring plan.

But more importantly it raises the question of whether Greece could be setting itself up for a second default, at least in technical terms. Let us explain:

Greece will certainly be judged to be in default by the rating agencies after CACs are triggered, but once the bond swap is completed and new bonds are issued it should come out of this rating fairly quickly. Yet, a month later it could again trigger CACs on foreign law bonds. Even worse, it could just leave these bonds and default on them through non-payment as and when payments are due (this could run long into the future). If this constituted another default it would have a negative impact on funding for Greek banks and the stability of the economy - so would be something to avoid.

Ultimately, it comes down to whether the new Greek bonds have ‘cross-default clauses’ in them – which means if Greece defaults on other bonds it will default on these too. From what we can see, the new bonds do not have general cross-default clauses (despite earlier versions of the plan including them), only ones which apply to the new group of bonds which exist after the restructuring.

This makes the threat to default on the remaining foreign law bonds much more credible. It would still be an extreme course of action, but one which looks increasingly attractive given the extra debt relief it could deliver (which Greece will need).

This is something which bondholders would do well to keep in mind if they are planning to try and get paid out in full.

Despite a mundane EU summit, plenty of challenges remain in Greece

Just a quick post on the developments at what must be seen as the most mundane (if not pointless) EU summit on eurozone issues for some time. Reports today suggest that the eurozone will withhold part of the bailout funds for Greece, only paying out the part required to ensure that the voluntary Greek restructuring can go ahead.

This was mostly expected and as we have noted previously, as well as in our report released yesterday, the amount that needs to be paid out is sizeable. The eurozone estimates it at €58.5bn, while we have suggested it could be closer to €86bn.

The main reason for this difference arises from the expected level of recapitalisation for Greek banks. The eurozone returns to previous estimates of around €23bn to aid the banks, despite widespread reports that this could reach €40bn - €50bn as admitted by the leaked EU/IMF/ECB debt sustainability analysis. For our part, we estimate that the bank capital needs could fall between €36bn - €46bn (depending on how they incorporated the write downs onto their balance sheets) to meet the European Banking Authority’s 9% capital requirements.

It is likely that Greek banks will need at least €50bn in the longer term, so it may be that the eurozone is keen to limit the immediate capital pay-out to the minimum necessary to stabilise the banks. This may be prudent on one hand, since it reduces the amount which needs to be raised to push the restructuring through and is less politically divisive. However, running the banks so close to the edge in an economy as uncertain as Greece’s could be asking for trouble.

The final point worth considering on the Greek banks is the issue of collective action clauses (CACs – see here for background). It looks increasingly likely that they will need to be used to get the necessary participation in the Greek restructuring (notice at this point we finally drop the ‘voluntary’ qualifier, as in no way could that still be claimed to be the case). This would leave Greek banks in a tricky situation. Under this scenario the rating agencies would likely leave Greece in a ‘default’ rating longer than expected, meaning that Greek banks will be locked out of borrowing from the ECB for some time (funds which they need to survive). The main way to keep Greek banks alive would be to transfer their funding to the Greek Central Banks Emergency Liquidity Assistance (ELA) as we discussed here.

This is far from ideal, since the ELA is opaque and secretive, but ultimately it may be necessary and unavoidable. Triggering CACs at this stage may be one of the few ways to actually deliver the debt relief which Greece needs. It presents many challenges and unknowns but it still seems better than pursuing a path which seems to be fundamentally flawed.

The second Greek bailout: Ten unanswered questions

We put out a briefing note today outlining the ten questions and issues that still need to be resolved in the coming weeks in order for Greece to avoid a full and disorderly default on March 20.

The briefing argues that, realistically, only a few of these issues are likely to be fully resolved before the deadline meaning that Greece’s future in the euro will come down to one question: whether Germany and other Triple A countries will deem this to be enough political cover to approve the second Greek bailout package.

In particular, the briefing argues that recent analyses of Greece’s woes have underplayed the importance of the problems posed by the large amount of funding which needs to be released to ensure the voluntary Greek restructuring can work – almost €94bn – as well as the massive time constraints presented by issues such as getting parliamentary approval for the bailout deal in Germany and Finland. While the eurozone also continues to ignore or side-line questions over the whether a 120% debt-to-GDP ratio in 2020 would be sustainable and if, given the recent riots, Greece has come close to the social and political level of austerity which it can credibly enforce.

The briefing concludes that, ultimately, there’s no way Greece can actually ever fully meet the conditions laid down by the EU and IMF – particularly if they keep piling on new demands. The scale of the cuts goes far beyond any fiscal consolidation – successful or failed – that any country has gone through in living memory. The question is instead one of how long the eurozone’s charade of unrealistic conditions in return for more bailout cash can continue. Specifically, will Germany and other Triple-A countries accept half-baked solutions to the big unanswered questions that still haunt the efforts to save Greece?

To read the full briefing click here.

Has Schäuble given up on Greece?

It is estimated that 80,000 took to the streets of Athens yesterday to vent their anger at the latest round of bailout austerity. Another 20,000 reportedly protested in Thessaloniki.

After days of talks, Greek MPs finally approved the latest round of measures required by the EC-ECB-IMF troika. The vote was carried by 199 in favour to 74 against. But the Coalition parties expelled 43 deputies for failing to back the bill.

Police said 150 shops were looted in the capital and 48 buildings set ablaze. Some 100 people - including 68 police - were wounded and 130 detained, a police official said this morning.

While condemning the violence, Prime Minister Lucas Papademos conceded yesterday that, "The full, timely and effective implementation of the program won't be easy. We are fully aware that the economic program means short-term sacrifices for the Greek people."

The problem is that "short-term sacrifices" is rather optimistic. Everyone recognises that Greece needs to reform, and no one could fail to be shocked by yesterday's scenes, but the Greek people also need to be offered some hope of a brighter future. Given that the plan for Greece is for it, in 2020, to be in more or less in the shape that Italy is in now - and many would suggest Italy's situation is unsustainable in the long-term without its own dose of reforms - the structural change required in Greece looks to be well beyond what the country can take.

At the weekend, German Finance Minister Wolfgang Schäuble seemed to be reaching a similar conclusion. He said in an interview published in the Welt am Sonntag newspaper that, "The promises from Greece aren't enough for us any more. Greece needs to do its own homework to become competitive, whether that happens in conjunction with a new rescue programme or by another route that we actually don't want to take."

When asked if that other route meant Greece quitting the eurozone, Schäuble said: "That is all in the hands of the Greeks themselves. But even in the event [Greece leaves the eurozone], which almost no one assumes will happen, they will still remain part of Europe."

Today, FT Deutschland quotes sources involved in the bailout negotiations suggesting that Germany's position on Greece is hardening to such an extent that it would actually now rather see Greece default. "Germany confused everyone else" in the negotiations, complained one. The paper also suggests that observers in the CDU are noticing a rift between Schäuble and his Chancellor. "Schäuble supports the bankruptcy of Greece, Merkel wants to strictly avoid it," said a leading member.

However, it seems that some in the German government may finally be beginning to realise that they are flogging a dead horse.

The Greek end-game?

Greece is on a "knife edge". That was how Greek Finance Minister Evangelos Venizelos put it on Saturday ahead of emergency talks between Greek political parties and the EU/IMF/ECB troika (with eurozone countries and private sector bondholders thrown in there somewhere as well).

We're sure you're thinking - surely, we've heard this all before? That may be the case, but unfortunately this time may be different. For once, Greece has a hard and fast deadline to meet to avoid a disorderly default.

But lets back up a second, whats the current disagreement between the Greek government and its creditors all about? Well, despite seemingly getting talks with the private sector bondholders pretty much finalised, new gaps between the Commission/ECB/IMF troika and Greece have opened up over the second bailout (as we predicted in our previous posts). The main areas of contention (as expected) seem to be the desire for eurozone countries to see greater wage and spending cuts. However, the three party coalition which underpins the 'technocratic' government of Lucas Papademos is refusing to back greater austerity - they simply believe their parties and the public won't support it. They may well be right but they may also have one eye on upcoming elections (as has been suggested). All of this puts the eurozone at yet another impasse. There is no way eurozone states will agree to disburse another €130bn - €145bn without a greater commitment to austerity in both the Greek public and private sectors. But without support from all three parties any commitment would be an empty one.

Usually, this would spell another round of talks, negotiations and some form of muddling through. However, this time they have essentially set a deadline of the start of this week to finalise the entire Greek package. The reason for this is the €14.4bn in Greek debt which needs to be paid off on 20 March. For the next bailout to be released, the 'voluntary' restructuring needs to have taken place and the new austerity measures need to be making their way through parliament. Without the money from the second bailout Greece will not be able to pay off this maturing debt. Most experts and those involved expect that six weeks is the minimum amount of time it will take to put the restructuring in place - meaning that it needs to get underway this week, hence the deadline.

There is also the 'side' issue of how much money will actually be paid out in the second bailout and whether the official sector (eurozone loans/ECB) will take losses in the restructuring. These are in themselves massive issues which will affect the future of the eurozone - particularly the role of the ECB (as we have previously discussed here). But in the eyes of the eurozone these discussions cannot even take place until there is a consensus from the Greek political elite to commit to greater austerity. Unfortunately, then, there are still some very big issues to be ironed out, even after the current disagreement is settled.

The term "knife edge" does seem fitting here...

Updates 06/02/2012: We will continue to update this blog with developments from Greece throughout the day.

09.30am - Reports this morning suggest Greece has been set a deadline of noon to find an agreement amongst the political parties in favour of the necessary austerity. However, this has been denied by Greek officials, who suggest the deadline is simply for an agreement to be struck ahead of the next eurogroup meeting (which was due to take place this afternoon but has now been moved to an undefined date).

12.20pm - RANsquawk is reporting that the Greek political parties have reached an agreement on a 20% wage cut and a reduction in supplementary pension, pushing them closer to a deal with the troika. No formal announcement yet but one is expected later today. Meanwhile, Merkel and Sarkozy have been holding a joint press conference in which (other than praising each other) they continued to reiterate their firm stance on Greece, although also stating that they expect an agreement very soon. If there is a consensus found in Greece today we can expect an emergency Euro-group meeting tomorrow or Wednesday.

2.00pm - Despite rumours of an agreement being reached, it looks as if the negotiations are far from over. Greek Prime Minister Lucas Papademos is set to hold talks with the troika later this evening to update them on his progress. Papademos will then hold another meeting with Greek political leaders tomorrow, presumably to communicate any messages which the troika wish to send. We assume the message will be for greater austerity. So don't expect a Euro-group meeting until at least Wednesday.

2.20pm - France and Germany earlier requested that Greece create a special account targeted at financing Greek debt, although specifically paying off interest rather than the total amount for now. The plan remains unclear and undeveloped but seems very similar to the recent German demands that Greek bailout funds go towards paying off debt first and foremost. Could the issue of an EU budget commissioner be revived during these negotiations then? Unlikely, but still risky ground for the French and Germans to tread given the heightened tensions since that leaked document.

5.20pm - After a slightly quieter afternoon than anticipated, AP has announced that there is a consensus between the Greek parties to accept the demand to cut 15,000 public sector jobs. A deal looks to be edging closer but is far from sealed yet. There is also set to be a general strike for the whole day tomorrow, meaning there is a good chance of massive protests and possibly even large riots in Athens.

6.15pm - Things have picked up again in the last hour, particularly with Greek PM Lucas Papademos reportedly asking the Greek Finance Ministry to do a thorough assessment of what a Greek exit from the eurozone would mean. Papademos is currently in a meeting with the troika (which began at 6pm), during which we're sure these reports will be broached, mostly likely with some disdain on the part of the troika. In the meantime, Merkel and Van Rompuy have been reiterating their positions by continuing to insist that the situation is not as bad as it seems and that Greece can avoid a default.

What keeps central bankers in Frankfurt awake at night – and why should Britain care?

In a blog post for the Telegraph, we argue,

In his speech in Davos yesterday, David Cameron outlined some very sensible proposals for how to deal with Europe's economic crisis. But, almost in passing, he also called for a eurozone “central bank that can comprehensively stand behind the currency and financial system”, implicitly suggesting that the ECB must be ready to provide more cash to struggling banks and governments around Europe. Unfortunately this statement completely misses the intricacies which the ECB and the eurozone face in the coming months.

The ECB’s balance sheet now stands at a pretty scary €2.7 trillion, higher than that of the money-printing Federal Reserve in the US. By buying government bonds and providing cheap cash to banks around the eurozone, the ECB is now leveraged 33 times – up from 24 times only last summer. This means that for every €1 the ECB holds in reserves and cash, it has €33 swirling around somewhere in the eurosystem.

But it isn’t the size of its balance sheet that keeps ECB officials awake at night – all central banks are leveraged – as much as the circa €60bn of (nominal) Greek bonds festering on its books. This (relatively) tiny item has become political dynamite, as Greece is set to default on its debt in March, either through a voluntary agreement with its creditors or by simply running out of money. As creditors and the Greek government are locked in to talks over which one it’ll be, big question is: will the ECB be forced to take a hit?

The question is crucial as the ECB has said in the past that it will not take losses on its eurozone exposure – ever. For the Germans, losses for the ECB would mark a huge betrayal of the Bundesbank-model, in which a central bank is trusted and prudent, and doesn't take on excessive risks – and therefore has the credibility to control inflation. Many German commentators have spent the past year grumbling about the ECB’s back-handed Quantitative Easing and illegal financing of state deficits. The ECB has got around this by purchasing the bonds on the secondary market, but if it took losses on Greek debt, this argument falls.

But at the same time, if “public” bodies, including the ECB, holding Greek debt don’t accept losses in a Greek default, the write-down may not be large enough to give the country even a hypothetical chance of bouncing back, meaning the EU/IMF cannot give it more loans. For the ECB, this amounts to a pretty awful catch-22: accept losses and see your credibility and rationale undermined or reject losses and at worst prompt a disorderly Greek default or possibly just massive distortions in eurozone bond markets.

So what’s the best solution? We’ve long argued for a full restructuring of Greece’s debt (now 60-70%) and reassessment of Greece’s position in the euro. But that looks unlikely right now. Instead, the ECB could be offered an escape route. It purchased its bonds at around a 30% discount. It could accept a 30% write down without taking any losses and would give Greece some additional debt relief. Another option would be for ECB-held bonds to be bought by the euro bailout fund, the EFSF (at cost price), and then submitted by the EFSF to the voluntary restructuring. The EFSF could absorb the losses, though it too may have to deal with some very uncomfortable questions from taxpayers who will have lost money. But arguably it’s better than sacrificing the credibility of the ECB.

Both options would still be a tacit admission of failure by the ECB, since it always claimed it would hold the government bonds it bought to maturity, but it may have little choice.

All of this should concern the British. Not only because the eurozone crisis is linked to the fate of the UK's economy. But also, as Anglo-Saxon commentators are coming out in droves – alongside the UK government itself – in calling for the ECB to load up on yet more eurozone government debt if need be, it should be a reminder: in the eurozone as in the UK there’s still no such thing as a free lunch.

In the end, someone has to pay – and if you want to keep the Germans fully on board, it best not be the ECB.

Friday the thirteenth in the eurozone…

Over on the Telegraph blog, we look at today's euro developments:

It all looked so good in euroland after a market rally and successful Italian and Spanish bond auctions this week. However, on Friday the eurozone crisis again took a turn for the worse. Standard & Poor's – the increasingly unpopular credit rating agency – is set to downgrade France and Austria from their AAA ratings. At the same time talks broke down over what losses banks and other bondholders will be forced to accept when Greece writes down its massive debt, injecting another huge dose of uncertainty into the euro mix.

Euro policy geeks are already engaged in fierce debate about which of these two events constitute the worst news for the eurozone. Let’s have a look:

Downgrades: Friday the thirteenth jinx aside, this downgrade could be spotted a mile away with S&P putting the whole eurozone on negative watch before Christmas. Other eurozone downgrades are also taking place, notably of Italy, but the loss of AAA ratings are undoubtedly the most critical. In addition to the symbolism of having one of the EU’s big three economies downgraded, the eurozone’s €440bn temporary bailout fund (the EFSF) – aimed at backstopping fragile euro states – could be soon to follow. The EFSF needs its current AAA rating to continue to dish out cheap loans to Greece, Portugal and Ireland (and any other country that might need help). But as France is a major contributor to the EFSF, a downgrade for the country could result in a corresponding slash to the rating of the EFSF.

The effect would be higher borrowing costs for the struggling countries that tap the fund, reducing effectiveness of the ESFS as a backstop measure. In addition, an EFSF downgrade will make the fund – and the eurozone – even more reliant on German taxpayers. This would further expose the German economy to potentially bad eurozone debt and, at worst, even threaten the country's own credit rating.

It also raises even more questions about an EU plan, currently being negotiated, to increase the lending capacity of the EFSF through a complicated leveraging and insurance scheme (for details, see here). You simply cannot create money out of nothing – and even more so when one of your key players has just suffered injury.

So expect short term market jitters. But so far, we’re only looking at one credit rating agency, with the other two holding their fire – which is probably why the news coming out of Athens is more significant.

Greece: The negotiations over losses for investors in a voluntary restructuring of Greek debt are starting to look like a bad horror movie. For all the grand talk from EU leaders and officials, bondholders (especially smaller firms such as hedge funds) still have a massive incentive not to participate in the voluntary restructuring – either Greece pays back the money they owe them or there is a default, in which case their insurance on Greek debt (known as credit default swaps) are paid out and they recoup their losses at least.

The crux is that Germany and the IMF in particular have made a write down of Greek debt a precondition for paying out the next trance of bailout money, which Athens needs by March 20 to pay off €14 bn in debt due. If neither Greece, the bondholders nor Germany/IMF blink, we may be looking at a forced Greek restructuring (where Greece legally enforces losses on bondholders) or even a full default and, at worst, a eurozone exit. But there’s still plenty of negotiating time before March.

What’s clear is that both the downgrades and the break-down in the Greek restructuring talks could change the face of the eurozone crisis. Though the downgrades seem more dramatic now, the Greek problem could soon begin to hit home. An enforced write-down or uncontrolled default both essentially amount to the same thing in the eyes of the markets and investors will begin to have doubts about the future of other eurozone countries – if a default can happen in Greece, why not in other insolvent eurozone states?

Tags: bail-out, Credit Default Swaps, credit rating, default, eurozone, France,Germany, greece, Sarkozy, sovereign debt crisis

Will the euro crack in 2012? It'll be turbulent but probably not...

In a blog post for the Telegraph, we ask this simple and yet brutally complicated question. This is what we argue:

In truth, as the crisis is overwhelmingly about erratic domestic politics, it’s absolutely impossible to predict when the euro will bite the dust. What’s clear is that in the absence of some sort of fiscal union (likely to be collective borrowing amongst euro states in return for German-style budget rules), the single currency is doomed in the long-term. In the short term, however, there is still scope for plenty of muddling through – which is to say that there’s a strong chance that the euro survives 2012. So what is the likely good (an expression used loosely here) and bad news for the eurozone moving in 2012? And what would, to complete the phrase, an “ugly” scenario look like?

The “good”

The ECB stepping up: Arguably the biggest threat to the survival of the eurozone in 2012 is a deep freeze in the banking system. That is, banks get so incredibly nervous that they completely stop lending money to each other, leaving some banks bust. Governments would find it very hard to refinance themselves and credit to the wider economy would be choked off.

Now, for those who think short-term (which is most people), the good news is that the ECB has stepped in to offer ridiculously cheap loans to any bank in the eurozone that asks for it (under a new euro acronym known as the LTRO), giving them the cash and confidence to continue lending this year – at least in theory. There is a catch of course: as with all other ECB intervention, the LTRO serves to transfer more risks from private creditors to European taxpayers (as the ECB is ultimately taxpayer-backed) and there are little signs of a plan to wean banks’ off their growing reliance on public money. How all 523 banks that have taken loans so far will be able to rollover nearly €500bn in funds, all due for repayment in 2015 – when the ECB wants its money back – is a question few are asking at the moment.

There’s bailout cash left: Though not nearly enough to act as proper lender of last resort, there’s bailout money left in the pot for the eurozone to play with this year. Following a second Greek bailout, the temporary and permanent euro bailout funds (the EFSF and the ESM), set to run in parallel in 2012, have a combined lending capacity of between €500bn and €750bn with potentially another €170bn of IMF money to add. In addition, the ECB can still buy a limited amount of government bonds, albeit reluctantly. Compare this to the roughly €800bn that eurozone governments need to raise between them (including countries that are safe) this year, and it might just about add up – for 2012, that is.

The bad

Recession inevitable: No matter what happens, it will be an incredibly painful year for the eurozone, with recession plaguing several countries, exacerbated by a slowdown in the rest of the world. Low growth and poor competitiveness remain the euro's greatest curse.

The Greek factor: Without the next tranche of EU bailout cash, Greece will default in March, and is almost certain to default sooner or later anyway. Greece is currently in negotiations with private creditors over a ‘voluntary’ restructuring of its €360bn debt mountain – it remains uncertain whether it can remain inside the eurozone absent a deal, which would mean a ‘forced’ restructuring. However, both the Greek electorate and the political elite remain committed to the euro and I doubt eurozone leaders will have the nerve to force Greece out this year. But anything can happen should, say, the present Greek technocratic government fall (it's worth reading Paul Mason's take on it).

A French downgrade: Due to the large exposure of the country’s banks, France could well be downgraded at least one notch. Among other things, this would hit the creditworthiness of the euro bailout funds, meaning higher borrowing costs for those countries that tap them and even more reliance on German taxpayers’ cash.

Risk of unexpected bank collapse: Despite ECB liquidity, the sudden collapse of a large eurozone bank is an ever present risk. The radical increase in banks’ use of ECB cash (via the LTRO and other programmes) is an alarming sign that one or several banks are in serious trouble.

Europe stands alone: No one seems willing to come to Europe’s rescue, with international lenders from Beijing to Washington frustrated by the EU’s dithering.

The ugly

Though the risk is still small, there’s a possible perfect ‘storm scenario’ for the euro in 2012. As events are so incredibly intertwined, it’s impossible to tell which would come first. But the scary thing is that just one or two of the below factors may be enough to start a chain of events which would lead to the disorderly break-up of the eurozone:

• Widespread downgrades, including of the eurozone’s remaining Triple A countries, by credit rating agencies. Serious questions would be raised over the viability of the eurozone’s bailout funds as they rely on an ever thinner list of Triple A eurozone states, leaving the euro with little more than a paper tiger as a backstop.

• Spanish banks could hit the iceberg as households fail to pay their mortgages and the level of non-performing loans pile up. If it gets bad enough, the Spanish government wouldn't afford to recapitalise these banks on its own and must seek a potentially huge bailout from the EU/IMF.

• In addition to those in Spain, one or more banks in Italy or France could sink due to large exposure to weaker euro states - following a hard Greek default for example. As in Spain, there are doubts as to whether these governments could afford to bail out their banks without outside help.

In parallel to these economic concerns, the political tensions between what’s required to keep the euro together versus what citizens are willing to swallow could reach breaking point. A new French government might try to renegotiate the euro’s new budget and fiscal rules, causing uncertainty and delays, while Angela Merkel’s opposition to bailouts and ECB intervention could increase as national elections loom large in early 2013. Meanwhile, the push by unelected governments in Greece and Italy for ever more austerity, could trigger a fresh wave of political unrest. Though still unlikely, the Monti government in Italy could lose its support in Parliament, leading to fresh elections, more uncertainty and spiralling borrowing costs for Italy. The country remains too big to be bailed out.

Ultimately, it is how these political tensions are played out in various countries that is likely to determine the eurozone’s fate. My best bet is still on the euro surviving this year – we haven’t yet reached rock bottom. But make no mistake, this will be another incredibly messy year for the euro and the choice between what’s right for democracy in Europe and what’s right for the euro cannot be avoided forever.

Troika blues

Just a couple of brief comments on the 'Troika' report that's now been out in the public domain for over 24 hours (through various leaks). Linkiesta has the text of the report here.

Just to recap: the European Commission, the IMF and the European Central Bank - the so-called Troika - released (or leaked) their report yesterday and today, on the state of Greece's debt. It is a seriously damning account of the Greek economy (in parallel with reading the Troika report, it's worth re-visiting our briefing on the second Greek bailout). The report basically sets out how Greece would need far more in assistance than previously thought - possibly around half a trillion euros - in absence of far-reaching private sector write downs on the country's debt. As we argued in a report published earlier in the week, and as the Troika have now essentially admitted, private creditors would have to take a 60% haircut on their bonds, in order for Greece to have any chance to return to debt sustainability.

We found this part of the Troika report particularly interesting:

“In keeping with experience to date under the programme, it is assumed that
Greece takes longer to implement structural reforms, and that a longer time frame
is necessary for them to yield macroeconomic dividends...A longer and more
severe recession is thus assumed.”

Basically, the Troika report drops all pretenses, and acknowledges that Greece can't meet the conditions and commitments agreed under the first (and second) rescue packages - it's just a case of accepting that and moving on. It is incredibly telling that this assumption forms part of the troika's baseline (expected) scenario.

Furthermore, the report states that even with a 60% haircut, Greece's debt will still amount to 110% of GDP by 2020, including €115bn which the troika expect Greece to receive from the second bailout(remember currently currently only totals €109bn). In other words, to avoid a further deterioration of Greece's debt, the second bailout as well as the level of private sector involvement will have to increase in size.

Translation: Prepare for another round of hugely painful and frustrating negotiations, between governments, ECB, IMF, Commission and the banks....

In a sort of twisted hat tip to this upcoming strife, one of the footnotes states: "The ECB does not agree with the inclusion of these illustrative scenarios concerning a deeper PSI in this report." Apparently, the ECB and the IMF didn't quite see eye to eye on the level of write downs bondholders should face and Greece's debt sustainability. Forgive us, but given the IMF's extensive experience in the matter we slightly inclined to side with them on this one.

As Paul Mason did a good job of illustrating on yesterday's Newsnight, the chart (on p. 3) comparing the debt sustainability, according to the Troika's updated figures, to the equivalent analysis in the previous Troika report is fairly damning as well. Either the Troika got it completely wrong previously or things have got massively worse (probably both). In combination, this seems to suggest that Greece won't be able to return to the market until 2020, even with the help of a second bailout.

And yet, the Troika seems to suggest - echoing some EU leaders and the ECB - that Greece can avoid a default - even on the back of that report. That can only be described as an insult to the intelligence.

A non-starter?

In today's City AM, we give our take on the idea that was floated over the weekend to top up the EFSF, using the fire power of the ECB:

THERE was quite a bit of excitement in the media and financial markets over the weekend. The hot news was that Eurozone leaders, on the sidelines of the G20 summit, forged a new grand scheme to save the embattled euro. The plan, we were told by some, would be announced “within days”. Alas, details are still thin on the ground and talk of an imminent deal looks wide of the mark. So what’s the fuss about? The key proposal would see the Eurozone’s undersized bailout fund, the European Financial Stability Facility (EFSF) topped up through a complicated scheme involving the balance sheet of the European Central Bank (ECB). This would increase the fund’s lending capacity to around €2 trillion, allowing it to contain a Greek default, by providing a much needed backstop to Italy and Spain, as well as covering the recapitalisation needs of Europe’s banks. EFSF funds would be used to cover the first 20 per cent of any losses the ECB makes on purchases of government bonds or the recapitalisation of European banks. The proposal gets good marks for creative thinking, acknowledging that an orderly Greek default is the preferred option and attempting to address Europe’s unhealthy banking system. Unfortunately, the proposal is also a non-starter.

Firstly, the plan would require a radical reworking of the EFSF framework, since it is not designed to be leveraged or be subordinate to the ECB in terms of covering losses. Remember, following a deal agreed in July, most of these countries are still scrambling to get a more moderate boost to the EFSF past national parliaments, which are becoming increasingly resistant to what they see as a potential blank cheque.

Secondly, using the ECB’s balance sheet to top up the EFSF would further expose the former to even more risky debt. As of August this year, the ECB was leveraged around 25 times with an exposure of around €510bn to the peripheral Eurozone economies – with much of this debt being of very dubious quality. It faces potentially hefty write-downs should a Eurozone country actually default (it remains unclear how these losses would be covered).

In theory, the ECB has an unlimited capacity to lend, and can even do so to some extent without triggering inflation, due to control over future money supply. But this is where politics kick in. By effectively merging its balance sheet with that of a government-run institution, the EFSF, the ECB would fully enter the domain of fiscal policy. This is critical for a number of reasons. The ECB’s freedom to act without political influence affords it the trust of financial markets, and allows it to effectively transmit monetary policy, including managing inflation expectations. It was on this premise that the single currency was sold to the German electorate in the 1990s – the ECB was going to be the heir to the trusted Bundesbank. As former European Commission President Jacques Delors once famously observed, “Not all Germans believe in God, but all Germans believe in the Bundesbank”. In contrast, a growing number of Germans now view the ECB with growing suspicion, as was seen in the dramatic resignation last month of Juergen Stark, the German representative on the ECB’s executive board, allegedly over the bank’s decision to start buying Italian and Spanish government bonds. One step further, and German support for the entire euro project could start to diminish.

This links with another crucial question: who, exactly, is in charge? The advantage of using the ECB as lender of last resort for the Eurozone is that it can act quickly without seeking a democratic mandate from voters, which is a slow process. Combined with its capacity to massively expand its balance sheet, this is one of the reasons why the ECB is, in theory, the one institution that can move markets. But since it hinges on EFSF loans, the proposal discussed over the weekend would presumably still be subject to approval by each member state (and various national parliaments), meaning that we would be stuck with the same political bottlenecks as now.

There are also, it should be said, familiar economic risks involved. Leveraging the EFSF’s lending capacity, which is mostly backed by six triple-A states, could negatively impact on the credit ratings of the member states, most notably France (through contingent liabilities). This could lead to a vicious circle, with the rating of the EFSF suffering a corresponding blow.

Not much of a surprise then, that politicians and central bankers in triple-A countries have lined up to criticise this proposal, with Bundesbank president Jens Weidmann saying: “If [the EFSF were to finance government bond purchases] through the central bank, it would be monetary state financing. Whether you do it directly or whether you do it via the detour of a special purpose vehicle makes no difference economically.”

What’s positive about the apparent change in mood over the weekend is that Eurozone leaders are beginning to realise that without a restructuring of Greece’s, and possibly some other country’s debts, and proper recapitalisation of European banks, there’s absolutely no way out of this crisis. But proposals need to be rooted in political, legal and economic reality. Otherwise, the huge gap between what markets demand or expect, and what politicians can deliver, will grow ever wider – and the rollercoaster ride will continue.

The statement that said nothing - and yet meant everything

Last night, German Chancellor Angela Merkel, French President Nicolas Sarkozy and Greek PM George Papandreou held another one of those crunch-time talks, as the fate of the euro balanced on a knife's edge. Amid reports that Greece is falling well short of meeting its austerity targets, markets feared an imminent Greek default, with the risk that the country would have to leave the eurozone altogether. Following IMF/ECB/EU pressure last week, Greek PM Papandreou announced new austerity measures, including a property tax and further cuts in public sector jobs.

But the jitters remained. As ever, it's one thing to announce new measures, a completely different thing to implement them in a way that actually results in savings - and even with these new cuts, Greece's situation looks rather hopeless, and a default inevitable.

So what to make of yesterday's statement by Sakrozy and Merkel? Well, this was the thrust of it:

The Chancellor and the President are convinced that the future of Greece is in the eurozone. The implementation bailout deal obligations is essential for the Greek economy to return to sustainable and balanced growth. The Greek Prime Minister has confirmed the absolute commitment of his government to take all necessary measures to implement the obligations in their entirety. Greece's successful adoption of the measures will strengthen the stability of the eurozone.

Absolutely nothing new in there. But as we argued yesterday on Newsnight, there appears to be an implicit guarantee that, even though Greece is falling short of its commitments in reality and will be unable to reduce its debt mountain by its own strength alone, Germany and France will stand behind the country - at least for now. The charade over impossible austerity targets will continue - to appease increasingly restless parliaments in Triple A countries - but Greece will receive the next tranche of EU/IMF money, worth some €8bn (needed for it to avoid immediate bankruptcy).

The statement may also be a nod in the direction of the IMF, whose officials remain unconvinced. It'll now be very difficult for the IMF to refuse to unlock the next tranche of aid to Greece, following EU/ECB/IMF evaluations that will resume next week. Olli Rehn today also effectively confirmed that Greece will receive the next tranche.

Behind the scenes, meanwhile, finance ministries continue to scramble for some sort of 'solution' to the Greek problem, with an orderly default sailing up the wish list as one of the few realistic alternatives. As ever, buying time is the only strategy. Very uncomfortable questions about Greece's future inside the eurozone remain.

In public

Apparently, the Dutch Parliament has given the country's Finance Minister Jan Kees de Jager until Friday to outline possible scenarios for how to deal with Greece, including the impact on the Netherlands should the Greek government default on its debt.

This comes hot on the heels of leaks in the Dutch media, claiming that the Dutch Finance Ministry now considers a Greek default "unavoidable". According to the leaked documents, the Dutch government is now instead planning for how to manage a Greek default in an orderly manner. The reports were immediately denied by the Finance Ministry). The other night, Dutch TV programme Nieuwsuur (the Dutch equivalent to BBC Newsnight) featured an interview with de Jager (picture), who said (our emphasis):

"as Finance Minister I need to assume in public that Greece is complying with its obligations, but for us it is important that we continue to insist that Greece sticks to the agreement and if they don't, then we'll have to indicate that we cannot contribute our share."

As the reported highlighted, note the use of "in public" (suggesting that "in private" he thinks otherwise). Hardly an earth-shattering revelation given the state of the Greek economy, but still interesting to see him being so candid about it. He also seamed to suggest that leaks of this kind could serve to put additional pressure on Greece.

A the risk of a Greek default, he said:

"There is indeed a large risk, and it can be that Greece forces us to do that. However, this kind of pressure can push Greece to take yet another step. And that's what we're assuming for now."

Summit side note: Beginning of the end for CDS?

An interesting side note to the second Greek bailout deal is that it may in fact have killed off the credit default swaps (CDS) market, or at least kick-started its demise. The reason for this is simple: the deal undermines confidence in the belief that CDS can work as a form of insurance against default. (A quick recap: a CDS on sovereign debt is essentially a form of insurance, which the purchaser pays into every so often and which pays out if the country defaults on its debt. As such it is used as a hedge against exposure to sovereign debt as well as against lending in unstable/risky economies.)

Fitch and Moody’s have already declared that they consider the private sector involvement in the second Greek bailout to be a default. This is because bondholders will be taking part in a bond swap or rollover which will result in them receiving less money than promised under their original bond. Simple enough and probably the correct decision.

So why aren’t CDS paying out? A credit event or default which would trigger CDS is determined by the International Swaps and Derivatives Association (ISDA) which has announced that it does not judge Greece to be in default. This is because the bond swaps or rollovers are completely voluntary. If CDS were triggered you could get a situation where people who didn’t take part in the swap or rollover are still getting paid out on their CDS and so are reaping their full rewards of both the Greek bond they’re holding and the insurance on it – a perverse situation, no? So, clearly, this looks to be the correct decision as well.

So, since you have a situation where the increasingly expensive insurance on Greek sovereign debt essentially becomes useless, the whole market for CDS has become undermined, possibly irreversibly so. We’ll gloss over whether this was intentional or not for now (undoubtedly there are plenty of EU officials who would like to punish the CDS market for what they see as detrimental speculation in the financial and eurozone crisis, as we’ve pointed out with our commentaries on the new short selling regulation). But it goes to show that the complexities of the eurozone bailouts can lead to significant and potentially harmful side-effects.

Let's not kid ourselves, CDSs can be used as a speculative tool but also play an important role in market liquidity nowadays. Reducing the use of CDS makes it harder to hedge against risk; this could make investors less keen to purchase the sovereign debt of struggling eurozone countries (such as Spain and Italy) and could therefore filter through to higher borrowing costs for many eurozone economies (due to higher risk premium). It could also make it harder for the private sector in these economies to get loans and funding as well, since CDS is often used to insure against the risk from these types of loans. So, in sum, we could see higher borrowing costs and lower economic growth as an impact of a smaller CDS market, clearly not a desirable effect given the current crisis.

Although, we’re sure there will be a few EU officials with a wry smile on their face at the potential demise of the CDS market, intentional or not, it could yet come back to haunt them.

Everybody's lining up to comment on the euro now...

Just thought we’d highlight some interesting comments on various aspects of the eurozone crisis, given the sheer volume of pieces out there.

Leading economist Kenneth Rogoff talking about Greece on BBC Hardtalk:

“I don't think there is any question that if you look at it narrowly from Greece's point of view, it would be better to default now, clean it up and move on. Yes, it is painful to default, but countries grow afterwards and many countries have done it and done very well. The problem here is that Europe can't handle it so easily because Portugal is weak, Ireland is weak, the banking system is weak. And in essence what's happening is that Europe is bribing Greece not to default. They are giving them lots of money. Greeks aren't paying now, they are getting new money”.

Ambrose Evans-Pritchard (back with a vengeance) writing in the Telegraph on the EU and credit rating agencies:

“The EU authorities are attempting to muzzle free opinion, first by threatening Fitch, Moody’s, and S&P with vague retribution, and then by drafting restrictive laws to prevent them from publishing unwelcome messages.”

“Now, if the EU institutions wish to avoid being held hostage by the robber agencies they should stop using the ratings as a basis for lending collateral at the ECB. They should create their own more rigorous method of assessing credit-worthiness, ignore the agencies altogether, and make their case directly to global investors…What the EU should not do is try to muzzle free opinion, or free speech. We are on a slippery slope.”

Nick Malkoutzis in Greek paper Kathimerini highlights the coming pain for Greece under the second bailout agreement:

“Like a Hollywood sequel which follows a dire original, Memorandum II is likely to make us want to look away in horror.”

“But as we move from Memorandum I to its potentially scarier successor, it still doesn’t appear to have sunk in either at home or in Brussels, Frankfurt and Washington, where the decision makers of the European Commission, European Central Bank and the International Monetary Fund reside, that all the slashing of public expenditure and hiking of taxes is not going to solve Greece’s problems."

Just snippets of some good pieces, we recommend reading/listening to them all in their entirety.

Cliffhanger

There were some interesting comments today by Warren Buffet, Chairman and CEO of Berkshire Hathaway, on the eurozone debt crisis.

In particular, Buffet gave this very apt analogy:

"The European situation is not solved... They've got a lot of work to do. When you have 17 countries that all have the same currency, and the yields on their bonds are all different, the situation is not solved. It's like 17 people holding hands and one guy starts walking towards the end of the cliff, and suddenly there's 12 people left and you have to start thinking -- do I want to be holding hands with this group?"

(This is also an analogy we've hinted at before on here)

We would add though, that it now looks more like these people have their hands handcuffed to each other and they're all looking around realising none of them brought a key...

Remember AIG?

The Bank of International Settlements - the go-to source for checking the exposure of one economy to another - published some new data last week.

As always, it makes for interesting reading. In particular, we were fascinated by this: while European financial firms have huge direct exposure to Greece, Ireland and Portugal (since they own most of the bonds issued by these countries), it is American firms that have sold a substantial portion of the insurance on this debt (in the form of credit default swaps). This means that if, for example, Greece was to default the Americans would take a pretty hard hit since they would have to pay out on the insurance they have provided against a Greek default.

So if this reading is correct, a surprising number of American firms that have taken the opposite side of the bet on a Greek default.

AIG anyone?