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Wednesday, June 22, 2011

Delaying tactics are only increasing the costs of the eurozone crisis

Over at the FT's newly established "A-list" blog, Martin Feldstein sets out the reasons why Greece will inevitably have to default, arguing that the key now is to delay it long enough for banks to get their act together. He argues:
Greece is not alone in its insolvency and a default by Athens could trigger defaults by Portugal, Ireland and possibly Spain. The resulting losses would destroy large amounts of the capital of banks and other creditors in Germany, France and other countries. There would be a drying up of credit available to businesses throughout Europe and there could be a collapse of major European banks.

This inevitable contagion and its potential consequences for the European financial system is the reason the European Central Bank is determined to avoid a default at this time. The challenge, therefore, is to find a way to postpone the defaults long enough for the banks and other creditors to withstand the write-downs of bond values if Greece, Portugal and Ireland default simultaneously.
You can read the full article by following this link, but here is our response in full - we agree with Feldstein on many points, but argue it is better to face the inevitable sooner rather than later:
It now seems widely accepted that a Greek default is not a matter of if, but when. The most important question is therefore: when would such a default be most cost-effective? The answer to this extends beyond just the economic costs and into the political sphere.

While it is true that allowing creditors more time to buffer up against the write-downs resulting from sovereign defaults (in Greece and possibly Portugal and Ireland) could be beneficial, such delaying tactics come with three major drawbacks.

First, will the banks actually get their act together? The truth is that banks have had more than enough time to reduce their exposure to Greece. Even as late as February, Greek bonds were trading at 80 per cent of nominal value – a pretty decent recovery rate given the situation. Why have the banks not done so? There are a number of reasons for sure, ranging from greed to bad judgement. But one of the main ones, surely, is that they are continuing to expect that, given the enormous stakes, politicians and the ECB will continue to bail out Greece. The fact that Germany, for example, continues to resist stringent capital requirements for its banks is a sign that lessons simply aren’t be being learnt. This takes moral hazard to a whole new level and continues to fuel Europe’s debt bubble.

Secondly, the first round impact – and probably also the knock on effects – of a default will increase. We estimate that a 50 per cent haircut would be needed to get Greece down to a sustainable debt level, around 90 per cent of GDP. By 2014, following a second bailout, the necessary haircut would increase to 69 per cent.

Thirdly, and related to the prior two points, by our estimates the EU, IMF and ECB accounted for 26 per cent of Greek debt at the start of this year. By 2014, following a second Greek bailout, this will have risen to 64 per cent, meaning that roughly two-thirds of Greek debt will be taxpayer-owned by that date. Thus Europe is setting itself up for a massive political fall-out: taxpayers in creditor countries will utterly despise having to cough up cash (as loan-guarantees are turned into outright losses), as “bankers” are let off the hook. On the other side of the coin, the second bailout plan assumes that the Greek electorate is willing and able to swallow three more years of tough austerity measures. Even with some token private sector involvement, it looks as if taxpayers across Europe would judge a second €100bn-plus bailout of Greece a massive injustice. This is a major political gamble.

A second bailout is not the way forward. The EU needs to face up to reality and plan for an orderly debt restructuring as soon as possible, which could involve a limited cash injection. The current delaying tactic is only increasing the economic and political cost of the eurozone crisis.


Zocco said...

Surely the ECB are buying up Greek debt at a big discount( 40%?) so if there is a 50% haircut they are only looking at a 10% loss - not 50%. Same for other organisations. How much of the total debt is already heavily discounted?

Open Europe blog team said...

Thanks for the response Zocco. We do take account of this in our paper on the ECB (http://www.openeurope.org.uk/research/ecbandtheeuro.pdf). We expect that the bonds which the ECB bought directly have been done so at a discount of around 30% (keeping in mind that they've been bought at various prices over the past year not just the current price). So the actual hit from 50% restructuring would be 20%. The ECB also has significant exposure through the collateral which it has taken on from its liquidity provision, but again with some buffer. You should check out the ECB paper in the link above, all of the potential costs to the ECB from a Greek default are laid out there. The methodology also explains our approach to the discounts.