Berlin - Valentine's Day is supposed to be a celebration of
love between partners, but that was in short supply when ministers from
Europe's single currency zone met on the fifth floor of the Justus Lipsius
building in Brussels on February 14.
After a brief lull in their debt crisis at the start of
2011, tensions in the 17-nation euro area had returned and financial markets
were piling new pressure on the bloc's weakest members.
Ten days earlier, German Chancellor Angela Merkel and French President Nicolas Sarkozy had sparked an angry EU backlash by unveiling a plan to impose debt limits and harmonise wage policies across the vast economic area of 330 million people.
Deep divisions over the shape of a new anti-crisis package that European leaders had promised to unveil by late March were opening up. Also hanging over the meeting was a new fear so troubling the finance ministers had taken special care not to discuss it in public - the rising risk that Greece would have to restructure its €327bn debt mountain.
The week before, inspectors from the European Union and
International Monetary Fund (IMF) had approved €15bn in aid to Athens,
the latest tranche of a €110bn bailout package sealed in May 2010.
But Poul Thomsen, the IMF envoy monitoring Greece's economic
progress, had coupled that decision with an unusually stark warning to the
government of Prime Minister George Papandreou which instantly rang alarm bells
for investors.
Without a "significant, broad-based acceleration of
reforms", he said, Greece's rescue programme was doomed.
Even with the curtains drawn and their words safely muffled
by heavy wood panelling in the large Brussels conference room named after
Finland's first permanent EU representative Antti Satuli, the ministers were
uneasy.
Jean-Claude Trichet, the president of the European Central
Bank (ECB), who had travelled from Frankfurt for the meeting, accused the
ministers of "shooting at your feet" for broaching the idea of buying
up Greek debt and then retiring it to reduce the country's burden.
In the same building nine months before, Trichet had come
under intense pressure to allow the ECB to acquire Greek debt on the open
market, later pushing this controversial decision through over the objections
of German Bundesbank chief Axel Weber. With his term at the helm of the ECB
nearing an end, he was desperate to get tens of billions of euros in toxic
Greek paper off his books. But governments were not cooperating.
As the barbs flew, Jean-Claude Juncker of Luxembourg, who
was chairing the meeting and sat at the opposite end of the room from Trichet
in a black suit and lavender tie, reminded participants that it was important
to present a positive, united message on Greece's woes to the public.
Staying positive was not easy. To the left of Trichet,
wearing a black dress and white Chanel jacket, Christine Lagarde of France grew
impatient. Discussion of a Greek default, the former synchronised swimming
champion said, should be avoided at all costs as it could unleash consequences
beyond the control of the bloc and its members.
"You can't stroke an elephant just a little bit,"
Lagarde warned, according to confidential minutes of the meeting seen by
Reuters.
Elephant indeed. Despite the best efforts of policy-makers
to suppress discussion of Athens' problems, the expectation that Greece will
become the first western European country to restructure its debts since
post-war Germany in 1948 has taken on a sense of the inevitable in the past two
months.
Last week a small group of eurozone finance ministers met
in Luxembourg and admitted what had been clear to others for some time - that
last year's bailout of Greece had failed to restore confidence in the country's
finances and new steps were urgently needed to alleviate its debt burden.
Sources tell Reuters they are now considering throwing more
money at Greece and easing the terms of existing loans, possibly in combination
with the "voluntary" involvement of Greece's private creditors.
But this strategy will only delay the real pain until a
later date.
Most economists now believe that without an aggressive
restructuring which forces private creditors to take losses of 50% or more on
their Greek holdings, the country will not emerge from its downward spiral.
The only obvious alternative - keeping Greece on EU life
support for many years - seems a political non-starter given the growing
opposition to further aid in northern European countries such as Germany,
Finland and the Netherlands.
Greece's debt crisis is the biggest challenge the bloc's policy-makers have faced since the launch of their bold currency experiment 12 years ago. European monetary union was always more about politics than it was economics.
That's been part of the problem. Now those two factors -
economics and politics - are on a collision course that could ultimately
fracture the bloc, with Greece and other vulnerable countries like Ireland and
Portugal forced to consider exiting the eurozone.
That would be a devastating setback for Europe, whose common
currency is the culmination of half a century of closer integration.
"Greece's debt is at levels where it is very rare for a
country to make it without a restructuring," Kenneth Rogoff, an economics
professor at Harvard University and co-author of "This Time is
Different", a best-selling 2009 book on debt crises, told Reuters.
"It is a manageable problem but it needs to be managed.
You can't just put your head in the sand and hope it goes away."
The benefit of hindsight
It wasn't supposed to come to this. Last year, when the EU
and IMF teamed up to rescue Greece, they mapped out what they believed was a
realistic plan for overhauling its ailing economy through a combination of
spending cuts, tax hikes and deep structural reforms.
Coupled with an aggressive drive to root out corruption and
tax evasion, this austerity was the shock therapy Greece needed to regain
competitiveness, reduce its debt and win over investors again, the argument
went.
Just in case markets hadn't got the message, it was driven
home in a September paper by Carlo Cottarelli, the head of the IMF's fiscal
affairs department, entitled "Default in Today's Advanced Economies:
Unnecessary, Undesirable, and Unlikely".
With the benefit of hindsight, however, the scenario mapped
out by Greece's saviours looks wildly optimistic.
Predictably, Athens has struggled to curb rampant
tax-dodging and suffered repeated revenue shortfalls as a result.
A return to economic growth next year - envisaged in last
year's rescue package - now looks doubtful, as do plans for Greece to return to
the long-term debt markets in 2012 to fill a €27bn funding gap.
Greece's debt load is set to rise to nearly 160% of annual
output next year, a level that puts it on a par with Zimbabwe.
Other countries have seen their debt shoot up to similar levels, particularly in times of war, without losing access to the capital markets.
Japan's debt-to-GDP ratio, for example, is projected to top 200% this year. But unlike Greece, a large portion of Japan's debt is held by domestic savers who are in no rush to jettison their holdings.
Japan, like most countries, also benefits from having its own currency and a central bank that can tailor monetary policy to its needs.
Greece, by contrast, cannot unilaterally devalue the euro to
boost competitiveness, nor convince the ECB to keep interest rates low when
much bigger eurozone economies like Germany are thriving and inflation is on
the rise.
Crucially, Greece also suffers from a credibility gap,
having defaulted on its debt repeatedly over the course of its turbulent
history.
"Greece has spent a supermajority of its time as a
modern, independent state in default or rescheduling," said US economist
Nouriel Roubini. "Indeed, recorded sovereign defaults begin with
city-states in ancient Greece."
The verdict of investors, who have pushed the yields on
Greek two-year bonds up to an astounding 26% in recent days, is clear: a
restructuring of Greek debt is now inevitable.
Can of worms
To ensure their currency bloc survives intact, European
policy-makers must come up with answers soon on how and when that will happen.
None of their options are attractive and every one of them carries big risks
for the euro zone.
Their first priority is figuring out how to plug a funding
gap of approximately €65bn that looms for Greece in 2012 and 2013 if, as
expected, it cannot return to the markets.
The bloc's immediate solution appears to be to offer Athens
more money and simultaneously loosen the terms of the loans it offered last
year, by cutting the interest rate it is charging and extending the period over
which Greece must repay them to 10 years or more.
A source in Germany's ruling coalition told Reuters this
week that these steps could be accompanied by private sector involvement - in
which banks, for example, agree to extend the maturities on their holdings - on
a voluntary basis.
Recent research from JP Morgan suggests banks holding Greek
debt on their banking books - as opposed to their trading books where assets
must be marked-to-market - might be able to avoid impairment charges under a
maturity extension if coupon payments were left unchanged.
Eurozone politicians hope that a "soft
restructuring" of this kind, with banks playing their part, might make the
idea of giving Athens more aid an easier sell to leery constituents.
The problem is that few experts believe it can work.
"Getting investors to participate on a voluntary basis
is a huge can of worms," said Andrew Bosomworth, a senior portfolio
manager at PIMCO Europe in Munich.
"Who owns the bonds? Nobody knows. And even if you do
figure that out what incentive do these investors have to roll over their debt
or extend their maturities, especially if they fear more pain may be looming
down the line?"
But Greece desperately needs more time to deliver on its
fiscal adjustment plan. Papandreou's government has promised to sell off €50bn in state assets by 2015. If some of that money starts flowing in over the
next two years, it could help Greece chip away at its debt pile.
Kicking the can down the road also gives European banks
additional time to build up provisions for their Greek sovereign debt holdings,
reducing the risk that governments will have to recapitalise them later.
The dilemma for Europe is that even with modest private sector
involvement, the plan will not put Greece back on a sustainable debt path nor
ease market fears that a sizeable "haircut", in which investors are
forced to accept a cut in the value of their bonds, will come in 2013, when
policy-makers have said they could consider more radical steps.
Throwing more EU money at Athens will also increase the size
of the public sector's exposure to Greek debt.
Once 2013 comes around, the only way to provide sufficient
relief may be for European governments to hammer their own taxpayers by
accepting big losses on the emergency loans they made to Greece. No sane
politician will want to do that.
In the shadow of the guillotine
Delays in dealing with Greece's debt problem increase the
likelihood that European governments will pay a high price down the road.
That is the crucial difference between the eurozone's debt
crisis and the one experienced by Latin American countries starting in the
early 1980s.
In Latin America, banks were given incentives to maintain
their sovereign debt exposure over many years. When the day of reckoning
finally came with the arrival of Washington's Brady Plan in 1989, it was the
financial institutions that had lent the money in the first place which felt
the pain.
In Europe, by contrast, the banks holding Greek debt are
gradually being bought out by European governments in what former Argentine
central bank governor Mario Biejer has likened to a "giant Ponzi
scheme".
"If the sword of a debt restructuring must eventually
fall in order to render Greece's debt stock manageable, that sword will fall
principally on the neck of the official sector lenders," wrote Lee
Buchheit, a lawyer at Cleary Gottlieb Steen & Hamilton in New York who
helped negotiate Uruguay's 2003 debt restructuring, in a paper on Greece's
options last month.
"The original creditors will have swapped place in the tumbrel with official lenders quite literally in the shadow of the guillotine."
Reuters calculations, based on a conservative estimate that
official lenders - EU governments, the IMF and ECB will hold about €160bn in Greek debt
two years from now, show that even eviscerating the entire value of the debt
held by private creditors in 2013 would be insufficient to push Greece's
debt-to-GDP ratio down to the EU's formal ceiling of 60%.
Even if one assumes the EU and ECB are treated the same as
private creditors, the overall haircut would still have to be a whopping 68% to
return the Greek debt ratio to that level.
Would Europe accept such losses?
Doing so would amount to political suicide for many of the
bloc's leaders. For the ECB the blow to its reputation, and future role as
lender of last resort would be at least as traumatic.
The central bank bought an estimated €40-50bn in
Greek debt at the height of the crisis, but those bonds were bought at a
discount and a haircut on them would be manageable.
The real risk to the ECB is via the Greek debt - both
government and government-guaranteed - that it has accepted as collateral in
its lending to Greek and other banks.
When these exposures are combined, they amount to €194bn, analysts at JP Morgan have estimated - roughly equivalent to the annual
economic output of the Czech Republic.
Add in the eurozone's exposure to countries like Ireland and Portugal, which could come under pressure to restructure as well if Greece went down this road, and the risks multiply further.
Fears about its own balance sheet go a long way to
explaining the dire warnings from ECB officials that a Greek debt restructuring
would unleash chaos similar to that seen after the 2008 collapse of US
investment bank Lehman Brothers.
"If the bank exposure was impaired this could be very
serious for the ECB," a chief economist at a major European bank said,
requesting anonymity because of the sensitivity of the issue.
Banks exposed
What about the banks themselves?
The hit to the Greek banking system, which holds close to €50bn in Greek sovereign bonds, would be the hardest.
JP Morgan estimates that a haircut of 50% percent on Greek debt
now could reduce equity in the Greek banking system to just €4bn, or 1%
of assets - a powerful hit that would require recapitalisation stretching the
country's €10bn euro Financial Stability Fund (FSF).
However, those losses would be much smaller if a
restructuring took place in mid-2013, according to the bank's analysts, as the
average maturity on the bonds they hold is five years and roughly €10bn matures each year.
For European banks outside Greece, the headline sovereign
debt exposure number looks manageable at roughly €65bn, with German
institutions holding €26bn and French nearly €20bn, according to the most
recent data from the Bank for International Settlements (BIS). Add in their
exposure to Greek private sector loans, repos, guarantees and credit
commitments, however, and the figure swells to over €200bn, led by
France at €92bn.
For leaders in Berlin and Paris, giving these banks a few
more years to build up provisions and allow some of their Greek debt to mature
would seem to make a lot of sense.
How does it end?
But what happens once 2013 rolls around?
It seems clear that private holders of Greek debt will be
forced to take major losses. What is less obvious is whether that will be
enough to deliver Greece the relief it needs and pave the way for its return to
the markets.
Until that happens, more European money will need to go to
Athens. How long can that go on without sparking a political backlash in
Berlin, Helsinki and other European capitals?
German Chancellor Angela Merkel faces an election in
September 2013, just as the Greek debt crisis could be coming to its ominous
climax. Two years from now, will she be able to sell the idea of keeping Greece
on life support to German lawmakers and citizens who are already balking at it?
Rogoff at Harvard University believes the eurozone can
emerge stronger from the crisis, but says some form of breakup may be
unavoidable.
"I would recommend that Greece take a sabbatical from
the eurozone, do a massive currency devaluation and then re-enter at a later
date, although I realise there is a very strong political commitment not to let
that happen," Rogoff said.
He is not alone. A growing number of economists and bankers
who have looked at the Greek debt issue closely are coming to the view that the
clash between economic and political forces within the eurozone may lead it to
splinter, even if the costs - to both Greece and other members - would be huge.
If Greece were to leave the bloc it would have to hive off
its bank deposits from the rest of the eurozone banking system as it
introduced a new currency, risking a run on its banks and huge disruption for
its companies.
Banks across Europe would face losses on their Greek debt, trade flows would be disrupted and social unrest could result.
"Two years ago I would have said it was impossible in
theory and practice," a European banker, who requested anonymity, told
Reuters.
"Today it at least seems theoretically possible. When I visit Berlin I hear people thinking aloud either about exclusion or about a voluntary exit," he said. "But it would be the worst scenario possible for all concerned. It's a lose-lose-lose proposition."