Greece will not default this year - but it will, eventually


The adjustment Greece is being asked to make will be very tough and too many other factors are working against it, writes WOLFGANG MÜNCHAU

FINALLY THERE is a deal. It came late and only after the financial markets – and a ratings agency – forced the European Union to put up or shut up.

The EU will provide Greece with emergency loans at a rate of about 5 per cent, which is lower than current market rates. There is no agreement yet about the overall amount of money to be disbursed. But I hear that the total figure will be much larger than has been widely reported – somewhere between €50 billion and €60 billion.

It is not the worst conceivable deal, which would have been the German idea of providing the funding at market rates. It is evident that the economic advisers of Angela Merkel, the German chancellor, have little experience in resolving international solvency crises, because otherwise they could not have conceivably insisted on such a ludicrous idea.

The 5 per cent interest rate that has been agreed is, in my view, still relatively high given the situation Greece is in and the likely debt dynamics it will face in the next few years.

However, 5 per cent is better than the 7 per cent or so of recent market rates for Greek two-year bonds. Moreover, the European Central Bank decided last week to prolong the exceptional collateral regime, which allows banks that own Greek bonds to exchange their assets for cheap central bank funds.

This was a significant announcement and will provide Greece and its creditors with breathing space.

So, will this stave off insolvency? It is important to distinguish the near-term insolvency as a result of the failure to roll over existing debt, and the country’s long-term solvency position. This deal, I am confident, will solve the first issue. As I predicted last week, Greece will not default this year. But I am still sticking with my second prediction – that Greece will eventually default. The numbers simply look too bad. The adjustment effort Greece is asked to make will be one of the largest in history.

However, unlike other countries that made a similar effort in the past, Greece cannot devalue; it faces a much more challenging global environment; it has a weak fiscal infrastructure, a low consensus in society in favour of deep reforms and a fragile financial system.

The agreed bailout terms do not exactly offer much relief, except in the very short- term. It will become clear very soon that this loan agreement represents a net transfer of wealth from Athens to Berlin – and not the other way round.

All this points to an eventual, but not imminent, default. It is important to remember that default does not usually imply a complete wipe-out. Bondholders usually recover some proportion of their holdings. I would expect that some form of restructuring of the Greek debt is inevitable, whereby bondholders will see a percentage subtracted from the par value of the assets. The 5 per cent interest rate, relative to the market rate, may already be a metric of the size of a future restructuring. It is hard enough to imagine how Greece can get out of a simultaneous debt and competitiveness crisis without falling into some vicious circle – debt deflation, for example, or just extreme public hostility that will thwart the government’s reform efforts.

It is impossible, though, at least for me, to imagine a situation in which Greece can manage to extricate itself from a pending catastrophe without some debt restructuring.

The EU and its institutions do not come out of this with much glory. The European Council made a political statement on February 11th saying it is willing to support Greece in principle, while subsequently failing to agree on a firm package. In March, it appeared to suggest they had a deal, but they did not. There was a lot of deceit in the process. It took a speculative attack on the Greek bond market to bring concrete action. A lot of harm has been done in the meantime.

It is still not a coherent policy. Many questions remain. What, for example, will happen if Greece fails to repay the loan? Will the bond market interpret the deal as a sign that the EU will not let anyone fail who acts in good faith or will it start testing the EU’s solidarity for Portugal and possibly even Spain or Italy? There will come a point when the EU will no longer be in a position to help, even if it wants to.

The cost of the Greek bailout is not high compared to the hypothetical alternative of uncontrolled Greek default inside the euro zone. Portugal is a smaller country than Greece, in terms of gross domestic product (GDP), but Spain is the euro zone’s fourth- largest economy, with an annual GDP of more than €1,000 billion at current market prices.

Is this going to be a sovereign-level re-run of the bailout decision of the US government in respect of Bear Stearns and Lehman Brothers? Will Greece be lucky because it was first to receive help, while Portugal and Spain, like Lehman beforehand, will enjoy no such support?

It is impossible to answer these questions, but it is evident that whatever will be agreed will only apply to Greece. The EU has still not provided a generalised crisis resolution regime. I suspect smart investors know this. – Copyright The Financial Times Limited 2010

Lucy Kellaway is away