THE BIG ISSUES:GREECE WAS the starting point of the sovereign debt crisis and remains its engine room.
When Athens admitted falsifying its public accounts two years ago, the impact was akin to that of rocks being thrown into a pond. The ripples have been spreading ever since, magnifying the frailty of countries like Ireland and unsettling even well-financed states like France.
Markets have seized on concern the rescue measures to date do not go far enough to bring Greece’s ailing finances onto a viable footing, fuelling months of turmoil.
There is more. Greek premier George Papandreou is a weakened force, raising questions about his ability to deliver painful budget cuts and difficult reforms.
THE PROBLEM
EU leaders agreed in July to provide a second bailout to Greece, a deal necessitated by IMF rules which prevent it from financing a country whose funding outlook is unclear over a 12-month horizon.
As a condition for additional aid, the EU leaders yielded to German pressure for Greek bondholders to bear costs as part of the rescue effort.
The European Central Bank was opposed, fearing contagion. But the leaders went ahead anyway and struck an agreement with a lobby group which represents the world’s biggest banks.
This deal didn’t work. First, market participants immediately said the 21 per cent loss to be voluntarily borne by bondholders was too small. By this they meant the reduction in Greece’s debt wouldn’t bring it back to a sustainable level.
Second, even with the debt reduction, the worsening of the country’s recession means it is unable to achieve the targets it must meet to secure bailout loans.
Third, the plan triggered uncertainty about the fate of French banks, which have the greatest exposure to Greek debt, and other banks also exposed.
Fourth, the plan raised questions about the safety of Italian and Spanish debt, prompting the ECB to buy their sovereign bonds to try to keep their borrowing costs in check.
At this point the crisis entered a new phase. Two of the biggest users of the single currency were threatened, with the consequent risk the entire euro zone would be engulfed by crisis. If that were not enough, interbank lending started to freeze over again.
THE FIX
EU leaders are now working to increase the losses borne by Greek creditors. This could see the 21 per cent “haircut” agreed in July rising to 50 per cent or more. The move will be dressed up differently but this is default or debt-restructuring by another name, something Europe vowed to avoid.
To protect banks, the authorities are working on a plan to greatly increase the capital held by the weakest institutions. Furthermore, leaders want to increase the flexibility of their bailout fund so it can give greater cover to the likes of Italy and Spain. Still, the effort is not without complication.
For one thing, the banks which backed the July deal are resisting moves to impose greater costs on them. For another, the ECB fears an increased “haircut” would fuel yet more market tension. Against that, however, is the argument that it is only by fully confronting the financial black hole in Greece that the country can be turned around.
More important still is the clamour in Germany for private creditors to face the consequences of poor investment decisions. This is crucial, given the likelihood Berlin’s exposure to the crisis will be greatly increased in other measures to tackle the crisis.
WATCH OUT FOR
Imposing bailout costs on private investors is fraught with risk.
A prime consideration is that Europe wants to avoid triggering insurance claims against any Greek default. In market jargon, this is known as a “credit event”, something which could unleash yet more volatility in markets.
To guard against that, leaders are likely to insist that creditor participation in the initiative is voluntary. In doing that, they would be likely to make the point it is in investors’ own long-term interest to find a durable solution.
Whatever happens, the sense remains that Greece could remain under the tutelage of its bailout sponsors until well into the next decade. It is a chilling thought, which raises questions about political acceptability of such an endeavour for the euro zone.