It is clear that Greece has had a solvency
issue now for over 2 years. The ECB and Troika chose to treat it as a
liquidity problem. Maybe, they could have argued that in early 2010, but
by the summer of 2011 it was obvious to any credit observer that the problem
was solvency, yet they continued to treat it as one of liquidity. That is
scary because if they fail to see the problem correctly now, they will fail
miserably. Not only is the problem clearly solvency, but now forced currency conversion has been added to the mix.
Any “solution” from the EU must now address that risk, and it is not the same
as solvency. Programs that
can protect against solvency may do nothing for the redenomination risk.
Not only did Europe fail to address the problems, but in spite of convincing themselves that all these programs prevented contagion risk, they actually ensured contagion risk. That contagion risk, that they forced on themselves is now coming back to haunt them, and must be carefully addressed in any policy “solutions”.
Two Years of Bad Policy Have Created a Situation Like No Other
There is a lot of talk about what a Greek
exit would or wouldn’t look like. People are comparing it to other
defaults and currency devaluations. They are wrong. Greece is now
unique in that almost all of the debt is owed to institutions that normally
step in after devaluation. Greece is also unique in that it is
leaving a currency union that is already fragile, and being the first to leave
will open the floodgate of speculation as to what other countries will leave.
Greece is running a primary deficit, but
that doesn’t make its interest payments any less important. Greece has
€150 billion in loans, roughly half of which seem to be at 4% and half seem to
be tied to PSI, so I conservatively assumed 2% on those. About €4.5
billion of interest is being paid to the Troika annually on these loans.
The ECB (and EIB and other central
banks) hold approximately €50 billion of bonds at about 5% average coupon for
another €2.5 billion of interest. True
“private sector” holders of Greek debt only receive about €1.5 billion. Most goes to pay the €66 billion of 2% coupon
PSI debt and the rest is for the €4 billion of holdout English law bonds. I did ignore the €14 billion of t-bills in
this analysis.
It is very obvious though, that for Greece
to get any help on its current interest expense it has to cut back on the
Troika and ECB in particular. Over 80% of its annual interest expense now
goes to pay government and quasi governmental entities.
It’s not just the interest payments that
are heavily skewed towards the Troika, it is also the debt redemptions that
Greece is facing. A staggering 98% of all debt redemption in the next 6
years goes to pay off the Troika and ECB, with the ECB’s remaining bond
portfolio representing 35% of the total, and almost all of the payments in the
next 3 years.
Never has there been a situation where a
country is in such deep trouble that it needs to default and virtually all of
the debt is already held by entities which normally step in AFTER a default and
currency devaluation.
Damned if You do, Damned if You Don’t
If Greece defaults or restructures or
reverts back to the Drachma without forcing the Troika and ECB to take a hit,
then Greece is doomed to another round of defaults, likely within the year.
Speculation is that a return to the
drachma would result in a 25% to 50% currency devaluation. Just forcing
the private sector to convert their debt to the new currency does almost
nothing for Greece. The interest burden of attempting to pay Euro
denominated debt with devalued drachma’s would be impossible. The
redemptions would become unbearable. Greece cannot revert to a drachma
without immediately affecting the Troika’s holdings, or defaulting, likely
within a year.
This is where it is so different than any
other situation we have seen in the past. There is no private sector to
take the hit. The private sector already got wiped out with PSI.
Germany and the ECB should have made concessions then, but chose not to.
Now they are in a situation, where less than 3 months after a massive private
sector hit, the horrible plan is already falling apart, and Greece needs
immediate relief, or needs to leave the Euro.
So far Germany in particular has kept to
the “austerity” and “original plan” line. Neither the ECB nor the IMF
have done much for Greece, but at least don’t seem to be as belligerent or as
antagonistic as Germany. Rather than arguing why Germany, the ECB, and
IMF should rework the plan, I will look at the logical consequences of failure
to do so. I think the potential risk of forcing a “Grexit” at this stage
will become too obvious and be too large for the EU to risk it until better
policies are put in place.
Direct Impacts of Greek “Drachmatization”
If Greece returns to the drachma there is
a real risk that trade will break down. How will companies be
treated? What happens to contracts that Greek companies made? Will
they be honored in original form or also be subject to being
redenominated? Can Greek companies afford the contracts after introduction
of the drachma? This is just basic stuff, but in a world that depends on
global trade, it is hard to tell what the consequences of a trade breakdown
with Greece would be. We saw from the Japanese earthquake how
sensitive and widespread problems from seemingly isolated supply line problems
can develop.
That is all based on the hope that the
world doesn’t become fixated on a chaotic breakdown of Greek society. The
worst case is shortages of fuel and food where prices skyrocket in the
immediate aftermath of the redenomination. Industry grinds to a halt from
a lack of raw materials. This should be the easiest element of a
devaluation to deal with, but it will require planning.
I’m assuming that depositors will be
forced to accept drachmas in their bank accounts rather than keeping
Euros. If they are allowed to keep Euros, then the situation would be
better, except for the fact that the already insolvent banks would become more
insolvent if forced to pay out depositors in Euros while have most of their
assets turned into drachma.
These problems are unlikely to get out of
control, and should be “merely” disruptive but would benefit from planning and
preparation, none of which has really occurred yet.
Bank runs in Italy, Spain, and Portugal
This is the most likely result, no matter
what happens to the ECB, IMF, and EFSF’s positions.
If you have a deposit in a bank in a
country at risk of redenomination, then you would have to seriously consider
taking money out to avoid that risk. This isn’t default risk. This
is different. You aren’t concerned that your bank is going to default you
are concerned that €1,000 will turn into 1,000 lire or pesetas of unknown
value. Pan-European deposit insurance will NOT stop that flight of
depositor money, unless it also ensures against forced conversion. That
is a big risk to insure against, and may not be even remotely in the ECB’s
mandate. So this is another difference from any other situation. If
Argentina devalues, there is always risk that Brazil would devalue as
well. That contagion risk played out in Asia in the late 1990’s.
That risk is amplified here, because Greece will be a template for the
others. In the back of every depositors mind, will be the fear that their
country does it too.
I am scared that the ECB thinks they can
address that risk with liquidity measures because they cannot. I am
scared that the ECB thinks they can address that with solvency measures because
they cannot. Real fear of forced currency conversion and devaluation is a
new fear and new problem. You may not be concerned that BBVA is going to
default, but you may be afraid that your account will be turned into something
worth a lot less.
The only way to stop this is to insure
against it (difficult) or to force Greek banks to pay depositors in
Euros. But it is unclear how the Greek banks could afford to pay people
out in Euros. The banks are already insolvent and the amount of
additional money they would need to pay depositors in Euros would just push the
problem elsewhere into the system.
I don’t see an easy way to stop a run on
the banks in any of the weak countries if Greek depositors are forced into
Drachma, and I don’t see any way for the Greek banks to pay depositors in full
in Euros.
Anticipating what forced currency
devaluation would really do is a new aspect to the crisis. It isn’t a
liquidity or a solvency problem, it is its own problem. Politicians and
central banks have to focus on this issue. I remain afraid, that
like at so many other stages in this crisis, they will fail to understand the
real problem, so their “preparations” will fail to stop this run and the crisis
will escalate.
ECB Losses and Contagion
What will the ECB do with their
losses? This seems to be a case of being stubborn and foolish. The
ECB is not a mark to market entity. It funds incredibly cheaply and can
print money. I remain convinced that it would cost the ECB much to
convert their existing Greek bonds to PSI bonds at cost. With the debt
maturity schedule that Greece faces, this would be a big benefit and would take
a lot of pressure off the governments. Not the pressure to implement
reforms, but the pressure that is killing the economy.
If Greece leaves, what is the ECB really
going to do? Do they really expect Greece will pay them back at par in
Euros with their new weak currency? That is stupid. Will the ECB
print money to make up for the losses? That is one possibility, but given
how stubborn Germany has been about austerity and how they hate printing money
even more, I expect that the ECB would not print money to cover the losses.
If the ECB is going to take a loss and
won’t print money, then they would have to go to their members and ask for more
money. That seems highly unlikely, especially if Spain and Italy are busy
trying to prevent a run on bank deposits. So, sadly, the plan seems to be
to sell the bonds to the EFSF at either cost or par and let the EFSF take the
loss.
Feeding more losses to the EFSF starts to
fan the flames of contagion. The EFSF will have losses on its own loans,
but now for the first time, obvious to everyone, the EFSF will be just a loss
transfer mechanism. It will pay good money for garbage and then ask the
EFSF members to pay for it. Because of the guarantee program they may not
have to ask Germany and France for money right away, but the pretense that the
EFSF guarantees don’t count against a nation’s debt burden will be shattered.
Attention will quickly focus on how much
new money Spain and Italy are on the hook for. They are both
contributors, and Spain will be dealing with regions that are running out of
money, and both will be dealing with full fledged banking crisis of their own.
The scam that guarantees don’t count will
be exposed. Spain and Italy may even need EFSF money by now.
Investors will be thinking about the €160 billion or so of Spanish, Italian,
and Portuguese debt sitting on the ECB’s balance sheet and wondering what is
going to be done with that? Who is going to take the loss on that pile of
bad debt?
Everywhere you turn, you will see exposure
that was never accounted for and is getting worse. Some Bundesbank
official will blabber on about not printing money and the market will become
dizzy with fear. The ECB’s bond portfolio turns into losses for the
EU. The EFSF turns into losses for the EU. Spain and Italy will
need money from the EU for their own problems. The EU is just Germany and
France. They don’t have the money. Pandemonium ensues.
Maybe it won’t be that bad. The ECB
will launch LTRO3, but given the half life of LTRO2, that may do nothing to
quell the fears. Actually, depositors and bond buyers in banks that used
a lot of LTRO money will become scared of solvency. The LTRO helps banks
last longer, but any bank that defaults will have incredibly low recoveries for
unsecured lenders. The ECB will have all of the collateral, which will be
declining in value requiring ever more to be posted to the ECB and less there
for general creditors.
Just because the LTRO worked the first 2 times,
doesn’t mean it will work a 3rd time, especially since its flaws have been
exposed.
Simply put, the ECB should negotiate a
better deal with Greece now, rather than risk this potential turn of events,
and pretending that EFSF doesn’t actually create contagion is naïve.
Crumbling IMF Firewalls
The ECB won’t be the only entity to
lose. The IMF will too. The IMF is more senior, but will they
really be able to enforce any of their rights? This is also where the
problem is completely circular. Greece will need IMF money to
function. The IMF’s primary function is to ensure a country on the edge
can get the funds they need. So the IMF
will be the biggest existing creditor, but also the most likely future
creditor. What a mess.
A self-made mess since the IMF
traditionally forced defaults before lending. Remember back in 2010, the
IMF changed its policy for Europe and didn’t really force them to do anything
to private lenders before stepping up? They had those policies in place for
a reason, precisely to try and avoid this sort of situation.
Then there is Lagarde’s precious
firewall. Do you think she told any country they might have losses on old
loans within 2 months of agreeing to this new and bigger firewall? I
think a lot of people pledged their support because it seemed costless and were
assured that the IMF never loses money and would likely never need this money.
With Greece, the IMF will lose money in
the initial devaluation, or when Greece defaults because they played hardball.
With countries witnessing the losses, and seeing the risk that any “firewall”
contributions to Spain and Italy go down the tube as well, the reluctance to
live up to pledges will grow.
The IMF could try to impose very strict
terms on Spain and Italy for “firewall” money, but then it is highly unlikely
it will really be of much help, and will just once again shift around who bears
the ultimate cost.
The IMF, another entity without anything
resembling a real world P&L might just be tempted to cut the interest
payments and extend the maturities on its existing loans to Greece and
others. If not, look for the fabled firewall to be just that – a fable.
They See the Light or Dark Bottomless Pit
I keep playing with scenarios and find it
hard to find out where a Greek exit doesn’t result in a steep sharp decline in
the market. We could go through more ideas of ECB intervention, but in
the end most will have flaws. Dealing with currency conversion risk is
huge. Dealing with the contagion risk that has been created by the EFSF
is huge.
I believe that as they start to plan, they
will eventually listen to some of the “doomers” and decide that they should
attempt some policies to retain Greece for now. To fix the situations in
Spain and Italy so that a return to the drachma isn’t likely to spark fears
that Spain and Italy will also redenominate.
Can Greece leave and the damage be
contained? Sure, it’s possible, but seems highly unlikely. Can
Europe do enough to keep Greece in for another 3 to 6 months and make plans
that make an exit controllable or possible avoid an exit altogether? That
is possible, and seems a better solution. Will Europe force Greece out
thinking they have a plan that fails miserably and sparks the miserable series
of consequences I’ve outlined? Sadly, yes.
No comments:
Post a Comment