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Some Thoughts On Greece And The Euro Zone

By Win Thin

The narrative has shifted recently with regards to Greece. Greece had been portrayed by many as a small economy one tenth the size of Germany whose debt problems could be solved by throwing EU/IMF money at it. Now, Greece appears to have become a much bigger problem whose default/restructuring could throw the entire European banking system into turmoil. What changed? More and more market participants and policy-makers have come to the realization that a “soft” restructuring (lowering rates, extending maturities) was not going to be a sustainable solution, and that a “hard” one would have to be done that imposed significant haircuts. Greek banks are the biggest holders of Greek debt, and so would be hit the hardest by these haircuts. However, it is known that core euro zone banks are significant holders of Greek debt and so the balance sheet destruction would be felt beyond Greece. While most estimates of Greek holdings by non-Greek banks are significant, they do not seem large enough to warrant the level of concern from officials in Europe. ECB’s Gonzalez-Paramo and Stark have both recently warned that a Greek debt restructuring could trigger a Lehman-type banking crisis (or worse) in Europe.

Euro zone policy-makers have typically tried to sugarcoat and downplay risks from the periphery, so these ECB warnings certainly raised eyebrows. Because the Greece numbers still appear to be manageable, we think that those warnings and concerns are stemming from the huge contagion risks that remain in play. If Greece restructures, then why not Portugal or Ireland too? As more countries are potentially brought into the mix whose bondholders face large haircuts on principal, then it’s clear that the European banking sector becomes much more vulnerable. Throughout this European debt crisis, contagion has been strong and seemingly unavoidable. That is why policy-makers in Europe continue to kick the can down the road, hoping to delay any sort of haircuts until European banks are in better shape and the ESM comes into effect (2013). If the wider euro zone weren’t at such risk, we think some sort of “hard” Greek restructuring would most likely have been considered long ago.

Officials are only now belatedly acknowledging that the original rescue plan for Greece has to be amended, and while officials go back and forth about whether there is to be a “hard” restructuring or not, we do not think it can be avoided. Going back to our EM experiences, “soft” restructurings rarely work (think Baker Plan in the early 1980s) and we think that “hard” ones are needed to address serious solvency problems (think Brady Plan in 1989). We think that the Europeans will continue to try to kick the can down the road again, with the easy solution of a “soft” restructuring favored that simply boosts EU/IMF moneys again but perhaps with guarantees or collateral needed in return for lowering rates or extending maturities. But given such alarm about haircuts within official circles, any Plan B to emerge probably won’t address the underlying solvency issue, a solution that would require large haircuts that risk the health of the already-weakened European banking sector. While it will be tempting for markets to breathe a sigh of relief on an announced increase in aid to Greece, we think that another muddle through solution would only provide temporary relief for Greece and for the markets.

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Win Thin

About 

Win Thin is the Head of Emerging Markets Currency Strategy at Brown Brothers Harriman. He has a broad international background with a special interest in developing markets. Win received his Ph.D. in economics from Columbia University in 1995, specializing in international and development Economics. He received an MA from Georgetown University in 1985 and a B.A. from Brandeis University 1983.

3 Comments

  1. Both James Baker and Nicholas Brady were mentioned this morning on one of Finland’s economic news. The news was all about how differently the crisis are being handled now in the Europe than it was handled back in 1980′s in Latin America. The research based on recent study named ”
    Greek Debt – The Endgame Scenarios” written by
    Lee C. Buchheit
    and
    G. Mitu Gulati.The main difference is the fact who’s on the driving seat. According to the study the real drivers are European banks and nations will follow. In my opinion this is due to bloated banking sector in Europe. I fear Belgium will be the next in line. Belgium has got sovereign debt around 100% of GDP and its three biggest banks hold asset books over 600% of Belgium’s GDP. This similiar pattern can be seen on other European nations. This leaves banks very vulnerable as they are also leveraged themselves to exorbitant ratios. There will be more challenges like Basel III and the eurozone people has gotten fed-up this bail-out procedure. Here in Finland the “aid package” of Portugal seems to be passing through now that Centre party, National Coalition party and latest addition, Social democrats are all approving the bailout for Portugal. Meanwhile, there was a another large general strike in Greece, majority of German people start to become sceptic about this procedure would do any good. Everyone seems to be annoyed, except the banks. They can keep borrowing cheap money from the ECB, who is reguraly forced to show up on troubled countries’ bond auctions.The official strategy that Greece could come up on its own within a year and sell bonds can’t hold much longer. It looks like Greece needs another €60 billion to honor maturing bonds on the next two years, before the ESM is established. A year ago, when praised ESFS was forged to give temporary mechanism to bail out the troubled countries is now in danger to face the thing not many believed: it will show out soon.We Finns are mainly scapegoated as being “trouble child” of Europe because this bailouting has become vastly unpopular scheme. Trichet, Rehn and Juncker have been actively lobbying Finnish policymakers to approve the bailouts. Nevermind the fact that the Finns are required to fund these bailouts ten times more they are holding the risks in countries in crisis. Nevermind the fact that Finland didn’t have got any priviledges to audit troubled countries’ budgets as they were against Maastricht convention. E.g. Portugal had debt to GDP ratio over 60% already in 2005. I have written this elsewhere, but the way European Union works resembles a famous organization, which left “offers the customer can’t refuse.” There has been intimidation, extortion and threatening all over.

  2. Both James Baker and Nicholas Brady were mentioned this morning on one of Finland’s economic news. The news was all about how differently the crisis are being handled now in the Europe than it was handled back in 1980′s in Latin America. The research based on recent study named ”
    Greek Debt – The Endgame Scenarios” written by
    Lee C. Buchheit
    and
    G. Mitu Gulati.The main difference is the fact who’s on the driving seat. According to the study the real drivers are European banks and nations will follow. In my opinion this is due to bloated banking sector in Europe. I fear Belgium will be the next in line. Belgium has got sovereign debt around 100% of GDP and its three biggest banks hold asset books over 600% of Belgium’s GDP. This similiar pattern can be seen on other European nations. This leaves banks very vulnerable as they are also leveraged themselves to exorbitant ratios. There will be more challenges like Basel III and the eurozone people has gotten fed-up this bail-out procedure. Here in Finland the “aid package” of Portugal seems to be passing through now that Centre party, National Coalition party and latest addition, Social democrats are all approving the bailout for Portugal. Meanwhile, there was a another large general strike in Greece, majority of German people start to become sceptic about this procedure would do any good. Everyone seems to be annoyed, except the banks. They can keep borrowing cheap money from the ECB, who is reguraly forced to show up on troubled countries’ bond auctions.The official strategy that Greece could come up on its own within a year and sell bonds can’t hold much longer. It looks like Greece needs another €60 billion to honor maturing bonds on the next two years, before the ESM is established. A year ago, when praised ESFS was forged to give temporary mechanism to bail out the troubled countries is now in danger to face the thing not many believed: it will show out soon.We Finns are mainly scapegoated as being “trouble child” of Europe because this bailouting has become vastly unpopular scheme. Trichet, Rehn and Juncker have been actively lobbying Finnish policymakers to approve the bailouts. Nevermind the fact that the Finns are required to fund these bailouts ten times more they are holding the risks in countries in crisis. Nevermind the fact that Finland didn’t have got any priviledges to audit troubled countries’ budgets as they were against Maastricht convention. E.g. Portugal had debt to GDP ratio over 60% already in 2005. I have written this elsewhere, but the way European Union works resembles a famous organization, which left “offers the customer can’t refuse.” There has been intimidation, extortion and threatening all over.

  3. Blankfiend says:

    Barry Eichengreen has a good piece on the Brady plan at http://www.project-syndicate.org/commentary/eichengreen30/English.

    Martin Wolf sums it up nicely in the FT, telling of a king who sentences a subject to death within a year unless he can make the king’s horse talk. The condemned subject agrees to the terms. When asked why, he responds that “Anything could happen – the king could die, I could die, or the horse might actually start speaking.”

    I think European leaders are praying for the resurrection of Mr. Ed.

  4. Blankfiend says:

    Barry Eichengreen has a good piece on the Brady plan at http://www.project-syndicate.org/commentary/eichengreen30/English.

    Martin Wolf sums it up nicely in the FT, telling of a king who sentences a subject to death within a year unless he can make the king’s horse talk. The condemned subject agrees to the terms. When asked why, he responds that “Anything could happen – the king could die, I could die, or the horse might actually start speaking.”

    I think European leaders are praying for the resurrection of Mr. Ed.

  5. DavidLazarusUK says:

    “But given such alarm about haircuts within official circles, any Plan B to emerge probably won’t address the underlying solvency issue, a solution that would require large haircuts that risk the health of the already-weakened European banking sector.”

    That is the issue. The bail outs are not to save the nations but to rescue the very weak core nations banks. Using tax payers as fodder for the banks. This will end in disaster.

  6. Anonymous says:

    “But given such alarm about haircuts within official circles, any Plan B to emerge probably won’t address the underlying solvency issue, a solution that would require large haircuts that risk the health of the already-weakened European banking sector.”

    That is the issue. The bail outs are not to save the nations but to rescue the very weak core nations banks. Using tax payers as fodder for the banks. This will end in disaster.