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.