Is Schaeuble Calling for Restructuring or Posturing?

By Marc Chandler

German Finance Minister Schaeuble wrote a letter earlier this week to the ECB, IMF and euro zone finance ministers that appears to be putting the proverbial cat among the pigeons. The latter has been leaked to the press. He seems to be tacking a course that runs into direct opposition to the ECB, IMF and France.

Until recently Schaeuble seemed to argue that a restructuring of Greek debt needed to be avoided because of the systemic risks. However, the letter suggests a different assessment. Schaeuble essentially argues that the EU/ECB/IMF plan has failed. Full stop. It failed because Greece cannot go back to the capital markets next year as initially envisaged and if Greece needs funds for not only next year, but 2013 and 2014, estimates suggest as much as another 100 bln euros may be needed (1st package 110 bln euros).

He seems to argue for going back to the drawing board. And in bailout 2.0, time to get what he calls a "quantifiable and substantial contribution" from the private sector.

Schaeuble would like, according to Der Spiegel, a bond swap that extends maturities by seven years. He must realize that this runs counter to what the ECB, France, and even Merkel recently have indicated. He must also realize that the rating agencies would likely see this as a credit event, i.e. trigger credit default swaps. He would seem to be playing with fire.

However, there is another level of analysis. It is the level of German domestic politics, which often seems to be the "sixth man" (basketball analogy)–not a player often cited but who plays a critical role. The response to shocks is constrained by domestic institutions, but colored by interests of the economic and political elite. German domestic resistance to more aid to Greece is palpable.

German domestic political considerations are arguably increasingly important at the moment. The latest polls show Merkel’s CDU/CSU/FDP coalition lagging behind SPD/Greens 35% to 49%. Merkel appears not to have stolen the Greens’ thunder by adopted its anti-nuclear stance, but rather is seen as flailing.

Merkel and Schaeuble are expected to brief the German parliament later today on Greece. The coalition parliament members are drafting a resolution to provide instructions to Merkel and Schaeuble regarding negotiations over Greece. This will lead to a non-binding vote on Friday. Reports suggest that there may be two resolutions, one on Greece and one on ESM.

Last year, Merkel had seemed to be moving down the same road that Schaeuble apparently is in his letter. Some suggest this hastened Ireland’s decision to seek assistance. She backed off and favored restructuring only after the ESM is in place.

Schaeuble may be repeating that behavior. Greece does not need its next tranche of aid until mid-July. Concluding the end of the brinkmanship game is premature. In exchange for some disruption in the capital markets, Schaeuble is positioning to win more concessions at the informal EU fin min meeting on June 4 and the "big one" on June 20. The euro has rallied from just below $1.40 on May 23 to almost $1.47.

In that span, it only slipped below the previous day’s low once and that day–June 2–actually posted an outside up day (trading on both sides of the previous day’s range and close above the previous day’s high), which is a constructive sign. The advance was partly predicated on ideas that Europe will kick the can down the road by treating the solvency issue as a liquidity issue for the next couple of years, not because it is right or fair, but because it is understood by the political elite as the least costly alternative.

The ECB meets tomorrow and the market expects Trichet to signal a rate hike next month. In some ways the rate hike is not in spite of the peripheral debt crisis, but because of it. The ECB, which has come under biting criticism for becoming a holding toxic assets, has to drive home the point, beyond doubt, that it 1) makes a distinction between monetary policy and liquidity provisions and 2) it is independent (makes Bini Smaghi more likely to resist pressure to step down and make room for a French candidate for the ECB board once Trichet retires). Next month’s rate hike is nearly fully priced in. That suggests an asymmetrical risk at tomorrow’s press conference. The euro faces more downside risks if Trichet fails to provide the word cues then the upside if he provides them.