Tuesday, May 10, 2011

No easy win in Greece

Standard & Poor’s has cut Greece’s credit rating two notches from BB- to B. This follows growing speculation over recent weeks that a restructuring of Greek sovereign debt is imminent. This itself followed comments mid-April from German officials indicating they wouldn’t oppose a restructuring. All those comments really indicate is European authorities are still struggling with the concept of speaking with one voice. Since then Greek bonds have sold off significantly and credit default swaps have blown out.

Some Greek and German authorities have recently floated the concept of a “voluntary restructuring” or “re-profiling” of Greek debt. This would involve extending debt maturities, meaning debt holders would get paid back, but at a later date. Standard & Poor’s today said that approach amounted to “selective default”.

There is no easy win for Greece. As we have noted since Europe debt issues surfaced early last year, we believe a restructuring of Greek debt is inevitable. The debt to GDP ratio is approaching 150%, the Budget Deficit was recently revised down to 10.5% of GDP in 2010 and the improvement in the current account deficit is largely due to financing inflows from the EU. The only issues are how and when a debt restructuring happens.

Today, there appear to be two options, neither of them overly palatable. The first is to give Greece more time for reforms, those already made and those still needed, to have an impact on the economy.

This would necessitate Euro Area members and the IMF agreeing to a new loan to cover Greece’s borrowing needs out to, say, 2013. The terms of the original bail-out package did not include the necessary refinancing of existing debt in the order of €25b in early 2012. At the time it was expected Greece would be able to re-enter capital markets in 2012. That appears unlikely. Such an approach would also most likely require a softening of deficit reduction targets. Restructuring of debt could then occur later in a more orderly fashion.

The big downside of this approach is political. There is already negative public opinion in some lender countries towards bailouts. Public opinion will most likely balk at the suggestion of another loan to Greece.

Which brings me to the second option – that debt restructuring happens now. I can’t see any upside in this scenario. At a stretch, it could lead to Greece being able to put its debt issues behind it and to move on to a more prosperous future. Like I said – it’s a stretch.

There is political downside here as well, including for the very same sovereign lenders who may be against a second loan to Greece. Debt restructuring implies losses on the loans issued just last year. That’s not likely to lead to a “win” in the court of public opinion either.

In the finance sector, bank’s that hold large quantities of Greek debt are not likely to be sufficiently well capitalised to wear large losses now. In order to prevent a credit crunch, these banks would have to be recapitalised. Under the first option, these banks will have longer to build capital to protect themselves from losses further down the track.

It’s time to drag out a well worn phrase: There’s no such thing as a free lunch. The Greece debt issue is best approached as a “loss minimisation” exercise. It’s also the case that whatever path Greece ends up going down, or gets forced into going down, it must lead to economic growth. In that regard the first option must be preferred. It also seems to me to be the option that minimises the risk of contagion. Here’s the “but”: but such an outcome requires politicians to start singing from the same song-sheet….