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Wednesday, May 18th, 2011

Greece is still the word
posted by Ross Dawkins


“This is the life of illusion
Wrapped up in trouble laced with confusion
What we doing here?
[Extract from Grease, copyright of Frankie Valli]
There is some convergence amongst commentators that a 50% haircut on Greek debt is inevitable. 
I am not yet fully convinced that this scale of debt re-structuring is inevitable — although this does put me on the side of the ECB against the market (not perhaps a comfortable position, as in the end the market will always win - but the market may change its mind first!). Having thus made myself sufficiently a hostage to fortune on this, there are a few aspects to my thinking about re-structuring that I want to discuss here. 
First, there is the potential for moral hazard: the idea that post-restructuring Greek politicians will lack the appetite to continue reform. Greece’s finances are not sustainable without major structural reform, full stop — i.e. without such reform, there will be a further restructuring at some future date. 
To the extent that the capital markets appreciate this, then Greece will have to continue to rely on the rest of Europe for financial support. Capital markets tend to be wary post-default anyway as psychological compensation for the inadequate wariness beforehand. On this basis, a lack of substantial reform in Greece would make for a huge challenge to the continuance of Greece’s membership of the Eurozone (maybe even to the Euro idea itself).
Such a large haircut would also put Greece’s debt: GDP ratio below that of — at the least — Ireland, Italy and Belgium. This may be technically justifiable but would be blatantly easy to make political capital of as a slippery slope to haircuts all round by “sceptics” of the euro or the EU. The rest of the Eurozone would, I suspect, see it as simply overly-generous to Greece.
Another political fear (which should translate through to political resolve) is that Greece’s government has access to more assets than it has so far committed to sell, i.e. that Greece has a liquidity problem rather than being simply bankrupt. In a corporate re-structuring, one would expect to see the value of any such assets realised for the benefit of creditors (potentially at fire-sale prices). I would expect to see some such commitment to creditors to be part of any re-structuring of Greek debt.
Last — but not least — there is the impact upon the Greek banking system and the potential for contagion. On the one hand it is widely recognised that Greek banks have large holdings of Greek government debt so that a restructuring in the latter will imply major problems for the former. On the other hand, treatment of this tends to be limited: “…and the Greek banks will need to raise some capital, etc” without identifying what this means or how this is going to happen.
Let’s begin with some context. Non-Greek banks have reduced their exposure to Greece significantly from a peak in about in June 2008. The reduction is quite large — a peak of $293 billion spread amongst all European banks (as defined by the BIS) — this extends beyond the Eurozone and indeed the EU) to $136 billion at December 2010. A further reduction in the several months since then seems more than likely. 
Of the December 2010 total, $57 billion is with French banks and $34 billion with German ones. Of the rest $10 billion is with Portuguese banks (intriguingly little changed from peak) and a further $14 billion with British banks. The rest is fairly well spread about.
This is within the context of a general reduction in cross-border claims within the European banking system post-credit crunch. Such claims increased dramatically in 2005–07. In contrast, claims by European banks on Brazil, China and India are at an all-time high. Similarly, foreign claims by US-based banks are almost at an all-time high. So there is a European dimension to this and Greece has seen much retrenchment than most.
Not all of these claims relate to Greek Government debt: Robert Peston estimates about $20 billion each for French and German banks.
If that’s right there is another $14 billion of government debt held by credit institutions based elsewhere. If the exposure of British banks is proportionate to their overall share of all claims, then perhaps they held $5 billion as at the close of 2010.
Greek banks hold a good deal (€48 billion in bonds and another €13 billion in loans). Their capital and reserves (excluding bad debt provisions) were in aggregate €29 billion at the end of February 2011 (according to the National Bank of Greece).   So a 50% write-down on the bonds alone would be locally apocalyptic and carry some contagion risk as a further raft of claims on Greece relates to its financial sector. However, this has also reduced dramatically, so that the claims by European banks on Greek ones stood at $11 billion at the end of 2010. The chart below illustrates the scale of change here. 

Source: BIS
This is relatively small beer compared to the direct impact but may have consequences on Greek corporates that then throws all other claims into at least some doubt.
In any event, a re-structuring would need to factor in an immediate recapitalisation of the Greek banks affected to avoid wholesale loss of confidence by customers and creditors that would be disastrous for the economic recovery of Greece and its removal from the life support being offered by the rest of Europe. 
Needless to say this recapitalisation is not going to be by the Greek government (nor would nationalisation really solve the problem of meeting internationally-set capital rules - it could do little more than create some accounting book entries). One possible avenue would be the acquisition by international banks, in which case it is a question of value (i.e. would be buy and at what price given the cash required to re-capitalise them) and (to a lesser extent) of the political acceptability of this in Greece. It may be that a holding vehicle (guaranteed by the ECB, say) would be a necessary intermediate step. 
This would be extremely messy but the firewall around any re-structuring would need to be extremely potent to avoid contagion to the global banking system. It would also need to be in situ to avoid a re-run of Lehman Brothers.


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