Monday, January 16, 2012

Why so much fear of a default?

I have raised before the question why everyone is so scared of the possibility of a Greek default. A default typically has 2 major consequences for the borrowing country: it wrecks the country’s creditworthiness and it makes it impossible for the country to return to capital markets for quite some time. Well, Greece has already paid that price.

Obviously, a Greek default could have major consequences on financial markets but allow me to ask whether this should be primarily Greece's concern or someone else's?

The table below shows that Greece has been in default about half the time since her independence. Somewhere else I had once seen a statistic putting that figure at two-thirds. Either way, a default now would not be a radical precedent in the history of modern Greece.

It all depends how a default is handled. The first question is: was default provoked by the borrower or did it come about after all attempts to avoid it had failed? Greece would be foolish to provoke a default but she could consider letting it happen.

Once default happens, all hell can break loose --- outside the country! In the country, it all depends on whether the government has "put aside" enough liquidity to allow normal operations for a reasonable period of time. Here I would have confidence in "Greek creativity" on the part of the government that such liquidity has been put aside.

A liquidity run on Greek banks? Could very well happen which is why a temporary freeze on deposits (with only minimal withdrawal possibilities for personal use) must be imposed.

Bankruptcies of Greek banks? Would be a real threat considering that banks would have to write-down the value of their Greek bonds. The government would have to be prepared to put in place a bail-out package.

The most important thing is that Greece can reach as soon as possible a situation where she is deemed by the EU to be acting in good faith to reschedule her debt with existing creditors. If that can be accomplished, Greece should expect the EU to provide bridge-financing for the budget and current account deficits. Based on numbers of the last few months, this should come to about 3-4 BN EUR per month in Fresh Money requirements when including full interest expenses. Since significant reductions of interest would be part of the rescheduling negotiations (and perhaps even capitalization of some interest), the monthy cash requirement could be reduced quite a bit.

Could creditors boycot the above action plan? Yes, they could but it wouldn't make sense for them because they have much more to lose from a boycot than from an orderly and fair debt rescheduling. And for those who predict the end of the world should governments not pay out private sector creditors, the EU should have lists prepared of all the sovereign debt reschedulings which have been made since WWII so that private sector creditors (and the public!) understand that a debt rescheduling is quite a normal thing to do.

Tax payers of surplus countries who have become accustomed to hearing amounts of first 110 BN EUR and then another 130 BN EUR should be quite relieved when they now hear that "only" about 3 BN EUR per month are required.

And parallel to the debt rescheduling negotiations, a giant private sector investment stimulus would have to be arranged for Greece (private foreign investors, EIB, Structural Funds, etc.).

If this process is managed swiftly and successfully, a very surprising thing could happen in financial markets: within only one year, and even if the debt rescheduling has not been completed yet, one might see the prices for Greek bonds increasing in value again. Why? Because once there is good news for a positive future perspective for Greece, investors will start speculating that this positive perspective might indeed come true.


  1. if a greek default happens ( and an exit from the euro) in your opinion what would happen to

    a.) people's deposits in greek banks?
    b.) pension fund in greece as it is heavily invested in GGB and a default would trigger no money for the pensioners?

  2. As I have argued in previous posts, a default does not have to mean a Euro-exit. Greece would be foolish to leave the Euro. With a Euro-exit, all domestic financial assets (bank deposits, pensions, etc.) would overnight be devalued by at least by 40% (some predict way over 50%). Anarchy would be a consequence in my opinion. No one can force Greece to leave the Euro. A Euro-exit might make sense in a few years’ time when things have settled down but not now.

    In my default-scenario there is no Euro-exit. Thus to your questions:

    a) Euro-deposits in Greek banks remain Euro-deposits in Greek banks. There are temporarily frozen to avoid a run, probably until the debt rescheduling is completed (minimal withdrawals for personal use allowed). No loss of principal or interest.
    b) Pension funds: that is a real problem without a default, with a default, without a Euro-exit or with a Euro-exit. Greek banks have the cushion of equity (about 50 BN EUR) which goes out the window in case of a bail-out before anyone else suffers. I doubt that Greek pension funds have that kind of a cushion. When a fund, be it an investment fund or a pension fund, holds assets which devalue, you have a real problem with pay-out’s (I have 2 pension funds which had to reduce pay-out’s for some years now). Mind you, Greek pension funds would suffer the most in case of a Euro-exit because then not only the assets lose value but also the currency in which they are in. I would suspect that pension funds would require a political decision where society as a whole (i. e. tax payers) are called upon to make sure that everyone receives at least a minimum pension.

    But you have the problem with pension funds right now anyway with the proposed PSI, don't you?

  3. I have had this question for a long time, and you seem like you could provide some insight.

    Based on the numbers I have found, the EU and IMF have contributed roughly €200 billion to bail out Greece. Europe's entire exposure to Greek debt (public and private) is between €130 and €140 billion. I know this may be relying too heavily on hindsight, but what if they had allowed Greece to default, ejected them from the EU and used the bail-out funds to prop up the banks who were hardest hit? Then, the remaining capital could have been used to further lever the EFSF in order to protect the other struggling countries.

    I understand this is a theoretical proposition, but it seems like the bailouts have done little more than kick the can down the road, and I am curious as to if there could have been a better way. What am I missing here?

  4. Eric, you have hit on the point which I have been hammering in this blog since the spring of last year. Since a sovereign state virtually never repays debt (only refinances it), a debt rescheduling is the most normal thing to do and, outside Europe, it has happened innumerable times in the last decades. There is no need to talk about things like default, expelling Greece from the Eurozone or the EU, etc. One simply gets the job of a debt rescheduling done.

    A default can only be avoided if one recognizes early enough that a rescheduling cannot be avoided. When that rescheduling is successfully completed in time, there can no longer be a default because what would have defaulted is now consensually rescheduled. Essentially, existing creditors have agreed consensually on new lending terms (they have “cured” what would have caused a default).

    When a country like Greece starts experiencing a run on its sovereign debt and on its banking system, you know that you better start with rescheduling negotiations soon. Such a run cannot be stopped! The run against Greece started slowly in 2008 and it really accelerated in 2009 when the new government announced the budget problem. Anyone familiar with sovereign debt problems would have known at that time that it was “game over” for Greece.

    So one would have basically rescheduled maturities of existing debt with existing creditors and negotiated the Fresh Money requirement with the EU/IMF (budget deficit) and ECB (current account deficit). If the EU-elites had made just one phone call to Citibank (probably the bank with the most experience in sovereign debt reschedulings), they would have been told coolly that this was standard operating procedure and nothing out of the ordinary. Instead, the EU-elites announced that the future of the Euro and perhaps even the EU was at stake! That’s the fastest way to bring speculators on the scene. If the next time California can’t pay her bills, the US President, his Secretary of the Treasury and the Fed Chairman call a press conference to announce with somber faces that the future of the USD and the American Union might be at stake, and if they repeat that often enough, markets will start to believe it!

    Regarding the numbers, Greece as a country (i. e. the government and other private sector borrowers) owe foreigners about 500 BN EUR at this point (the Bank of Greece publishes excellent statistics). How much money has been disbursed since the beginning of the crisis (for the wrong purpose)? Well, about 73 BN EUR under rescue facilities from EU/IMF; the ECB is said to hold about 50-70 BN EUR of Greek bonds; and (this is almost being kept from the public) another almost 100 BN EUR which the ECB lent to Greek banks so that the Greek banking sector would not collapse. So, all told, you are talking about roughly 250 BN EUR which can now be considered as spilled milk (but many bankers are happy about that milk…). If they had only used half of that money for real help for Greece, we would have a totally different situation today (and some banks would today be in public ownership…).

    How much of that money stayed in Greece? Estimates are around 20%. The rest went right back to the creditors. So to put it in a nutshell: “helping Greece” has so far been nothing other than using the balance sheet of Greece to bail-out the banks.

    Maybe the links below will be of interest to you.