Research Blog
How will Greece default?
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Grant Lewis, Economic Research
Daiwa Capital Markets Europe Limited
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19 January 2012
2012 has got off to a fairly positive start for the euro area. Notwithstanding S&P’s decision to downgrade nine euro area countries last week, both Italy and Spain have maintained bond market access, with yields in both countries now well below the highs seen in late-2011.
So, is the worst of the crisis behind us? Or is this merely a period of calm ahead of an even bigger storm? Yesterday we published our euro area strategy outlook for 2012, which highlights the myriad challenges still facing the euro area. While our central view is one of “muddling through” we conclude that the risks lie heavily towards a further escalation of the crisis.
Of all the risks, the most imminent, and arguably the one with the potential to cause the most mayhem, is that posed by negotiations around the second bailout package for Greece. This second bailout, agreed by euro area leaders in October, is contingent on (a) the Greek authorities continuing to meet the budget and reform conditions attached to the bailout packages and (b) private sector creditors taking a sufficiently large haircut on their holdings to make the sums add up.
Given weaker than expected growth and slow progress on implementing reform measures, the risk that Greece fails to meet the bailout conditionality remains significant. But targets, and whether or not countries are meeting them, can always be fudged, as they have been previously in the case of Greece.
The greater threat in the near term is that posed by the ongoing, and fraught, talks on the degree of private sector involvement (PSI) in the second bailout. In particular, having been initially told that the haircut would be 50%, private bondholders are now reportedly being pressured into accepting a haircut closer to 70%. Unsurprisingly, getting the agreement of a sufficiently large number of bondholders is proving problematic. And even if the negotiations, which re-started this week, reach agreement, it is unclear whether enough private sector bondholders, most of which are not directly involved in the negotiations, will eventually opt to participate.
But time is fast running out – Greece has a €14.5bn bond redemption to make on 20 March. Agreement soon is therefore required to ensure that the second bailout package is operational in time to prevent Greece formally defaulting on that payment, possibly in a disorderly, and catastrophic, manner.
The Greek drama in numbers
Source: Various and Daiwa Capital Markets Europe Ltd.
Failure of the PSI talks to achieve the required target need not automatically lead to a disorderly default – there are a few options available to rescue the second package.
Top of the list of options is the Greek government’s threat to retrospectively impose collective action clauses (CACs) on outstanding bonds, effectively forcing haircuts on bondholders. On the face of it this seems a fairly clean solution, and removes the problem of some private sector bondholders “free-riding”, allowing others to take a haircut while continuing to receive full payment themselves.
But the option carries with it its own issues. First, it might require that the bonds held by the ECB and other central banks, currently deliberately not included in the ongoing PSI negotiations, also take haircut. Such a move would also trigger CDS contracts, something that euro area leaders have been desperate to avoid. Finally, any move to change the terms of outstanding bonds retrospectively would open up the prospect of lengthy legal challenge, and probably ultimately delay Greece’s return to capital markets. And, of course, in the eyes of investors, it would open the door wider for potential restructurings elsewhere in the euro area.
A second, albeit less likely, option would be for the ECB, whose €45bn or so of Greek bond holdings have so far been excluded from consideration for a haircut, to soften its line before the Greek government considers enforcing a haircut. Inclusion of the ECB’s holdings would mean that a smaller haircut is required from private sector bondholders to meet the debt reduction target in the bailout package, which would make reaching agreement easier.
And the ECB has options. It could either offer to sell back its bonds to the Greek authorities (financed by the EFSF) at the price it paid for them (i.e. below their par value). This would mean that the ECB would not take a loss on its holdings. Or it could go further, offering to participate in the debt exchange in the knowledge that a disorderly default would see its holdings potentially written off altogether. To date, however, the ECB has been resolute in its opposition to own participation in any haircuts.
Ultimately, of course, the rest of the euro area and the IMF could give up on the idea of haircuts for bondholders, and fill the financing gap themselves. But that seems most unlikely. Even under the assumption of PSI, Greece would still be left with a debt stock of at least 120% of GDP, the sustainability of which is doubtful given fading prospects of near-term growth. In any case, there is a determination from some euro area countries and the IMF that bondholders take some of the pain – that doesn’t look like a principle that will be backed down from readily, if at all.
So things really are going to the wire for Greece. While hope remains that the PSI negotiations will ultimately deliver, even those involved in the negotiations are sceptical that agreement can be reached to beat the deadline of the 20 March payout. So, there remains the possibility that, by accident or design, Greece will get to 20 March without a debt package in place and the necessary funds to make its redemption, triggering a default without the safety net of a bailout package in place.
If it does come to a disorderly default, this would have horrendous consequences for Greece. Banks would see the value of their massive holdings of Greek debt wiped out, causing the banking system to fail (assuming that an acceleration of deposit flight ahead of an anticipated default didn’t cause it to fail before that). And with no functioning banking system, there can be no functioning economy.
Meanwhile, without external financial assistance and with no ability to print its own money, the government would find itself with a massive financing gap with tax receipts collapsing as the economy falls of a cliff. The result would be widespread social and economic breakdown in Greece. Under such circumstances continued Greek participation in the euro would seem impossible, although quite how it would leave, establish a new currency, etc. is far from clear.
For the rest of the world the direct impact would be relatively limited. But the resultant contagion could make last November look like a period of relative stability. Portuguese yields have already spiked to new record highs as the Greek talks have stumbled. In the event of a disorderly default, expect these price moves to be much greater, and to encompass not just Portugal, but the rest of the periphery, and potentially others, as well. Events in Greece still have the potential to drag the euro area back towards the abyss.
Grant Lewis
Head of Research
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