Greece may be known as the cradle of European civilization, but it increasingly looks as if it could turn out to be the graveyard for the euro project.
In May 2010, Greece was forced to seek a E110 billion bailout from its European partners and the International Monetary Fund to prevent it defaulting on its massive debts, triggering fears of financial contagion.
A year on and little has changed for the better. Ireland and Portugal have had to seek bailouts, speculation that Greece will need to restructure its debts has fuelled fears of a break-up of the euro, and the financial vultures are circling around Spain.
At the heart of the latest bout of speculation is the realization that the Greek authorities need to raise E25–30 billion next year – something that would be impossible and unaffordable in the current market conditions.
Barry Eichengreen, an expert on the euro and an economics professor at the University of California, Berkeley, says the reaction by policymakers highlights failings in the leadership of the project. He points to the fact that the finance ministers of France and Germany and leading EU figures were unable to keep secret a meeting to discuss how to deal with Greek debts. “They then denied anything was discussed, which is hardly credible and does not add lustre to their record as competent leaders,” he says.
AVOIDING A GREEK TRAGEDY
Yields on 10-year Greek bonds hit 16% in the second week of May as investors dumped the country’s debt. This is double the rates paid by Ireland and Portugal and almost twice what it was paying a year ago. Two-year bond yields reached 24%.
The flight to quality was spurred by the decision by Standard & Poor’s, the credit rating agency, to downgrade Greece’s sovereign debt by two notches to B, putting it deep into junk bond territory.
It said it was responding to Greece’s failure to hit its targets for cutting the fiscal deficit and to the growing pressure from lenders for a rescheduling of Greece’s debt. “To solve Greece’s problems, you need a real improvement in macroeconomic performance or you need another solution,” says Frank Gill, senior director for European sovereign ratings at S&P.
SURVIVAL MECHANISM
Given that the scale of debts makes growth unlikely, that “other solution” will involve some mechanism to resolve the debt issue: a default, a voluntary restructuring or for the EU to take the place of private investors by stepping in and buying up Greek debt.
Jan Randolph, director of sovereign risk country analysis at IHS Global Insight, is optimistic, saying there is greater appreciation among European policymakers of the choices available to them.
Just two months ago the EU, led by Germany, agreed on a plan to establish a permanent rescue fund, the European Stability Mechanism (ESM), to replace the temporary European Financial Stability Fund (EFSF).
The ESM is a much stronger defence, as it will have more money – E700 billion rather than E440 billion – be permanent, have preferred creditor status and include collective action clauses that will mean private bondholders will share the burden of restructuring.
But the downside is that the need for euro member states to agree on funding and sign off on the details of the restructuring means that it won’t take effect until June 2013, when the EFSF expires.
This means any crises in the intervening 24 months would have to be tackled on an ad hoc basis. “The problem is that Greece may not be able to wait that long,” Randolph says.
Stephen Lewis, chief economist at Monument Securities in London, says it was indicative of the lack of foresight by EU leaders that only a few weeks ago they were hailing the ESM as a permanent lending mechanism that would draw a line in the sand. “In the event, it has taken less than two months for the eurozone to be plunged back into crisis,” he says. “The strategy that eurozone leaders adopted seemed destined to run into insuperable problems long before 2013.”
AVOIDING A DEFAULT
But many commentators believe policymakers will find their way to a solution that avoids default. HSBC gives odds of just 5% of an involuntary restructuring before the ESM opens its doors in June 2013.
“There would clearly be fears about contagion spreading to other peripheral countries and the financial sector if Greece restructured,” says Steven Major, a strategist at the bank.
The debate will be over how the eurozone can make sure Greece can be financed to ensure it can fund itself up to June 2013. But that debate has become more complicated following the arrest of IMF managing director Dominique Strauss-Kahn, a key negotiator in the process.
Eichengreen insists that some form of restructuring is “unavoidable” but how it will take place is up in the air, as it would mean that creditors would have to take haircuts – losses on the value of their loans. “The question is whether they will simply stretch out the maturity of the debt – which would solve nothing – or also require haircuts of the creditors and, if so, whether the haircuts will be well designed,” he says.
Crucially, the ESM will include a provision for “burden sharing” – making haircuts for creditors’ rescues using taxpayers’ money – that was supported by Germany. “The question for the Germans is do we bring forward the principle of burden sharing, in which case we are talking about soft default measures,” says Randolph.
PAIN IN SPAIN
The danger is that this raises fears of contagion if bondholders, fearful of taking a haircut of 50–70%, rush to pull out of other vulnerable countries, particularly Spain, before 2013. While Greece accounts for 2.5% of eurozone GDP, Spain represents 11.5% and E700 billion of inter-eurozone bank-to-bank debt, way in excess of the EFSF’s E440 billion.
On the positive side, Madrid is seen as having taken some of the tough fiscal action needed to reassure markets.
Gill at S&P plays down the risk of a domino effect, saying that Spain’s creditworthiness depends on its fiscal performance, GDP growth, the impact of labour market reforms and its ability to generate tax revenues. “Spain’s rating has to be reflected by what happens in Spain and not what happens in Greece and Ireland,” he says.
TOWARDS A EUROZONE BREAK-UP?
But the bigger issue is what the problems with the Pigs (Portugal, Ireland, Greece and Spain) mean for the future of the euro as a currency zone.
Some analysts say that it is only a matter of time before the tensions within a system with a single currency but no ability to control government spending and tax, explode. Capital Economics, a consultancy run by former UK government adviser Roger Bootle, believes that the chances of break-up within five years are more than 50%.
Ben May, its senior European economist, says that a Greek default will be the first stage in the break-up of the euro. “Indeed, as time goes on, we expect fears of a Greek euro exit to increase,” he says. “With worries about Spain also likely to resurface, the eurozone debt crisis may be entering a new and more dangerous phase.”
Lewis at Monument, who has long warned that the euro will fracture into a strong German-led northern euro and a “softer” southern Mediterranean currency, says the Greek crisis has highlighted the impossibility of convergence between the two halves of the single currency area.
“It will either break up as a result of an attempt to restructure the debt of one or more peripheral countries that will have implications for the banking system, or there will be a unilateral or agreed departure of one or more states.”
Randolph disagrees, saying that Anglo-Saxons often forget that the euro, like the European Union itself, is as much a political construct as an economic one. He compares the euro to a condominium building. “The Germans have the nicest, largest apartment at the top while the occupants of the others have wild parties and run up huge debts and then call for help,” he says. “It is not up to Germany to guarantee their mortgages, but they accept that sorting out the debt will be good for the building as a whole.”
IHS puts the odds of a country breaking away from the euro at 20%, and the idea of a total disintegration of monetary union as “negligible”. “The most likely scenario is one in which the eurozone remains intact,” says Randolph. “A break-up would unravel decades of European political and economic integration and severely damage the common market.”
He says Angela Merkel, the German chancellor, will not want to go down in history as the “one who lost the euro” and that Germany is now breaking with recent tradition and taking on the mantle of leadership.
S&P also believes that a break-up of the euro is “highly improbable”. “Exiting the eurozone would take months,” says Gill. “It is not something you can do overnight, so during that period it would have led to a run on your financial system that would bankrupt it. The sovereigns that would benefit from leaving the euro would be the stronger ones, not the weaker ones – which is why the weaker ones will stay.”
CRUNCH TIME FOR THE EURO
Nevertheless, for the euro to survive, leaders will have to address the questions of financial and fiscal coordination that were avoided when the euro was born in 1999.
For Eichengreen, the eurozone is suffering from a banking crisis at a time when there are two dozen EU banking regulators, none of which worries about the impact of their actions on the other nations.
“Dealing with the bank regulation problem, including burden sharing agreements in the event that a big cross-border bank dispute has to be resolved, is the priority,” he says. “Such burden sharing would have fiscal implications, but that is the extent of fiscal federalism that the euro area needs, in my view.”
But for Lewis, even that level of burden sharing may be too much for member states: “I don’t think that degree of idealism exists.”
Robert Schuman, the German-French politician seen as one of the founding fathers of the European Union, said that Europe would be “forged by crisis”.
In contrast, the single currency was forged in a time of relative economic calm but it will be polished – or destroyed – by the current crisis.
As Eichengreen puts it: “I continue to think it is all but inconceivable that Europe will go back. Fifty years of history suggests it goes forward, and I continue to believe that that is what is going to happen.”