The possibility of a new bailout for Greece sent U.S. stocks higher Tuesday morning as officials of the European Central Bank, the International Monetary Fund and the European Commission converged in Athens, and, separately, European finance ministers prepared to meet in Vienna. But another package of loans may be just a short-tem fix.
Optimists like to imagine summer 2013. After three grueling years meeting the terms of its multibillion euro bailout loan package from other European Union members and the International Monetary Fund (IMF), and austerity measures that have frozen public-sector pay and decimated state spending, Greece has chipped away at its debt and been allowed back into the international financial markets with open arms. European leaders are congratulating themselves for preventing a banking crisis by holding Greece to the pledge it made back in 2010 that it would pay back all of its debt on time. Greece's biggest creditors -- northern European's overstretched financial institutions -- are heaving a sigh of relief.
As summer 2011 begins, however, few experts are convinced that the "official," happily-ever-after version of the EU's debt crisis will play out. Even as European finance ministers weigh whether Greece is meeting its targets to receive the next tranche of the bailout package, there are a number of other "endgame scenarios" in which Greece restructures its debt either before or after the terms of the 110 billion euro rescue expire in June 2013. None are ideal, and "all come at a cost," said Lee C. Buchheit, a New York lawyer with Cleary Gottlieb Steen & Hamilton who was a panelist at a Wharton co-sponsored conference at the European University Institute (EUI) in Florence, Italy, titled, "Life in the Eurozone: With or Without Sovereign Default?"
“People keep saying that in 2013, there are not going to be any more bailouts,” said panelist David A, Skeel, a law professor at the University of Pennsylvania. “Unless something dramatically changes in the next two years, that's not a credible promise at all, and we should act as if it is not a credible promise."
Greece’s public sector debt-to-GDP Ratio will be between 150 percent and
170 percent in 2013
Buchheit and other conference participants said any scenario that does not involve Greece defaulting looks less and less realistic. And if Greece hobbles to 2013 without restructuring, it can't expect to be embraced by the public markets as it once was -- when investors "to their regret today, failed to conceive of any credit differences between Germany and Greece," Bucheit said. Forecasters predict that Greece's public sector debt-to-GDP ratio in 2013 will be between 150 percent and 170 percent, compared with 143 percent at the end of 2010 -- the highest in the EU at the time and more than double the 60 percent ceiling EU members have agreed to maintain under the Maastricht Treaty.
In 2013, Buchheit said, more than half that debt will be held by the so-called "official" sector -- the EU, the IMF and the European Central Bank (ECB), which has been buying big chunks of the eurozone's "peripheral" countries' debt on the secondary markets. The official sector will be able to claim "preferred creditor status" ahead of other creditors, Buchheit noted, leaving investors in private capital markets out in the cold should Greece's economy teeter again.
"Projections that [Greece is] going to spend 5 percent to 10 percent of GDP on interest payments alone are just not going to happen," Franklin Allen, Wharton finance professor and co-chair of the conference said in an interview after the event. "I just don’t think they have the political will to go out and tax people and cut expenditure” enough to do that. He noted that Greece's economy has been contracting since 2008, and at some point over the next few years the country will have to restructure its debt by either writing off a portion of it or rescheduling repayments, potentially forcing banks to accept heavy losses and triggering a larger crisis across the region's financial sector.
"This is a debt problem with a banking problem, said Charles Calomiris, professor of financial institutions at Columbia University's Graduate School of Business, “one where a run on[Greece's] banks will make the crisis come to a head. "Were the balance sheets of Greece's banks to crumble as investors and customers fled … Who is going to put up the money to save the Greek banks?" asked Allen. "If that's a big enough number, and no one is willing to come up with the money, then Greece will leave the euro zone. They need to be able to print money so that the banks don't go bankrupt."
“I predict the end of the euro zone as we know it.”
European officials refuse to entertain the thought of any of the 17 euro zone members leaving the currency union, despite the drag on the long-term competitiveness of individual members and the growing unhappiness of their citizens living under the constraints of the euro, said Calomiris. "The change to the euro is first going to happen as a redenomination of the banks' liabilities. I predict the end of the euro zone as we know it."
Part of the challenge, if the EU wants to avoid the costs of future rescue funding -- and moral hazards of making defaults too tempting for member countries -- is that there is no bankruptcy framework to follow, said Skeel. "When you're dealing with sovereigns … you don't have the stick that we have in normal bankruptcy proceedings," he noted. "In normal proceedings, there's direct liquidation -- you're just going to shut everything down if bankruptcy doesn't work. You can't liquidate a nation."
Skeel recommended the EU adopt a "rules-based" bankruptcy framework, similar to what he and Patrick Bolton of Columbia Business School developed in early 2004. A key part of the framework includes a "first in time" priority system to reduce the risk of debt dilution in a restructuring based on when bonds are issued. For example, investors with bonds from 2010 would have priority over investors with bonds from 2011. Higher priority bondholders would be paid in full; others would not.
History is littered with examples of debt restructurings -- with as many as 60 sovereign debt defaults in recent decades, according to Buchheit. What history shows, he said, is that a country has a lot of leeway in negotiations with creditors, as long as it does not discriminate through legislation and has a good justification for the negotiations. Managed efficiently and fairly, a default can take six months from beginning to end, he added.
Gulati noted that Greece has factors working in its favor that other financially distressed countries don't have. "Their contracts are actually set up to do a restructuring," he said. Whether intentional or not at the time of bond issuance, "the Greeks negotiated for a lot of flexibility.”
Using local legislation, Greece can put in an orderly mechanism for a voluntary exchange of debt, Gulati said. "If that's not what we want to do, then we have to go to other, much more painful solutions, where we're going to creditors and saying, 'We owe you a euro or a dollar, but we'll pay you a fraction thereof.'"
Legal issues aside, the EU political machine continues to work on a different outcome. On May 7, the finance ministers of the EU's "inner circle" of creditors initially denied press reports they had met secretly in Luxembourg a week earlier to discuss, among other matters, Greece's exit from the single currency. Later that weekend, however, the finance ministers issued a statement saying that they had been "called to participate for an exchange of views regarding the financial developments in Greece.... It is absolutely evident that in these talks, there was no discussion nor was any issue raised concerning Greece’s participation in the euro zone, as various foreign media outlets said irresponsibly and for their own reasons.”
Republished with permission from Knowledge@Wharton, the online research and business analysis journal of the Wharton School of the University of Pennsylvania.
Greek Leaders Fail to Reach Consensus (Reuters)
Stocks Jump Amid Greek Bailout Hopes (CNN Money)
German Engineering and Greece’s Debt Crisis (TheStreet.com)