Monday, 20 June 2011

Why the next Greek Bail-out is Doomed to Fail

Monday, June 20, 2011

The cacophony regarding the current and future Greek bail-out packages reached fever pitch this past week. Last Thursday, 16 June, the Greek Prime Minister volunteered to resign if a national coalition government could be formed; this offer was quickly rejected after talks with the main opposition party broke down. Instead, a cabinet restructuring was implemented, including a change in the position of Minister of Finance.

Today, the Eurozone members announced that the disbursement of the fifth instalment of the original bail-out would be provided once a new austerity plan had been voted. The Hellenic Parliament has been debating precisely this, which calls for EUR 50 bln in privatisations and EUR 28 bln in short- and medium-term spending cuts and revenue rises by 2015. The government's vote of confidence is set for tomorrow evening (Tuesday, 21 June); the decision on the new austerity programme will come thereafter.

The vote of confidence and the austerity plan both depend almost exclusively on members of PASOK’s party. Currently ruling with a 155-seat majority, the party was shaken last week by the resignation of two deputies (who will be replaced with nominations from the party, not through by-elections).

I can’t predict the decision tomorrow, but if I were in Parliament, I could not say whether I would vote for this plan. Not because I’m against austerity or a reduction in the public sector—far from it. But because the plan as it is currently defined will again not be sufficient to solve the problem of Greek debt service costs and total debt levels.

On the European and IMF side, it has been painfully clear that the original conditionality in the May 2010 loan agreement was both poorly defined and did not present an adequate forecast of interest costs, GDP growth or total debt burden. The fact that the original plan called for a 2% deficit in 2015 and a return to the markets in 2012-2013 is nothing less than hallucinatory—evidence of the wishful thinking and flawed analysis behind this plan.

The fact that the plan was drafted at a time when most observers were aware of the hidden Greek debt (which was finally added to the public sector balance sheet in November 2010), displayed equally poor judgement. The plan should have foreseen a downside, given what was known, but what also could have been assumed or measured on the spot.

The other irony, of course, is that the IMF, which was responsible for the flawed plan in the first place, is now insisting that the Eurozone come up with a plan to cover Greece’s funding needs in 2012-2013, assuming that no return to the market is possible. This has led to the definition of a second bail-out, ignoring and confusing the fact that the first one was broadly on track, but suffered from a range of factors which remain in place in the second bail-out proposal.

At the heart of this new bail-out is the following assumption: that if Greece privatises EUR 50 bln, and cuts a further EUR 28 bln in spending to 2015, it will be able to service its debts.

Absent fundamental reforms in other areas, or a far higher GDP growth rate, this assumption is unlikely to materialise. The simple fact is that the current interest on the EUR 340 bln debt, assuming a 4.5% interest rate, is EUR 15 bln per year. EUR 15 bln x 5 years = EUR 75 bln in uncompounded interest.

This EUR 75 bln is nearly the amount of EUR 78 bln the government (and the Eurozone) are insisting will be sufficient to save the situation. And this does not take into account the risks in the second bail-out plan:

a. That it will be extremely difficult or impossible to achieve the privatisation targets by 2015;
b. That even with these new plans, the Greek government deficit remains;
c. That there remains no compelling strategy for growth or development in the remainder of the “real” economy.

A far more comprehensive set of reforms is needed, namely:

a. Use of privatisation proceeds to purchase Greek debt on the open market, retiring the interest costs and benefitting from the discounted value of government bonds;

b. A condition in any bail-out that a 1:1 redemption in value be accompanied by an extension of debt maturities at preferential rates;

c. A strategic, ambitious investment promotion campaign, together with a radical streamlining of the government bureaucracy, reduction of public sector spending, and implementation of e-government;

d. A campaign to investigate the Greek holders of international bank accounts: an estimated EUR 230 bln is held by Greeks abroad;

e. A major crackdown on corruption in Greece, including the funding of political parties, as well as bribery in public sector procurement.

Unfortunately, while there are some spasmodic efforts in some areas, there is still no uniform direction. In fact, the Eurozone debate remains free on any consensus or even realism on the correct way forward.

The European Central Bank insists on a full debt roll-over, without the participation of private lenders in a “voluntary” maturity extension. This position has been backed by most rating agencies, who claim that in the current situation, a “voluntary” extension is impossible. The fear is that any such extension would trigger the credit default swaps currently held by international banks and other firms. Germany has apparently backed down from its position that private lenders should participate; France apparently now supports Germany.

Viewing this divergence of opinion, it is difficult to imagine a worse way to solving a debt crisis of this magnitude. There is clearly no consensus on what responsibility the private sector must pay for unsustainable lending. The fears of a financial downside are consistently exaggerated: if it’s not the fears of a banking collapse due to a “haircut” on the value of Greek bonds today, it’s the fear of a collapse of the CDS market tomorrow.

Yet what is the purpose of a CDS or insurance, if it cannot be utilised? Is it not to compensate holders of bonds in the case of a default? The insurance has been paid for: why not use it?

To suddenly claim—as the ECB or the ratings agencies are—that a CDS event would bring down the world economy is ridiculous on too many counts:

• The international banks are already being bailed out at 100% of their face value plus interest (at a time when the market itself is discounting Greek bonds by up to 45%). This means that under any rational mark-to-market accounting rules, the banks should have already written down a significant portion of the value of their Greek government bonds.

• Any European stress test, and certainly any national regulator’s assessment, should have taken into account a 30%-50% haircut on Greek government bonds, reflecting current market bond values and CDS default indicators. This has not been done. This exposes banks, their shareholders and national regulators to yet more credibility damage in the future. It is difficult to understand why this is permitted to happen, although I can suspect the reasons behind it.

• The fact that many banks have managed to offload their Greek government bonds to the European Central Bank, or roll them over to the original bail-out, means that their exposure, although still large, is more limited than it was a year ago, and will be even less a year from now.

• The fact that the CDS/insurance policies are meant precisely to serve against a default insurance. That’s their role. It’s like saying that because there are too many car accidents, the car insurance companies should be bailed out. Whatever happened to the responsibility of the underwriter? Whatever happened to core capital standards? Could it be that, as with the mortgaged-back securities, the CDS market is yet another industry with absolutely no capital backing, no regulation and no intent to pay? Is there yet another emperor in the room with no clothes?

If the fundamental contracts and roles of different market and social actors are to be ignored in this manner, I can see little justification for continuing with the Greek austerity programme in terms of its effect on debt restructuring. It is almost pre-destined to fail.

Furthermore, I am quite sad to see the European Central Bank making mistakes of this magnitude. It has failed in its regulatory role, both in the run-up to the crisis, as well as during the crisis itself. The fact that today it is doing everything possible to safeguard the banking sector, while doing nothing to regulate it or ensure that basic market processes are allowed to work, is incomprehensible.

A heavy opinion, perhaps, with which to close this post. But I have rarely seen such fundamental mismanagement, dishonesty and stupidity in the realm of public policy and economics. The lessons of the 1997, 2001 and 2008 crashes have clearly not been absorbed; standards to change the practises of the dysfunctional banking and public sectors have clearly not been adopted. The results are plain for everyone to see.

© Philip Ammerman, 2011

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