Markets vs. Democracy - Round 278

The Irish government has just announced that it will hold a referendum on the euro fiscal compact. The Irish Taoiseach Enda Kenny said he had taken advice from the country’s Attorney General, and made the decision to call a public vote. He also said he would sign the fiscal compact treaty at the meeting of EU leaders on Friday, and the details and arrangements for the referendum will be sorted and announced in the coming weeks, with a vote to be held before the summer.

The Irish government had previously said that the chances (or risks if you ask the markets and EU elite) of a referendum were always 50-50, so this was far from a foregone conclusion. And, as Zerohedge put it, markets have reacted badly to the news of democracy, with the euro weakening significantly. But what is the precise significance of this announcement?

• The vote will essentially determine whether Ireland has access to future bailout funds or not. For a country to access the ESM, the eurozone's permanent bailout fund, it must have ratified and fully adhered to the treaty, according to the terms attached to the deal. The Irish government has already given indications that it will tie its approach closely in with the prospect of further bailout funding, with Deputy PM Eamon Gilmore pointing out the link between emergency funds and the fiscal pact approval. These scare tactics are likely to grow throughout the referendum campaign, with the flip-side of rejecting the treaty being seen as tantamount to a vote for eurozone exit. In other words, the Irish will vote with a gun to their head.

• It provides yet another illustration of the clash between different parliamentary/constitutional democracies (in this case the German vs the Irish constitutions) that time and again have served as an ‘obstacle’ to perceived crisis solutions.

• Irrespective of the outcome, the vote will not derail the euro fiscal compact as it only requires 12 member state ratifications before entering into force, though it could well limit the impact of the pact.

• Those that thought that the complicated political situation in Europe could be reduced to a simple 26 vs 1 narrative, following Cameron’s ‘veto’ to an EU27 Treaty back in December, have received another reminder as to why that isn't the case.

In sum, it would have been difficult to avoid this referendum and we're glad the Irish government did not engage in the legal gymnastics that have been going on elsewhere in the eurozone (*cough* Frankfurt). If further fiscal integration is ever going to succeed (leaving aside whether it's desirable), it will have to happen with a clear and strong mandate from the people. This is also a practical point which market players should ponder. Changes built on a clear mandate from the people (particularly when wrapped in pretty heavy austerity) have a far greater chance of standing the test of time.

But the likely approach of tying a Yes vote to access to more bailout funds and greater security and a No vote to a eurozone exit is already worryingly over-simplistic. Finally injecting some democracy into the eurozone crisis should not be watered down by pigeonholing it into tightly defined categories.

That said, as we've noted, the fiscal pact has already been watered down itself and signing up to it would not be the end of the world for Ireland - but only if that's what the people decide after a full discussion of the issue.

The ECB’s bazooka?

This morning saw the first allotment of the new unlimited three year ECB loans - the much hyped mechanism that some hope will solve the eurozone crisis by actually providing cash to struggling eurozone banks with which they can then use to buy Portuguese, Italian, Irish, Greek and Spanish debt, giving these countries some breathing space.

Banks demand for these new loans shattered almost all expectations, coming in at €489bn (from 523 banks), compared to an average estimate of around €300bn beforehand. In the run up to the operation there had been much debate over whether this was a ‘back-door’ bailout by the ECB or its version of ‘Quantitative Easing’. Christian Noyer Governor of the Banque de France even termed it the ECB’s bazooka (for our recent briefing on this see here).

With all this in mind one would expect a euphoric reaction from financial markets – unfortunately that doesn’t seem to have been the case. There was naturally some initial boost, but stock markets have settled quickly with some European markets even down slightly, while peripheral bond yields have continued their upward rise.

There are a few key reasons why this might be the case:

- The actual boost in liquidity is only €210bn, since the rest is moved from some of the ECB’s other shorter lending operations, so any knock on effects it does have are likely to be limited.

- Banks face a huge task to reach the 9% capital requirements laid out by the European Banking Authority (EBA), even with this extra liquidity banks are still going to be tempted to undertake significant deleveraging (reducing lending) to meet these requirements.

- Banks face huge amounts of debt which needs to be rolled over or paid off, this is far from covered by this extra liquidity.

- It is unlikely that much of this money will be funnelled back into sovereign debt (thankfully) since banks still face huge scrutiny over their exposures to the eurozone crisis, while any such investments would have to be hedged (the risk would have to be accounted for) - both of which decrease the value of such investments.

- Some of this money may filter through to boost lending by banks to the wider economy, but given some of the constraints above this is far from certain.

- Reports suggest the ECB has already begun purchasing Italian and Spanish debt to keep yields down this afternoon, a role which many expected banks to be playing once they were flush with all this new liquidity.

So, still plenty of concerns and questions for financial markets to ponder despite the big uptake in this morning’s lending operation.

Even if all of this money were used to purchase sovereign debt by banks it would not help solve the crisis. Not just because it would load under capitalised banks with risky sovereign debt (hinged on huge political uncertainty) but also because it only represents a short term liquidity boost. Sure, it might help Italy and Spain rollover a few billion in debt a bit more cheaply, but it does nothing to tackle the underlying problems of the crisis (lack of competitiveness and growth to name but two) nor does it help the already insolvent bailed out states.

In the end, the pressure is still on for eurozone leaders to find a comprehensive intergovernmental solution, they must take the lead, the ECB and the banks cannot.

The Battle for the heart and soul of the ECB

Open Europe has today published a briefing arguing that the ECB is unlikely to buy the hundreds of billions worth of government bonds required for it to properly backstop the eurozone, following an underwhelming agreement between EU leaders at the summit of 8 and 9 December.

However, Open Europe notes that, contrary to popular opinion, the ECB is already heavily intervening in markets. Through its government bond buying and liquidity provision to banks, we estimate that the ECB’s exposure to weaker eurozone economies has now reached €705bn, up from €444bn in early summer – an increase of over 50% in only six months, raising fresh questions about its credibility, independence and possible losses it may face in the case of future sovereign defaults.

The briefing also notes that other suggested options for boosting demand for sovereign debt – such as the newly announced three year long term refinancing operation (LTRO), due on Thursday – while helping to stem the short-term funding crisis, would also come with the risk of incentivising a weak banking sector to stock up on risky government debt. The ECB would also struggle to conduct ‘Quantitative Easing’ (QE) in the same vein as the Federal Reserve and the Bank of England as any QE would have to be spread proportionately around the eurozone, meaning that Germany would be subject to greater effects of any QE than Italy.

Open Europe concludes that there may come a day when the ECB has no choice but to intervene on a massive scale. However, if so, that will likely be a stop gap on the path to a new, slimmed-down eurozone, and probably following the default of at least one eurozone member.

Key points:

- As things stand the ECB should not, will not and cannot provide the unlimited financial backstop to the eurozone that financial markets seem to be clamouring for. The measures taken at the EU summit on 8 and 9 December are unlikely to supply adequate cover for the ECB to buy the hundreds of billions worth of Spanish and Italian government debt needed to fulfil this role.

- The ECB has taken on large amounts of low quality collateral in return for providing loans to banks, and has seen a massive surge in the number of asset-backed securities it has taken on to its balance-sheet. Though not all of these assets are bad or ‘toxic’, they are extremely difficult to value. At the same time, the number of banks which are becoming reliant on the ECB is alarming and hopes that the functioning of the European financial markets will ever return to normal are diminishing – creating a long-term threat to Europe’s economy.

- Through its government bond buying and liquidity provision to banks, the ECB’s exposure to the PIIGS has now reached €705bn, up from €444bn in early summer. This is an increase of over 50% in only six months and shows how, contrary to popular belief, the ECB is already intervening quite heavily in the markets. It also highlights how the eurozone crisis continues to transfer risks away from private creditors to taxpayer-backed institutions. It remains unclear how the ECB would cover losses in the event of a sovereign default.

- The ECB is likely to continue to keep interest rates low and continue to provide cheap credit to banks despite inflation fears in Germany. Currently, given the global slowdown, the different monetary policy needs of eurozone countries are small enough to paper over. However, this will not be the case for long and as German growth picks up the huge flaws in the one-size-fits-all monetary policy will again be horribly exposed.

- Moving forward, the ECB could offer a liquidity boost to Europe’s economy but little more. The term ‘lender of last resort’ is often misused or misunderstood – the ECB cannot fully backstop sovereign states or return them to solvency. At best it could ease the pressure on illiquid states, but even this depends on the legal constraints on the ECB’s defined role and being seen to give in to political demands that would hurt the ECB’s credibility and independence.

- Even if it can be achieved practically, Quantitative Easing (QE) by the ECB is unlikely to work. Even a €500bn bout of QE – as some have called for – would see only €90bn flow towards Italy, due to the need to spread QE evenly across the eurozone. This would not make a significant dent in Italy’s €1.9 trillion of sovereign debt.

- Alternative options such as the ECB lending to the IMF or lending to banks for them to stock up on sovereign debt, are preferable to direct ECB financing of states, since the IMF and banks can apply some conditions and maintain market pressure for reform, but create hazards and complications of their own without offering many additional benefits.

- Instead of arguing about the role of the ECB, EU leaders should focus on pushing ahead with debt restructurings in the eurozone, despite the ECB’s objections, and formulate a plan for how to mitigate the ensuing losses both on the ECB’s balance sheet and in the private sector. Ultimately, money would be far better used for these ends rather than flooding the eurozone with liquidity and recycling debt – both of which have failed so far.

- The time may come when greater ECB intervention in the sovereign debt markets is unavoidable, but at this point it would be a mechanism to help ease the transition to a new eurozone structure, probably with fewer members and a more clearly defined role for the ECB.

To read full briefing, click here.

FrAAAnce misses the point...

For all those who think that French President Nicolas Sarkozy will be sitting in the Élysée plotting some form of retaliation against Cameron, it has quickly become clear that he has much bigger things to worry about.

Rumours have once again been flying around that France’s triple-A rating is under threat and could be facing an imminent downgrade. These have become all the more serious by the numerous French government ministers that have publicly played down the gravity of any downgrade.

On Monday Sarkozy said that a downgrade would be “one more difficulty, but not insurmountable.” On Tuesday Valerie Percresse, French Budget Minister, made similar remarks saying, "The fundamentals of the [French] economy are good, and investors don't doubt France will pay back its debts," thereby playing down the impact of any downgrade. Finally, yesterday French Foreign Minister Alain Juppe said, “[A downgrade] wouldn't be good news, but it wouldn't be a cataclysm either. The United States lost their triple-A and still manage to borrow on the markets in good conditions.”

This public onslaught by the government on the cost of France losing its triple-A rating is widely being seen as a way of softening up the public and the markets for what’s coming. Ultimately, the impact of a downgrade on France will depend on numerous factors, not least: whether other countries are also downgraded, whether it is a one or two notch downgrade and the level of upcoming public and private financing which France faces immediately after the decision.

Our concern though is not about the impact on France. In fact the French government seem to be missing the bigger picture – the impact it will have on the eurozone bailout funds. The eurozone is already running short on money, at least in terms of providing a financial firewall to stop the crisis. As we noted in our ‘No Way Out' report a downgrade would not be good:

Since the EFSF’s Triple-A rating relies on Triple-A countries, a French downgrade would also mean a downgrade for the EFSF itself. For such a downgrade to be avoided, the remaining Triple-A countries would need to substantially increase their share of the guarantees, transferring even more of the burden on the already reluctant German taxpayer – while also threatening Germany’s own rating. In all likelihood, under the increased EFSF scenario, a downgrade of France would trigger a downward spiral of ratings cuts due to the extra EFSF liabilities which would make the entire fund completely unworkable.

So a French downgrade would be bad for the EFSF, the eurozone’s temporary bailout fund, while numerous downgrades could spell the end of its ability to borrow, and therefore lend, at low cost. It could also spell trouble for the ESM, the eurozone’s permanent bailout fund, which, despite some paid in capital, also largely relies on guarantees from its members.

In any case, the French government may be softening up its population for a downgrade, but who’s going to soften up markets for the realisation that the eurozone bailout funds could be rendered close to useless (more useless?)….

Update 15/12/11 12:20pm:

Christian Noyer, Governor of the Bank of France, today launched an attack on the rating agencies (and the UK), suggesting that they are not basing their decisions on economic fundamentals and if they were the UK would/should be downgraded before France.

Noyer raises some valid concerns about the level of the UK's debt, deficit, inflation and the dwindling credit availability - but he, like his colleagues mentioned above, misses the key point. The UK has full control over its own monetary policy and can balance it with its fiscal approach in any way desired. France however faces: a central bank whose thinking runs completely contrary to the government's desires, an overvalued currency, increasing fiscal constraints due to its exposure to the eurozone crisis and a looming election (along with potential political divisions over the eurozone crisis). All in all, the UK may economically be in just as bad a position as France, but the UK has the tools to deal with its problems, the French government is, on the contrary, massively constrained.

ECB lending to the IMF

This is the third time the prospect of the ECB lending to the IMF has been brought up as a potential solution to the eurozone crisis. As such it might seem like old hat, but this time round it may have a bit more substance to it. Bloomberg reports that at Tuesday's meeting of eurozone finance ministers the ECB President Mario Draghi, who was also in attendance, approved the creation of a plan to allow the ECB to lend to the IMF, and then the IMF to use these funds to lend to struggling eurozone countries.

Very much an initial stage, but more than the recycling rumour which we had before. The report suggests the lending could top €200bn, so not pocket change but not enough to stem the crisis. The likely plan would see the IMF using the funds to provide precautionary lending programmes to the likes of Italy and Spain.

So could such a plan work? As you may expect, we think probably not. Here are a few of our initial thoughts on why:

- Ultimately, this proposal doesn’t change much may allow a small boost of liquidity but doesn’t solve the underlying competitiveness problems and structural flaws in eurozone. Italy and Spain need devaluation to become competitive again.

- IMF can impose conditions, so does circumvent the moral hazard problem posed by direct ECB lending. It does seem that ECB lending to the IMF is preferable to the ECB funding states directly with bond buying, due to this added conditionality.

- Although, may be conflict between ECB and IMF over best practice and use of money. Already disagreed over Greek restructuring (to the point where the ECB added a footnote into the troika report stating it did not agree with the level of write downs).

- ECB will essentially be ceding control over a large amount of funds, does again raise questions over its independence.

- Will not de jure break the ECB statute (Article 23 allows it) but definitely de facto against the fundamental principles of the ECB. The legal basis for it was never intended to sustain large bailouts. Will not be supported in Germany generally.

- German government has suggested it would support bilateral loans to the IMF. Not clear if this involves the ECB, unlikely, probably more in favour of countries boosting their IMF contributions.

- Where would the funds come from? The ECB would basically just create new money and lend it to the IMF. No indication that collateral would be taken on (not needed from IMF really, but separates it from usual lending options) or that this would be sterilised in anyway. Seems a big abandonment of ECB principles.

- Impossible to justify this as monetary policy (as ECB has done with SMP etc.) just direct lending to IMF to finance states.

- Still stigma attached to asking for IMF help. Not clear Italy and Spain are ready to cross that line yet. Once it is crossed will be more pressure for funding to continue if initial bout is not successful (which it looks unlikely to be – both countries need huge reforms which cannot happen overnight, yet have huge funding needs).

- Not clear who would take losses, should any occur. IMF is always senior so unlikely to take any losses. But existing debt holders may not like the introduction of €200bn in senior debt, especially if it originates at an equal creditor (the ECB).

- ECB exposure to PIIGS is around €630bn now, adding another €200bn to that, even through the IMF, cannot be seen as desirable.

All in all then, many of the same problems as with any massive ECB intervention. Legally and economically this plan could be preferable to the direct ECB financing of states (but then almost anything would be) but politically, it still raises a huge number of problems.

Greater intervention by the ECB raises more problems than it solves

Over on the FT A-list we've got a response to a piece by George Soros and Peter Bofinger, who are calling for the ECB to act as full lender of last resort to struggling eurozone member states. As regular readers of our blog and comment pieces will know, we're firmly against this course of action, as we believe it would throw up huge questions over the credibility and independence of the ECB (both vital if the eurozone has any hope of surviving). It would also likely make Germany question its membership in the eurozone. See below for our full response (we'd recommend reading the Soros and Bofinger piece here as well):

George Soros and Peter Bofinger present a measured approach for the intervention of the European Central Bank in eurozone bond markets, essentially envisioning it as a temporary liquidity provider of last resort. However, the ECB is already playing this role to a large extent. It has along with the eurozone bail-outs bought European politicians 18 months in which to devise the fiscal rules and growth strategy the authors call for. Unfortunately, leaders have repeatedly failed to reach any semblance of consensus on a lasting solution to the crisis.

Therefore, the exit strategy envisioned here for the ECB is dubious. Without a clear mechanism for winding down the ECB bond purchases, it becomes impossible to imagine a situation where the ECB could end its bond buying programme without causing huge market distortions.

The authors approvingly cite the example of the unlimited liquidity provision given to banks. However, this could equally be used as an illustration of the risks mentioned above. Although the ECB’s unlimited liquidity provision for the banking sector may have avoided a bank run, it simultaneously created a set of so-called ‘zombie banks’. Precisely because of the absence of an exit strategy, these banks have now become reliant on ECB liquidity to survive, while stripping them of the incentive to reform the bad practices and mismanagement which got them into this situation in the first place. The cost of this is now becoming clearer, with some banks on the precipice of failure, forcing a widespread recapitalisation of the banking sector – of which some cost will undoubtedly fall onto taxpayers. Against this backdrop, it becomes a huge risk for the ECB to stake its independence and credibility on the hope that such a solution will be achieved in the near term.

Targeting the spread between German bunds and other eurozone bonds would also significantly undermine the ECB’s independence. Ultimately, the spreads are reliant on the fiscal policy and domestic politics of each member state. Any failure or uncertainty in either area spooks markets. As such, the level of ECB bond buying could become almost directly influenced by the political and policy decisions in member states. The ECB is already treading perilously close to this line. One step further and it would cease being the independent central bank that is so essential to future monetary stability, and instead become a fiscal actor highly susceptible to political wrangling.

This also raises questions over the definition of the bond run. It’s true that the yields may not currently accurately represent the economic fundamentals of each nation, however they are a result of the markets trying to price in the domestic and European political risk as well as the structural flaws in the eurozone exposed by the current crisis. Using the ECB to try to ‘correct’ these issues not only damages the price determination mechanism in markets but takes the ECB far beyond its mandate.

Moreover, the German fears over hyperinflation cannot be seen as an anomaly – it is a political reality that goes to the heart of the German post-world war settlement. The day the ECB is turned into a politicised lender of last resort, may also be the day when the Germans start to seriously question whether they wish to be a part of the single currency.

The struggling eurozone countries need to press ahead with economic and institutional reform. But in the longer term it has now got to the point where the eurozone will have to reassess its structure and membership if it is to survive. Having the ECB act as a full lender of last resort will detract from these requirements and may throw up more problems in the longer term; making it ultimately self-defeating.

Securing Portugal's deficit

The EU/IMF/ECB troika released a statement on its second review of the Portuguese bailout this afternoon. It was more or less what was expected, with a deeper recession forecast for next year (GDP contracting by 3%) and fears over some over-spending, particularly regionally, which could result in the country missing this year’s deficit targets. Other than that it was light on detail and heavy on the platitudes as with most EU statements these days. (We’ll bring you a full analysis of the report once it is released).

But there was one interesting point which caught our eye:

“The government is seeking to negotiate a voluntary agreement with the major banks to transfer part of the assets and liabilities of these banks’ pension funds to the social security system, so as to allow meeting the 2011 fiscal deficit target of 5.9% of GDP.”

This brought some memories rushing back from our investigation into Portugal for our report earlier this year. Portugal did something similar to this in 2010, where they transferred assets from the formerly state owned Portugal Telecom onto government books but failed to add the liabilities in a timely fashion, as we noted in the paper:

Three pension plans of Portugal Telecom (PT) were taken over into the public social security system. These pension funds are for employees that used to be civil servants at the formerly state-owned firm. The agreement between PT and the government was signed in December and in addition to the assets of the pension funds, PT will transfer a total of €2.8 billion to the government. This amount (around 1.6% of GDP) will be counted in this year’s general government revenues, while there is no change in the official debt figures.

So, the assets transferred boosted the government revenue figures but we suspect that since the long term unfunded liabilities don’t fall into general annual expenditure calculations, they went unnoticed allowing a reduction in the deficit.

Clearly, the statement above suggests that something similar may be done this year. In its statement the Troika does claim that the liabilities will be added as well, but if they are unfunded and merged into the broader pension liabilities of the state, then they may not fall into general government debt and deficit calculations, allowing Portugal to meet its deficit targets through an accounting trick for the second year running...

Sharing Greek debt

Over on his BBC blog Robert Peston cites some of our figures on the shares of Greek debt, so we figured we'd put up our full break down of who owns Greek debt. Given the problems in Greece its interesting to see where the debt is held and who could be exposed to losses in a disorderly default.



So, as expected, the official sectors (ECB, Eurozone and IMF) already own a substantial amount of Greek debt, around €130bn. This only includes current bailout funds dispersed, so will still increase with the completion of the original bailout programme and will skyrocket with the second bailout package. The large chunk held by non-Greek non-banks (essentially private bondholders located outside Greece that aren't banks) demonstrates the difficulty of imposing any significant write downs under a voluntary scheme. These bondholders would never take part in such a scheme, while the official sector loans have been off limits so far. As such the voluntary write downs will fall far short of the advertised 50% when only applied to European banks and some European non-banks.

Democracy is coming home...

Interesting developments coming out of Greece this evening, as Greek Prime Minister George Papandreou has called a referendum on the latest Greek bailout and austerity package. Speaking to the Greek parliament he said:

“The command of the Greek people will bind us. Do they want to adopt the new deal, or reject it? If the Greek people do not want it, it will not be adopted…We trust citizens, we believe in their judgment, we believe in their decision."

It’s not yet clear exactly what will be voted on, but we imagine it will have to include the entire second bailout package, including the 50% write down for Greek bondholders, as well as the austerity and fiscal conditions attached to the latest package. So a lot of important factors for the future of Greece in there. As if that wasn’t enough, it will be tied to a vote of confidence on the current Greek government.

So which way will it go?

Well, it’s tough to say off the bat. A recent poll showed that 59% of Greeks think the new package is “negative” or “probably negative” for Greece, and there’s been no hiding their displeasure with the austerity measure and economic collapse. As such, there wouldn’t be too many Greeks who would be sad to see the back of Papandreou.

On the other hand, they may be keen to see Greek bondholders take some losses finally and endure some pain (although given the Greek bank and pension fund exposure to Greek sovereign debt this could end up costing Greek taxpayers again in the end). The same poll also found that 72.5% of Greeks want to stay in the eurozone.

Clearly, there are some conflicting feelings. Have no doubt that if Greece votes down the latest package it could be bad for Greece and the eurozone. It would leave Greece with almost no funding and no government – pushing the country very quickly towards a disorderly default and disorderly exit of the eurozone. That would be painful for both the eurozone and, especially Greece, have no doubt, the financial market turmoil and unknown knock-on effects would send the whole of Europe (including the UK) into a spiral of uncertainty.

This could be big turning point in this crisis. The EU should move quickly to come up with plans to mitigate the fallout of a no vote, specifically how to handle a rudderless and broke Greece, which would probably include plans for allowing it to exit the euro. A yes vote would be far from a solution, at best it would buy some time for the Greek government and the EU to enforce some necessary reforms thanks to a fresh mandate.

As with any referendum it may come down to the phrasing of the question. Let’s hope the Greek government and the EU do a better job of communicating the issues at hand than they have done so far in this crisis.

Keeping the ECB independent is key to the euro’s survival

Over on the FT A-list, we've got a response to a piece by Jim O'Neill, who argues in favour of a Greek restructuring and bank recapitalisation (as we have many times before). On many points we agree with O'Neill but we do differ on the role of the ECB in solving this crisis.

We argue:

Jim O’Neill sets out some important and necessary steps for how to solve the eurozone crisis – including a restructuring of Greece’s debt, recapitalising Europe’s banks and greater leadership from the European Union leaders. However, the problem in the eurozone crisis was never primarily one of not knowing what to do, but how to get there within the constraints of a supranational currency, pegged to national democracies and fiscal policies. What’s clear, however, is that spraying more liquidity at the eurozone crisis is in itself not a magic panacea – and could even make the single currency less sustainable in the long term.

The notion that the European Central Bank should offer an “unlimited” backstop for eurozone nation states, as Mr O’Neill mentions, is a case in point. Clearly, the loser from the “muddling through” approach employed by EU leaders over the past year has been the ECB. It has seen its credibility drained and its independence compromised (for example through its U-turns on accepting junk bonds as collateral). In fact, an important component of finding a long-lasting solution to this crisis is that any financial backstop for the eurozone is established at the intergovernmental level, not through the ECB.

There are a number of reasons for this, many of which stem from the central bank’s experiences during this crisis. First, the cheap and plentiful liquidity that the ECB has provided to European banks created perverse incentives and moral hazard, possibly leading banks to chase profits through higher yields on peripheral sovereign debt, thereby increasing exposure to the crisis. In addition, this unlimited credit created a set of so-called ‘zombie banks’ reliant on ECB liquidity to survive, but without any conditionality to reform the bad practices and mismanagement that got them into this situation in the first place. The lack of an exit strategy from these policies shows why transferring this model to the sovereign debt markets would be dangerous and undesirable.

We go on:

Furthermore, let us not forget that, unlike the Federal Reserve and other central banks, the ECB does not have a dual mandate – its primary aim is that of price stability. If markets do not believe it can achieve this, and if the line between politics and monetary policy become increasingly blurred, then market instability and fluctuations may become the norm for the eurozone. That the eurozone lacks a lender of last resort, is a structural flaw in its fabric which has been sorely exposed by the current crisis.However, papering over it with unlimited liquidity in the near term will not solve the problem. And perhaps most importantly, forcing the ECB into the role of lender of last resort could seriously jeopardise German support for the entire euro project, with the ultimate outcome equally unpredictable to that of the current market turmoil. The Germans still take ECB independence seriously, as witnessed by the dramatic resignation of Jürgen Stark over the ECB’s bond-buying programme. As attractive as it may sound at first glance, we should be wary of the temptation of sacrificing the ECB’s credibility at the altar of a short-term fix.

Finally, let’s not forget that, even following a solution to this crisis, a vast array of countries will be left with mismatched interest rates, an overvalued currency and a convoluted decision making process. The problems in the eurozone run much deeper than additional liquidity can solve. Yes, Greece needs to restructure, banks need to be recapitalised and if an inter-governmental, democratic way can be found to top up the European financial stability facility, with more focus on banks, this should also be explored. Alas, this may not be enough to save the euro.

The ECB has been heavily involved in this crisis and it may have to continue its current role, but it's important it goes no further. The credibility and independence of the ECB is vital if the euro is ever to work in the medium to long term. Besides, having to sacrifice the principles of the institution which underpins the whole monetary union in order to ensure its short term survival surely says enough in itself about the underlying conflicts within the fabric of the eurozone.

What’s a few hundred billion between friends…?

Below is the current status of the EFSF upgrade as ratified by national parliaments. A reminder that this is the vote on the package of measures agreed by Eurozone leaders back in July, and does not increase the overall size of the EFSF, merely its lending capacity (from €250bn to €440bn) and expands its scope, allowing it to buy government bonds, engage in precautionary lending and capitalise banks.

Already Ratified:
Belgium – 14th September
Cyprus - 29th September
Finland – 28th September
France – 8th September
Germany – 29th September
Greece – 27th September
Ireland - 22nd September
Italy – 15th September
Luxembourg – 15th September
Portugal – Government has rubber stamped the deal
Slovenia – 22nd September
Spain - 28th September

Yet to Ratify:
Austria - Parliament’s finance committee approved the EFSF bill yesterday, paving the way for a special session of the assembly to give final approval in a vote tomorrow.

Estonia - Parliament is due to ratify the EFSF bill later today after making amendments to local legislation required by a constitutional watchdog and opposition Social Democrats. Also proposed amendment which would require the Estonian parliament to give approval every time EFSF is used (seems unlikely to be accepted given that it would stir huge controversy with other countries).

Malta – Government officially proposed the bill yesterday, voting is due to take place early next week.

Netherlands - Parliament is scheduled to approve a supplementary budget, which includes the proposed EFSF changes, next week. Government will probably have to rely on the votes of the centre-left opposition as Geert Wilders' Freedom Party is likely to oppose the bill.

Slovakia - Voting is planned for October the 25th, but Prime Minister Iveta Radicova has said that she would like Parliament to vote on the plan by October 17th, possibly as early as the 11th. There have been some indications from the second-largest ruling party, Freedom and Solidarity (classic liberals), which had opposed the upgrades, that the ruling coalition was close to an agreement on approving the EFSF overhaul, but this is yet to be confirmed. The centre-left opposition has said it won't prop up the government if the coalition fails to come to an agreement but that it will vote in favour if the government comes to a united position.

It appears that there should be no major problems with passing the EFSF expansion through the remaining national legislatures, although the Slovakian situation is still uncertain.

This entire eposide serves as an important reminder that national democracy is still king, and, at the end, will determine the fate of the euro (markets, analysts, diplomats and government cabinets can squirm all they want).

The somewhat scary thing is that the series of EFSF votes is essentially a legacy issue. Markets have already set their eyes on the next big battle as European, and (increasingly concerned) global leaders, are mooting that the EFSF needs effective resources of €2 trillion (some suggest using ECB leveraging, which we consider a non-starter).

The political manoeuvring that has been/will be necessary to squeeze the relatively modest July measures through national parliaments (particularly Germany, Finland and Slovakia) will be tested to the limit if the Governments go back to national parliaments asking for a multi-trillion top-up - not least in Germany(see our earlier blog on today’s vote).

The markets know all this, which is why the whole situation remains so uncertain in spite of the apparent consensus among eurozone members...

A structural funding solution to the crisis?

Over on his Telegraph blog noted economist Andrew Lilico has come up with an original idea for tackling the eurozone crisis. Lilico suggests using the existing structural funds programme to distribute further funding to the struggling PIIGS, thereby helping to boost GDP growth and stabilize the sustainability of their debt burdens (and appease markets about this point).

Credit to Lilico for coming up with an original and constructive idea (and we’re always interested in outside the box thinking) but there does seem to be a few issues with putting the structural funds to work in this manner.

First, the record of the Structural funds doesn't inspire confidence. Most of the evidence - including OECD reports and the influential Sapir report for the Commission - suggests that the impact of structural funds is inconclusive at best, with the causality and the counter-factual tough to prove (See here, here, here, here and here). In places such as Ireland and to a lesser extent Spain, the funds have had a positive economic impact (in Ireland because they effectively financed the government's pro-growth measures). However, in Italy, Greece, Portugal and Belgium (Wallonia) it's far less clear what the funds have achieved. The picture is particularly bleak in southern Italy.

But even assuming that the structural funds have had a positive impact on the GDP of some countries previously, it is very possible that this time around they could be lost in the black hole of fiscal consolidation and potential recession in the PIIGS. This relates to another point: the funds are simply wholly unequipped to serve as a backstop in a debt and solvency crisis. There are numerous technical features of the structural funds which would need to be completely revamped for them to be fit for such a purpose, to name but a few:

- Co-financing would have to be scrapped since the PIIGS can’t afford to part finance any structural funds projects (due to the liquidity crisis which this is aimed at tackling, clearly a catch 22). This is holding back disbursement at the moment and will do until it is removed completely, however, it is the only form of conditionality which is attached to these funds.

- To get the Germans to pay, another form of strict conditionality (which is to replace co-financing) would have to be introduced, possibly some form of austerity target, although then it ceases to be structural funding and becomes budget support. Given the PIIGS history of missing targets (including structural funds targets), its unclear whether this would make accessing the funds any easier and would throw up similar problems as the ones we’ve seen with disbursement of the bailout funds.

- The disbursement criteria would have to be completely changed. The current region-based (NUTS) system linked to Gross Value Added isn’t in any way designed to deal with liquidity and solvency crises (it’s based on long-term regional convergence). Again this means completely over-turning the structural funds. Why not just start from scratch with a purpose built mechanism if this is the way you want to go?

- The aim of the proposal seems to be to boost short term economic growth and help PIIGS deal with liquidity issues and budget problems, as such it would need to be a flexible and short term mechanism. Putting aside whether this is really achievable given EU bureaucracy, such a mechanism would not fit into the current EU budget framework which is negotiated in sever year blocks. (Trying to negotiate how to allocate the new funds within the structural funds framework, which relates to economic convergence, would most likely be hellish and long winded, neither of which is needed right now).

- The European Parliament – a hotbed for rent-seeking – would also need to be stripped of its effective veto over the long-term EU budget if such a mechanism were ever to be effectively implemented.

Ultimately, Lilico is looking for an existing conduit to centrally distribute funds to the PIIGS which will help economic growth, thereby bypassing some of the tricky economic and political debates which have been raging on - not least in Germany. The idea essentially requires a mechanism for transferring budget support to these countries with some limited conditionality. This can never really be done by structural funds - without effectively creating a whole new policy - and would lead us back to the same old questions and problems relating to monetary transfers during this crisis, just as we’ve seen with Eurobonds, the EFSF and the ECB, now wouldn’t it?

At the end of the day, alas, there's no short cut to a fiscal union - and it will come with a huge political cost no matter how we twist and turn it.

Eurozone crisis doesn’t take holidays…

While Eurozone leaders are off sunning themselves around the beaches of Europe the Italian and Spanish economies have been taking a roasting at the hands of the markets. Italian and Spanish ten year cost of borrowing hit record highs, reaching close to 6.25% and 6.45% respectively – disturbingly close to the 7% threshold, beyond which history has shown (read Greek, Irish and Portuguese bailouts) that financial markets really start to lose faith in the sustainability of large debt burdens. We also saw the Italian and Spanish stock markets take a battering yesterday, with Italian banks in particular seeing huge drops in their share prices, mostly due to the mountains of Italy government debt which they have hoarded onto their books in the past few years. Additionally, credit default swap prices (used as insurance against a default) on Italy, Spain and France hit record highs as markets fretted over the long term stability of the eurozone (despite the fact that the Greek deal significantly undermined their reliability).

To its credit the Italian government seems to be realising that more needs to be done to assuage the markets. Finance Minister Giulio Tremonti called a meeting of the Financial Stability Committee - made up of representatives of the government, the Bank of Italy, market regulator Consob and insurance authority ISVAP – for this afternoon to discuss the renewed fears surrounding the Italian economy. Prime Minister Silvio Berlusconi will also address both Houses of the Italian Parliament tomorrow, after remaining relatively silent on the crisis so far (although given his track record for verbal gaffes we’re not certain whether this is a good thing or not!)

Spanish Prime Minister Jose Luis Rodriguez Zapatero also moved to delay his departure on holiday in order "to more closely monitor the evolution of the economic indicators", according to a government spokesman. Although, El Pais reports that he has only delayed it by a few hours, so clearly he doesn’t plan to come up with any ground breaking solutions…

We hope eurozone leaders are enjoying their holidays and not getting burnt as badly as some of their economies are during their absence.

Missing the target…again…

Despite there now being less than 24 hours to go until the emergency eurozone summit on Greece, and probably Italy and Spain, there is still no clear consensus on what structure a second Greek bailout will take. The main sticking point, as has always been the case, is on private sector involvement.

The original ‘French proposal’ for a debt rollover now seems dead and buried. The German plan for a bond swap looks to have been brought back from the brink but still looks unlikely, given the complexities and the fact it will surely result in a default rating but deliver minimal debt reduction. The focus has, therefore, turned to two proposals: a debt buy-back and, more surprisingly, a bank levy.

We’ve covered the prospect of a debt buy-back before (in our Greek paper here), so we’ll try and keep it brief. It’s not the worst idea eurzone leaders have come up with, as it could raise a decent chunk of change given that Greek bonds are trading at substantially reduced prices. There are a couple of problems though. First, the ECB has said it will not sell any of the bonds its holding, which shuts off a large pool of potentially easy to negotiate deals. There are plenty of private bondholders who take a similar line since they’re holding the bonds at par value (level at which they were purchased) meaning that they would have to book the losses if they sold them (the idea here is that they expect the EU/IMF/ECB to find another solution so have no need to accept the offer - moral hazard at its finest). Lastly, the price of bonds would likely spike if a buy-back was agreed, massively reducing the benefit of the scheme (to avoid this, ex-ante agreements on prices of bonds would need to be made with all bondholders willing to sell, this raises a whole new host of issues such as collective action problems, complex negotiations and default in the eyes of the credit rating agencies).

So, on to the new darling of the day, the bank levy. This has come out of nowhere (and that’s where we expect it to go back to) after an options paper was leaked to the FT and Reuters. The details are incredibly thin but the basic idea is that a tax is imposed on banks in order to raise money to contribute to a second Greek bailout. The leaked paper suggests this could raise the necessary €30bn over three years (convenient and unsubstantiated). There are a lot of problems with this proposal.

First off, it’s an incredibly inefficient way of making the private sector pay for a Greek bailout since it’s levied across the board rather than on those with the biggest Greek exposure. It’s incredibly ironic (and ultimately depressing) that the most accurate tool for making the right people contribute (a restructuring of Greek debt) is already right in front of eurozone leaders' eyes, particularly after the data was released under last week's stress tests. Secondly, it is realistically impossible to achieve since the German, French and British banking federations have already come out against it, making any short term deal (which is exactly what is needed in the Greek case) very unlikely. And, if it was ever agreed, it would probably be passed onto consumers through higher fees and charges, not to mention the fact that banks may consider relocating outside the eurozone if they face an extra levy.

The levy also raises an interesting issue regarding the UK, since UK banks do have some, albeit small, exposure to Greece. Would eurozone leaders credibly propose that only eurozone-based banks would be subject to the levy. "What about non-eurozone banks that lent to Greece?" the eurozone-based banks would surely ask. But on the other hand, neither the PM nor the Chancellor will be in the room tomorrow and the likelihood of the UK agreeing to take part in the levy is, in any case, probably zero.

The bank levy seems particularly poorly thought through, even by recent standards, and looks to have greater political than economic motivation. Given the state of the crisis, and its recent escalation to include Spain and Italy, eurozone leaders cannot afford to waste time, not to mention the trust and patience of financial markets, on poorly targeted and poorly planned strategies. Ultimately, we still think a debt restructuring gives the best value for money in the long run, taking into account the positives of debt reduction and the negatives of a default (which you get from many of the other plans anyway).

The name's Bond....Eurobond....

The Economist has an interesting article in this week's edition which partly endorses the idea of 'eurobonds' (although with the qualification that they are politically unworkable right now).

The magazine argues:

"One useful means of allaying the panic might be for euro-zone countries to issue part of their debt as joint bonds. Jointly guaranteed bonds sold to raise money for the current bail-out funds are being eagerly snapped up by investors.

This may make financial sense. But the near-insurmountable obstacle is, as always, political: there is huge resistance to what would become a more overt 'transfer union'. In a group of democracies, where big decisions are taken by unanimity, consensus is hard to come by and takes time. Hence, leaders have acted only in the face of impending disaster, and then with half-measures. Markets operate on a faster timetable. They will not wait for Europe’s leaders, like Churchill’s Americans, to do the right thing after having exhausted all the alternatives."

We would contend that, apart from the obvious drawbacks in terms of democratic legitimacy, the 'eurobonds', at least in their current form, do not represent financial sense either (leaving aside for the moment the fact that taxpayers shouldn't be funding governments they can't democratically control).

The gist of the current proposal is that part of a country's debt would be financed by standard sovereign debt and the rest would be covered by eurobonds, around a 60%-40% split (an idea which has been proposed by Eurogroup chief Jean-Claude Juncker amongst others). However, its highly questionable whether this would be sustainable.

At our debate in London last week, Spanish MP Álvaro Nadal, shadow Economy spokesman for the Partido Popular, which might well be in government soon, commented that "for [Spain] eurobonds would be suicidal" as they would drive up the cost of the nationally financed portion of Spanish debt. He also warned of moral hazard, saying:

"The current eurobonds are very ill-designed. We need a method to encourage fiscal discipline but they are not it".

Handelsblatt economics editor Daniel Goffart made similar comments last December, suggesting that, "On balance, financing costs would not decrease" as the extra risk premium (higher interest rate) which investors would want on the nationally denominated debt, would outweigh the savings from the lower borrowing costs on the eurobonds. And it would not only be struggling eurozone countries that would see higher national borrowing costs, but also the likes of Germany, who would be explicitly guaranteeing eurozone debt, via eurobonds. Investors would be likely to demand a premium for this potential additional burden on Germany's national finances.

There's also the fear that this proposal puts the eurozone on a slippery slope. Once some debt is guaranteed by everyone and the cost of financing national sovereign debt starts increasing, there could be calls for a larger and larger percentage of debt to be in the form of eurozone-guaranteed eurobonds. Some might say this is a speculative fear but, given where we are now after the original bailout decision, it's clear that nothing should be unthinkable when it comes to the eurozone.

Last but not least, there is also the concern that eurobonds are, in fact, illegal under the EU treaties. Such fleeting issues have been circumvented in the past (bailouts), but it may be even more overt this time around. German Chancellor Angela Merkel and Finance Minister Wolfgang Schaeuble have already made strong statements on this topic. They were backed up this weekend by Bundesbank President Jens Weidmann.

Last December, Merkel made her position perfectly clear saying:

"It is our firm conviction that the treaties do not allow joint eurobonds, that is no universal interest rate for all European member states. Competition on interest rates is an incentive to respect stability criteria."

Although we all know that similar comments were made in regards to the bailouts, we hope Merkel and her government have learnt some lessons over the past year about how some decisions can snowball and take you to a place you don't necessarily want to go (second bailout, talk of permanent fiscal transfers, political unrest, a central bank bleeding credibility etc etc).

We don't think eurobonds will be on the table at this week's summit but expect the debate to continue back and forth in the weeks and months to come.

Another bad review for Greece…

Well, considering it’s through the rose-tinted glasses of the IMF, the fourth review of Greece, which the fund put out yesterday, does not make great reading (and that’s not just because its 173 pages long).

We’re just starting to pore over the report (although much of it is similar to one the Commission put out a couple of weeks ago) but here are a few of our initial reactions.

First off, the IMF expects a second bailout package for Greece of around €104bn, with €71bn coming from eurozone members (probably EFSF) and €33bn from private sector involvement. On the bailout's structure the report states:

"The [funding] gap will be filled through private sector involvement (PSI), with additional official support from euro area member states covering amounts not provided for by PSI."

Interesting, here how there is no mention of the IMF being involved, despite it taking part in all the other bailouts and everyone (including us) assuming it would do so for a second Greek package. This may not seem like a big deal but the Germans were originally very keen to have the IMF involved in any bailouts, so it could cause some friction. It doesn't fill us with confidence that even the IMF is reluctant to be associated with the next bailout package. That said we can’t imagine Lagarde would keep the IMF out given her previous cheerleading for the bailout policy.

Secondly, the whole report shows glimpses of just how wrong previous estimates from the IMF on Greece have been. Take, for example, the fiscal gap comparisons on p.12 which were 2.2% of GDP off for this year in the previous estimation (only completed in February). Yet despite this, they still give similarly optimistic estimates for next year. We can’t help but think that there will be similar revisions in the next review. (On a side note the IMF and the Commission have also decided to adopt even more complex and opaque tables in this review, making it much more difficult to figure out all the assumptions behind their figures, for example on short term debt issuance). It’s also good to keep in mind that, under the original reviews, the IMF thought or at least publicly suggested that the current bailout would be enough, yet now they’re showing a funding gap topping €100bn over the next few years.

As always the underlying assumptions play a crucial role in determining the debt sustainability of Greece. Again the IMF seems to have gone for some herculean assumptions on the Greek primary surplus and economic growth, particularly post 2015, but that seems par for the course in these reviews. Although we cannot clearly see the assumptions about short term debt issuance this time around (see above), it looks as if they expect Greece to roll it over continuously for a few years after letting some mature next quarter. We’re still sceptical about Greece’s ability to do this on a long term basis not to mention the extra €1bn it adds in interest every year.

The report does readily admit that if many of these targets and assumptions are not met, things could quickly spiral out of control for Greece (not sure where they’ve been for the past year), especially on privatisation and deficit targets. The report also admits that the assumption that all European banks and all Greek financial institutions will take part in a debt rollover looks unlikely to hold (no kidding) but adds that the slack would be picked up by eurozone countries (sure the Germans enjoyed that one).

We’d recommend checking out the analysis over on FT Alphaville and FT Brussels Blog (kudos to both on their turnaround time as well). In any case, as soon as Greece misses a few deficit targets and privatisation sales the whole report will become redundant anyway…

Running scared….

As we’re sure you’ve noticed, things are heating up in the eurozone (well going supernova now) with fears spreading to Spain and more crucially Italy. As we noted earlier, the Italian and Spanish cost of borrowing has been skyrocketing and bond prices crashing (along with bank shares and stock markets). There have been rumours that this has prompted the ECB to begin buying bonds from struggling eurozone countries again (possibly in tandem with the Chinese Central Bank).

Normally, we’d question the ECB for dredging up the bond-buying programme which they had tried so hard to leave behind but given the speed at which the fears have spread to Italy we can understand their concern. More importantly, this highlights that the current bail-out 'sticking plasters' policy is failing miserably, especially when it comes to containing contagion.

In any case, Willem Buiter, Chief Economist at Citi, thinks this is just the start, saying yesterday:

“If the ECB doesn’t come in, the Italian bond auction [today] is likely to fail. What we’re going to have is the ECB are going to be doing the heavy lifting."

So, Italian bond auctions may already be struggling to get off the ground meaning that the ECB - whose balance sheet is already already looking vulnerable - will have to start splashing around in a €1.6 trillion bond market.

We'll keep you updated on how the bond auction goes and if there are any signs of ECB intervention. In any case, this whole situation seems to have spurred on eurozone leaders a bit, since they've announced another emergency meeting for Friday, although given their track record for consistently failing to agree on a solution we won't be holding our breath...

Cliffhanger

There were some interesting comments today by Warren Buffet, Chairman and CEO of Berkshire Hathaway, on the eurozone debt crisis.

In particular, Buffet gave this very apt analogy:

"The European situation is not solved... They've got a lot of work to do. When you have 17 countries that all have the same currency, and the yields on their bonds are all different, the situation is not solved. It's like 17 people holding hands and one guy starts walking towards the end of the cliff, and suddenly there's 12 people left and you have to start thinking -- do I want to be holding hands with this group?"

(This is also an analogy we've hinted at before on here)

We would add though, that it now looks more like these people have their hands handcuffed to each other and they're all looking around realising none of them brought a key...

How attractive is the 'French Model'?

Apologies for the delay in getting our verdict on this plan out....

Following the negotiations over the last few days, between banks and the EU/IMF/ECB, a proposal has been put forward on how to involve the private sector in a second Greek bailout. The idea is to have investors share more of the burden, reducing the potential cost to taxpayers of a second Greek bailout.

Unsurprisingly, the ‘French Model’, as Sarkozy has gleefully termed it, still seems to involve some significant public sector guarantees. Apologies in advance for some technical jargon which may creep into this post - it's a complex issue but is vital to the future policy choices in the eurozone crisis. (FYI We’ll ignore the speculation about who might take part in this plan and how much it could save since any estimates would be mostly guesswork at this stage).

So, first off the plan calls for banks (read – private investors) to rollover or reinvest 70% of their holdings of Greek debt, which expire between July 2011 and June 2014, into new 30 year Greek government bonds. This debt will yield 5.5% (but could increase by up to 2.5% based on GDP growth) and will not be able to be traded until January 2022.

The Greek government will then take 30% of this money and loan it to a special fund (meaning that Greece only gets 70% of the rolled over 70% in cash, essentially accessing only 50% of the total amount originally maturing). This special fund will then use the money to purchase 30 year bonds from the EFSF (or some other triple-A creditor) equal to the same value as rolled over private sector debt (from we can tell). The fund will hold these bonds as collateral against the private sector involvement, essentially guaranteeing all the funds which the private sector has committed to the second Greek bailout. If Greece were to default, the special fund would sell these bonds and use the proceeds to cover the losses of those private sector creditors who rolled over their holdings of Greek debt.

But here’s the kicker. Since the bonds which the EFSF put up as collateral are only paid for at 30% of their value, the EFSF is essentially guaranteeing 70% of private sector involvement. If Greece were to default, even after this plan (which we’ve argued numerous times still looks likely), then the bonds would be sold off and the proceeds used to cover the banks losses. The hope seems to be that the bond will increase in value and so some profit will be used to reduce the public sector guarantee. Ultimately, how much the public sector guarantee is invoked depends on the level of losses which investors face from a Greek default (currently estimated at between 50%-60%). In the end though, governments will still be left to pay off the 30 year debt they issued as collateral and are unlikely to have ever received the full amount in cash to cover it, meaning they will essentially be indirectly paying for private sector losses.

Interestingly, we’re yet to hear from the credit rating agencies on this plan. Since the yields on the new 30 year Greek bonds would be much below market rates and the banks are still not fully recouping their original investments, the whole process could still be deemed a default, although much less likely than previous options. Oddly, earlier in the week ECB Governing board member Juergen Stark insisted that any 'Brady bond' style initiative (which is how many are viewing the French plan) would be illegal under the no-bailout clause of the EU Treaty (clearly the irony is lost on him).

In any case, it’s a complex and convoluted plan which looks to be as voluntary as possible and requires minimal private sector involvement. But, importantly, it looks reliant on significant taxpayer-backed guarantees. And we're therefore back where we started - taxpayers being left with the ultimate risk.

See below for the French Banking Federation's graphic of the plan:

Abandon Ship: Time to stop bailing out Greece?

We've put out a new briefing on the potential second Greek bailout and the cost of a Greek debt restructuring this morning. See here for the full report, but here are some of the key points:

- EU member states have in total amassed quantifiable exposure to Greece of €311bn (via their banking sectors, the bail-out packages and the ECB’s liquidity programme). France and Germany have exposure of €82bn and €84bn respectively, while the UK only has €10.35bn exposure (in direct exposures).

- In a best case scenario, to carry Greece over until 2014 a second bail-out would have to cover a funding gap of at least €122 billion. This includes Greece receiving the full amount of the original bailout as well as meeting its deficit targets and privatisation commitments. If these fail the funding needs could rise to €166bn, potentially requiring Greece to make a third request for external aid.

- The cost of restructuring will also increase with time, as Greece’s debt burden will only rise over the next few years. To bring down Greece’s debt to sustainable levels today, half of it would need to be written off. In 2014, two-thirds of Greece’s debt will need to be written off to have the same effect, meaning a radical increase in the cost to creditors. Put differently, each household in the eurozone today underwrites €535 in Greek debt – by 2014 and following a second bailout, this will have increased to a staggering €1,450 per household. This makes a second Greek bail-out far more politically contentious than any of the existing rescue packages, given the likelihood of debt write-downs with taxpayers footing a huge chunk of the bill.

- Unfortunately, this is a debt crisis and someone will have to take losses. We estimate that the first round effects of a 50% write down on Greece’s debt would cost the European economy between €123bn - €144bn (uncertainty regarding the ECB’s exposure accounts for the range). However, these are only first round losses. It cannot be emphasised enough that the main cost from a debt restructuring comes in the form of contagion and the knock-on effects of losses throughout the European banking system. Although this is a substantial cost, we estimate that in 2014 following a second bailout, a haircut of 69% would be needed, equal to €175bn, to reach the same debt level.

These graphs clearly illustrate why a second Greek bailout is such a difficult political sale. Basically: banks out, taxpayers in. Seriously, does anyone think that this is in any way sustainable?