Saturday, February 4, 2012

In Greek restructuring some institutions are more equal than others

It is understandable that the ECB would be sitting on the sidelines of the Greek restructuring process. But a simple statement from the central bank could go a long way in advancing the stalled negotiations. Draghi needs to agree that the ECB and other public holders of Greek debt must be treated the same way as the private bond holders. The pressure on the ECB to participate in the restructuring is now coming from both sides of the negotiations as well as from the IMF.
Reuters: Athens also wants public creditors like the ECB to take part in the bond swap deal, under which banks and insurers will take real losses of about 70 percent on the Greek debt they hold in a bid to ease Greece's debt burden by 100 billion euros.
Clearly that is not happening and the expectations from the ECB (and Germany who supports the central bank avoiding a haircut) seem to be that the €40bn of Greek debt it holds will have a priority claim. The Eurozone is beginning to sound like something out of Orwell's Animal Farm - all Eurozone institutions are equal "but some are more equal than others".
FT: “The balance between the participation of the private and the public sector is a concerning question,” Christine Lagarde said on a visit to Paris on Wednesday.
Back in the 90s Orange County California defaulted on its debt. All the public and the private holders were treated the same in the process. But imagine holding Orange County commercial paper and being told that a federal government agency who holds the same paper as you will be getting their money first, while you have to take a large loss. This is particularly ugly if you weren't told about this possibility when you bought the paper. (In fact there were rumors at the time that a pension fund may have a priority claim, but they turned out to be false.) Credit markets break down in these situations and that is what the Eurozone is now facing.

It is important to note that even though the ECB losses will be substantial, the central bank bought its Greek paper at a discount, mitigating some of the impact of the haircut. But it is unlikely that the ECB would be swayed by this fact:
Capital Economics: Draghi seems very likely to dismiss the idea, probably on the basis that the ECB’s purchases were designed to ensure the proper functioning of monetary policy - by lowering long-term interest rates - and not to relieve fiscal pressures on Greece or anyone else. What’s more, haircuts would presumably make the ECB even less inclined to buy other governments’ debt. 
All good points, but by avoiding a haircut the ECB will in fact end up raising long-term rates by undermining confidence in the credit markets. It may even end up having to purchase more Eurozone bonds in the future to maintain stability in sovereign debt because of this decision.

Greek default in and of itself is not going to have a dramatic effect on the Eurozone's financial system or the economy. The losses have largely been taken and the markets have adjusted accordingly. But it is the way the process is handled that will set precedence for sovereign credit markets going forward. There is little time left and a mistake at this juncture will have lasting implications for the Eurozone.
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