Greek contagion: no replicability, no circuit breaker

Are markets overreacting? Aren't Portugal and Spain very different from Greece?

With a public debt / GDP ratio of 77% and 53% and a public deficit of 9.4% and 11.2%, respectively, Portugal and Spain are indeed very different from Greece (115% public debt / GDP and public deficit of 13.6%). Portugal and Spain's problem is one of private debt, anyway. Not public debt. As long as the governments in both countries are able to resist the socialisation of private sector debt, government default will not happen. We could also argue that both Iberian countries have a far better track record of harsh public reforms than Greece.

Do all these arguments matter at this stage? No.

Financial markets have just taken the view that the Greek sovereign debt crisis will spread to Portugal and Spain and both countries need to be bailed out (with Ireland and Italy likely to follow, even though the total indebtedness of the Italian economy - as a % of GDP - is below that of France). It is useless to spend time arguing about the rationality of this view based on the countries' economic fundamentals. Markets are far from always being rational (and the fact the overwhelming majority of investors have a very short-term investment horizon does not help). Once enough investors share a view about a given economic outcome, chances are high that it becomes a self-fulfilling prophecy. The fact that financial markets are able to impact economic fundamentals in turn creates the ex-post justification for their ex-ante behaviour. An apparently irrational behaviour at inception is vindicated as rational in the end.

What can be done to stop the current financial market's prophecy for Portugal and Spain (likely to be followed by Ireland and Italy) from becoming a self-fulfilling one? A circuit breaker is needed.

Three months ago, any effective circuit breaker would have had to meet one single condition: to avoid a sovereign default by Greece. This would have given the European Union 12 to 18 months to put in place a systematic crisis resolution system and a more credible fiscal surveillance mechanism for its member states, and allow them to work towards better fiscal integration and the countries at risk to implement convincing structural reforms. Precious time was wasted. Now it's too late for it to work.

At this stage any effective circuit breaker will need to meet two conditions: 1) contain the Greek sovereign debt crisis; 2) be replicable one-to-one by Portugal and Spain (and whoever else is perceived to be at risk of defaulting), if needed.

Does the joint EU / IMF Eur 110bn bail-out package for Greece announced on Sunday meet these two conditions? No, it doesn't.

It is a bold and unprecedented bail-out package. But it cannot be replicated precisely because it is bold and unprecedented. Greece's public debt amounts to Eur 275 bn. That of Greece, Portugal and Spain combined amounts to around Eur 900 billion. If we add Ireland and Italy the figure rises to Eur 2.8 trillion. The IMF has an estimated Eur 170bn of financial resources left (following the Eur 30bn to be used as part of Greece's rescue package). The European Union (read Germany) is probably not too far away from reaching its limit of politically bearable financial support to weaker EU member states.

What can be done? Private sector participation and burden sharing is required. Greek sovereign debt restructuring and (implicit) haircuts are needed (followed by massive debt to equity swaps in the private sector at some point down the road).

The questions are:

·         Is it doable? Yes.

·         Is it fair to Greek bondholders and creditors in general? Nothing is fairer in a market economy than to be held accountable for the consequences of one's freely made decisions.

·         Is it replicable by other EU member countries, if needed? No doubt.

·         Would it make things easier for Germany? A lot easier. German taxpayers would rather (although reluctantly) accept that their government potentially had to bail out domestic banks hit by sovereign debt restructuring events (with burden sharing by the banks' private creditors) than make more financial transfers to Euro member countries cut off from financial markets.

·         Can it have unintended short-term consequences? Yes. Think Lehman.

The relevant question is, then, whether these potential unintended short-term consequences are a strong enough reason to avoid private sector burden sharing. That depends on the alternatives. So, what are the alternative circuit breakers?

1.    Fiscal integration? A higher degree of fiscal integration is unavoidable if the Eurozone is to survive. But it will take a long time to implement. It can't act as a circuit breaker.

2.    Split the Euro in two: a Northern Euro and a Southern Euro? It would take a long time to implement and can't therefore act as a circuit breaker either. Furthermore, it would only be feasible if France became part of the Southern Euro. That would be equivalent to France admitting economic failure. Won't happen.

3. Greece leaves the Eurozone, devalues the New-Drachma and rejoins the Euro at some point in the (distant) future (let's leave aside for a minute that the Lisbon Treaty doesn't allow a country to leave the Eurozone and remain in the EU). It wouldn't act as a circuit breaker either. It would, rather, act as a catalyst for more financial market pressure on Euro member countries perceived to be in a similar position as Greece. Additionally, this alternative could have two unintended consequences:

·         Financial and economic. Depending on the mechanism chosen, replacing the Euro by the New-Drachma would either lead to a blow-up of the Greek financial sector or an implicit haircut in public and private sector (currently) Euro-denominated Greek debt. Thus, the potential unintended consequences would be the same as the ones resulting from imposing burden sharing to the private sector.

·         Political. Once one country dropped out of the Eurozone others would follow, unable to resist financial market pressures. This would be a major setback for the European integration process initiated after the Second World War, which secured an unprecedented period of 65 years of peace in the region. Many might argue that it would be a minor step back and that the European Union is much more than the Euro. They should be reminded that History is full of political disintegration processes that started with minor steps back in the level of political integration.

4.    The ECB initiates a massive quantitative easing program and buys, in the secondary market, Government bonds of the countries currently under pressure. This would trigger a rally in Government bond prices, stabilise bond markets and lift the existing pressures. The perfect circuit breaker.

However, given the ECB's single price stability mandate, its Bundesbank DNA, and its focus on monetary aggregates, such a program would be limited in scope and time. The end game would always require debt restructuring and private sector burden sharing.

Looking at the alternatives we are facing, the choice seems clear: an ECB quantitative easing program alongside sovereign debt restructuring (implicit haircuts through extension of debt maturities) with private sector burden sharing.

The ECB, political authorities and private creditors need to rise up to the challenge we are confronted with.

At stake is nothing less than Europe as we know it.

Rui Soares, Partner at Hidden Pearl