Wednesday, May 4, 2011

Europe must plan for a Greek defult now

Greece has not been compliant with the terms of its rescue loan. The Germans are balking at a second rescue. I really don’t see what will prevent an attempted restructuring. Credit spreads are in the stratosphere.

Greece’s debt lacks a collective action clause, so that it cannot negotiate with its creditors the way a company can. However, because Greece is not subject to a court, it can restructure unilaterally. However, I would expect that it would seek to negotiate the terms of the restructure with the ECB, the IMF and the EFSF.

Greece has lost access to the capital market. Restructuring will be another nail in that coffin. A negotiated restructure will mean that Greece will be saddled with a mountain of debt and no hope for market access. This means that Europe (the EFSF) will have to finance Greece’s budget deficit. The terms for such loans will be draconian because Europe will want the budget balanced rapidly. Thus, failure to comply with the first rescue’s conditions will only result in worse conditions.

Greece also has the nuclear option: default and repudiation. Since the capital markets will remain closed, and the European spigot rapidly turned off, Greece would have to balance its budget while still owing an amount in excess of its GDP. What is the incentive to honor its debts if there is no reward? Germany is not going to invade if Greece defaults. We have already seen repudiation in Latin America (about 100 times over two centuries).

In the end, either France and Germany cough up a lot of money, or else Greece defaults and repudiates some or all of its debt. They can’t pay it and they won’t pay it. The Greek electorate will not willingly put itself through what Romania went through in the 1980s.

In my opinion, now is the time for Europe to forget its “stability” delusions and start thinking about how to manage a Greek default. This will require another bank recapitalization and, in order to keep the interbank market open, another bank guarantee scheme. The ECB will have to put aside its dreams of a rate hike, and instead launch a massive liquidity infusion.

Europe must also decide what to do about Ireland. Ireland’s debt exceeds its debt capacity.

A German official said that a Greek default will have a market impact an order of magnitude greater than Lehman in 2008. That depends entirely on how well the authorities handle it. If it is bigger than Lehman, the ECB and the EU will have to up their game considerably. Right now they are in denial and unprepared.