Satyajit Das: The Real Debt Crisis is in Europe – Part 1 – “Solvency But Not In Our Time”

By Satyajit Das, the author of Extreme Money: The Masters of the Universe and the Cult of Risk (published in August/ September 2011)

Despite the media hyperventilation and pundit hyperbole about the downgrade of US’s credit rating, the real issue remains Europe.

There is no imminent danger that the US cannot finance its requirements. The US’s cost of debt will not increase significantly as a result of the marginal downgrade, by one of the three major rating agencies. Despite the shrill rhetoric, the Chinese and other foreign investors will continue to buy US dollars and government bonds to protect their existing

For many European countries, the inability to access markets is a clear and present danger, which threatens financial markets and the global economy.

The Grand Illusion

Echoing Neville Chamberlain’s infamous “peace in our time” announcement, the European Union (“EU”) on Thursday 21 July 2011 announced their plan to end the European debt crisis. Unfortunately, the deal is a cease fire not a conclusive peace treaty.

The deal includes an Euro 109 billion second bailout for Greece, provided by the European Financial Stability Fund (“EFSF”) and the International Monetary Fund (“IMF”) with a “voluntary” contribution by private sector bondholders, in deference to German insistence.

The new package reduced interest rates charged to Greece to 3.5% per annum, as well as lengthening the maturity of loans to from the current 7.5 years to a minimum of 15 years and up to 30 years, with a grace period of 10 years. Portugal and Ireland were also offered the more favourable loan terms.

In order to reduce the risk of contagion, the powers of EFSF were increased, enabling it to buy bonds in the secondary market (previously only allowed in the primary markets) and buy equity stakes in banks. The EFSF was also authorised to take pre-emptive action where required. The change is less significant than suggested as the EFSF just takes over the role played by the European Central Bank (“ECB”), which has been active in buying sovereign bonds.

The program called for European public investment to help revive the Greek economy, dubbed by French President Nicolas Sarkozy – the European “Marshall Plan”, the $13 billion US plan to help rebuild Europe from the effects of World War 2. Details of the public investment plan and other elements of the grand compact are sketchy.

Significantly, the EU plan recognised the need for writedowns in the outstanding debt of the peripheral economies. The EU accepted that the extension of debt maturities by private lenders would result in a technical, though hopefully short lived, default.

The ECB, which had vociferously opposed any “default”, was bought off. Other countries agreed to cross guarantee the (possibly defaulted) Greek bonds provided to the ECB as collateral for funding. This protects the ECB from losses on its Euro 130-140 billion exposure to Greece, which is supported by only Euro 5 billion in capital (being increased to Euro 10 billion).

Several elements of the plan must be ratified by national parliaments in the Euro-zone members, expected by September 2011 although event may force this to be accelerated.

Christine Lagarde, the new President, has been guarded about further International Monetary Fund (“IMF”) participation, reflecting increasing opposition from emerging market countries. The IMF’s share of the first Greek bailout package was Euro 30 billion with a similar level of participation required in the second. If the entire European bailout fund was activated, the IMF’s share would be around Euro 250 billion. Representatives of India and Brazil have voiced concerns about the wisdom of the size of the current exposure, let alone any increase.

The level of “voluntary” private sector participation is unknown. It is also conditional on IMF participation, which itself is uncertain. Given its abysmal record to date and its rapidly deteriorating financial position, there is also no guarantee that Greece can meet the EU/ IMF conditions required for release of funds.

An effective plan must reduce the debt burden of the over indebted countries. In addition, any effective plan must limit contagion – the spread of problems to the banking system, other vulnerable countries such as Spain and Italy, which are both “too big to save” and “too big to fail”, and stronger European countries, especially Germany and France. An effective plan must address deep seated structural problems, increasing the level of European growth rates and correcting intra-European financial imbalances.

The new plan even if it can be implemented does not adequately meet any of these challenges.

Debt Fudges

Economists accept that the debt levels in Greece must be reduced by around 40-60% for the country to have any prospect of returning to growth and solvency. But the central premise of the EU plan is not to reduce debt. It replaces private lenders with official lenders, who are increasingly being subordinated, that is ranking behind, to private lenders as they get paid out after banks and other investors. If the two bailout packages are fully implemented, official lenders will total around Euro 219 billion, over 60% of Greece’s current total debt of Euro 340 billion.

The only debt reduction relies on a complex plan put forward by the Institute of International Finance (“IIF”), a lobby group representing major banks and investors. The plan requires a “voluntary” exchange of maturing Greek bonds for new bonds, with longer terms of 15 to 30 years with rates of between 4.50% to 6.42%, with higher interest rates deferred over time to give Greece immediate relief. In most cases, the repayment of the bonds will be secured, partially or fully, by collateral – 30 year zero coupon AAA Bonds to be paid for by borrowing the funds from the EFSF.

If implemented, the IIF plan provides financing to Greece of Euro 54 billion from mid-2011 to mid-2014 and up to a total of Euro 135 billion from mid-2011 to end-2020. Greece’s debt maturities would extend from an average of 6 years to 11 years. The reduction in the level of outstanding debt will be Euro 13.5 billion. Further reductions are possible through an unspecified debt buyback program.

The IIF debt exchange proposal is generous to banks and investors, allowing them to minimise losses transferring the major proportion to European taxpayers. The offer provides political cover for the EU to claim private sector participation and loss bearing but does not improve the sustainability to Greece’s debt position.

At worst, banks suffer a loss of around 21% on the value of their Greek bond holding, compared to losses of around 40-50% implied by current market prices. The need for AAA collateral to provide a principal guarantee will mean that Greece will need to increase borrowing by (up to) Euro 38 million (around 11% of its total debt) in the short term. Greece benefits in the long run when eventually the bond will be paid off and the monies in escrow released (as long as it does not default on the new bonds). In the meantime, it adds around 1% on its interest costs on bonds subject to the exchange.

Under the plan, Greece’s debt is reduced, at best, by around 10-12% of Gross Domestic Product (“GDP”). Given that the level of debt is around 150% and expected to increase further to 175% if EU/IMF plan targets are met, the reduction is far short of the required level of debt reduction.

There is confusion over the economics of the exchange plan and also the institutions that have agreed to it. Given the conditions applying to the plan, it is unclear whether the expected 90% participation rate will be reached.

The need for debt relief for Ireland and Portugal has not even been considered. The EU has repeatedly stated that this plan is only a “one-off” for Greece.

Dud Prophylactics

The EFSF is now tasked with preventing contagion by re-capitalising financial institutions, providing funding to nations and banks as required and intervening in the bond markets to ward of speculative attacks on vulnerable countries, read Spain and Italy.

The EFSF’s mandate is unclear. On 27 July 2011, Wolfgang Schaeuble, Germany’s Finance Minister told Bloomberg that: “The German government rejects a ‘blank check’ for the European Financial Stability Facility to buy bonds of troubled euro members in the secondary market, In the future such purchases must only take place under very tight conditions, when the ECB establishes that there are extraordinary circumstances in financial markets and dangers to financial stability.” The comments followed remarks by Chancellor Angela Merkel the day after the summit where she opposed allowing the EFSF’s “‘unconditioned’ bond-buying in the secondary market…”

When announcing the new measures, the EU elected not to increase the size of the EFSF. Taking into account existing commitments to Greece, Ireland and Portugal, the EFSF has around Euro 300 billion left out of its total resources of Euro 750 billion (including the full IMF contribution) available to meet any new commitments. It is doubtful whether the EFSF has the resources to play its super-hero role.

Ireland and Portugal may require additional funding. Italy and Spain must raise around Euro 700-750 billion in the period to the end of 2012 to refinance maturing debt and fund projected budget deficits. If they lose market access, then the EFSF may have to fund at least a portion of this. Even a precautionary credit line for a large country like Italy might total more than Euro 300+ billion.

In addition, European banks may need additional capital, estimated at as much as Euro 250 billion.

The EFSF does not have the money required, needing to issue bonds. To date, it has issued only Euro 13 billion. The EFSF’s ability to raise funds relies on its AAA rating, which is based on guarantees from Euro-zone governments. After Germany and France, the largest guarantors are Italy (18%) and Spain (12%). In effect, 30% of guarantees are from nations that might need support. If Spain and Italy were to require EFSF support, they could no longer effectively guarantee the fund, joining Portugal, Ireland and Greece on the “injured” list. The remaining Euro-zone members, principally Germany and France, would be forced to assume a larger share of the liability.

In a recent research piece, analysts at UK bank RBS estimated that containing the crisis could require a bailout facility of over Euro 3.0 trillion, providing an effective lending capacity of around Euro 2 trillion. The size of the facility is dictated by the fact that maximum lending capacity is limited by the guarantee commitments of the AAA countries.

If the guarantees are treated as debt, a facility of this size would add Euro 727 billion to Germany’s existing Euro 212 billion of guarantees (an increase of around 28% of German GDP that would bring its debt to GDP ratio to around 110%). France’s guarantee commitments would increase to Euro 705 billion from Euro 159 billion (around 27% of GDP bringing its debt to GDP to around 112%). The Netherlands’ France’s guarantee commitments would increase to Euro 198 billion from Euro 45 billion (around 25% of GDP bringing its debt to GDP to around 89%).

Stephen Jen, a currency strategist and former economist for the IMF, captured the essence of the problem: “The creditors are becoming the debtors ….The burden of support in the euro zone will become even more concentrated on Germany and France.” This will ultimately affect the credit ratings of these countries, causing financial problems if the contingent liabilities were triggered.

If the new plan fails to arrest the problems, Europe’s peripheral economies will be affected first, with problems spreading to Spain and Italy and perhaps Belgium. Increasingly, it would affect the stronger countries like Germany, France and the Netherlands. Rather then containing contagion, the EU plan risks spreading the crisis to the stronger members of the Euro-zone.