- Greece is now in too deep a hole - Debt restructuring is inevitable - Restructuring will be orderly so as to avoid contagion

By Greg Peel

“Greece is in a negative feedback loop in which high restructuring probability implies precarious debt dynamics, while such dynamics imply even higher default probabilities. We do not see any triggers – very high growth or draconian fiscal adjustment – that could move yields from current levels to those (6% or below) needed to stabilize debt dynamics in the near term.

“In our view, Greece is probably insolvent.”

What the economists at Barclays Capital are trying to say here is that Greece is now stuck between a rock and a hard place. It was over a year ago when Greek debt levels first hit the spotlight when the new government discovered that the books were in a much worse state than thought. Debt levels were well in excess of European Monetary Fund limits, fiscal policy was way too generous, and the great bulk of tax receipts were being lost to a black market economy. When bond traders started dumping Greek sovereign debt, Greece was in trouble. And that sparked contagion fears amongst the eurozone's other smaller, peripheral economies.

The US economy is also in a somewhat perilous state of excessive debt, but the Fed has been able to respond with quantitative easing – flooding the market with cheap funds to bounce the US out of recession so that it can then address the debt situation from a more stable vantage point. Greece never had that option given it is part of the euro common currency group. Indeed it is Greece's eurozone membership which has precipitated its demise, given strength in numbers meant Greece's currency was far more valuable than the small economy's currency should have been, leading to flagrant excess.

Eventually Greece was “bailed out” by a joint EU-IMF emergency fund, but in exchange for such support it was incumbent upon Greece to undertake strict fiscal austerity measures to reduce its debt levels over the next few years. Initially Greek bond yields settled back to lower levels, but not for long. They have since hit “junk” status of over 15%.

The problem is that the austerity measures hamper economic growth potential, making it harder to generate the taxes and other receipts needed to reduce debt. Weak subsequent GDP growth saw Greek bond yields begin to widen once more, and the higher the yield the more expensive it is for the government to refinance existing debt, placing an even greater burden on the economy. Hence the “negative feedback loop”. The EU-IMF initially thought it had struck the right balance, but that has proven not to be the case. There is always the problem of the so-called “bond vigilantes” who, through speculation, push up those yields in a self-fulfilling function.

An emergency meeting of officials from Germany, France, the EU and ECB was held last week and it was decided that perhaps a “soft” debt restructuring might be the only solution. However on Friday a German newspaper suggested there is disagreement on this strategy between Germany and the IMF on the one side and France and the ECB on the other. Squabbles lead to market uncertainty which only serves to exacerbate the problem.

From the moment Greece hit the headlines last year there have been fears of a possible debt default or at the very least a debt restructuring. A debt default means Greece effectively declares bankruptcy and does not pay on its sovereign bonds. Russia did this in the nineties and has managed to bounce back quite handsomely. Russian bondholders naturally lost a fortune, but the global impact was otherwise relatively minimal. It would be tempting for Greece to do the same, except that it is a member of the eurozone and thus can't make the decision alone. Eurozone officials do not want Greece to default given the domino effect it would cause across the zone, possibly destroying the euro for good.

Restructuring is a lot less dangerous albeit it still involves bondholders losing money and does not necessarily prevent contagion. Restructuring can take the form either of a straight forward “haircut”, in which all bond holders see their credit cut back to some amount in the dollar, representing a simple loss, or a “soft” restructuring, in which debt maturity is increased and coupon rate is reduced, and creditor losses are contained. Any restructuring is intended as a “work out” to avoid full default by keeping Greece solvent.

In October, Barclays Capital argued it was too early to consider Greek debt restructuring given the bail-out fund had not had time to make its impact, and under austerity measures Greece was not making the problem any worse. The caveat was that there had to be signs of success.

Barclays now suggests that success has become unlikely. The EU-IMF had assumed Greek yields would sufficiently fall once the package was put in place to thus allow Greece to refinance at a reasonable price, but yields have now blown out further still. Politics is a big part of the problem, given that the success the government has actually had in clamping down on spending and tax cheating has only resulted in popular unrest. The Opposition has jumped on the bandwagon, and there has been a lot of talk of Greece withdrawing from the EU (which, legally, it cannot). Were the current government to fall, anything might transpire, and that's a good enough reason for bond vigilantes to keep selling Greek debt.

Barclays believes the restructuring move will not be sudden or knee-jerk, but orderly for several reasons. The most important reasons are those related to contagion, and to who actually holds all the Greek bonds.

Most of the Greek debt held outside Greece is held by EU financial institutions, Barclays notes. The largest 30 holdings represent 65-75% of the total, and most of them are central banks or public institutions rather than private sector creditors. German and French banks alone hold 30%. It is one thing to slap a hedge fund with restructuring losses, it is another thing to slap the EU public sector.

This in itself suggests an element of pan-European contagion, but the real contagion fear is that if officials move too swiftly to restructure then the market will immediately assume Ireland and Portugal will not be far behind. This would mean further bond yield blow-outs on those countries, which in turn would make restructuring inevitable there as well. At this stage Spain is considered to be sufficiently out of significant danger, but contagion has a nasty way of escalating a problem.

Portugal and Ireland are also now under EU-IMF relief packages via bail-out funds. Unlike Greece, Barclays believes these programs do have a good chance of succeeding provided they are given more time to work. Thus to move too swiftly on Greek restructuring would be to blow that opportunity.

Barclays suggests the EU is most likely to continue supporting Greece as it can until end-2011. By this time Ireland and Portugal should be in better shape and contagion risk will be much lower. Then the Greek restructuring button will be pushed.

Barclays sees such an “orderly” process as the most sensible, and thus likely, outcome. It nevertheless still assumes EU-IMF programs will indeed succeed outside Greece and also assumes political instability anywhere does not derail the process. Were that the case, Barclays suggests restructuring could come sooner.

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