How Greece could avoid triggering a Lehman moment

May 10, 2011

By Hugo Dixon and Neil Unmack
The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

LONDON — Restructuring Greece’s debt is both desirable and inevitable, despite European Union insistence at the weekend that it is off the table. But restructuring could also cause mayhem throughout the euro zone. Indeed, many speak about a possible “Lehman moment” — a shock so severe that it would cause banking crises and domino bankruptcies throughout Europe.

The fears are genuine. But this should be an incentive for learning the lessons of the Lehman Brothers crisis so that, when Greece’s debts are restructured, the rest of the euro zone can withstand the tremor.

Greece’s debts are officially forecast to hit 159 percent of GDP in 2012. Sustaining such a burden would require so much austerity that the economy would be crushed for years. The country isn’t about to run out of money tomorrow, because it is supported by a 110 billion euro European Union/International Monetary Fund programme. But the government is only funded until early next year, and will need to raise 27 billion euros in 2012.

European finance ministers are discussing ways of getting Greece over the hump. Ideas doing the rounds include making the bailout terms more generous, and providing extra cash. But there’s still logic in restructuring Athens’ debt soon. With every month that passes, more bailout money gets used to pay off private debt, helping those who lent to it foolishly at the expense of taxpayers in other countries.

But how to prevent a restructuring becoming a Lehman moment?

First, haircut Greece’s debt by about 40 percent, so that its peak borrowings are just under 100 percent of GDP. This relatively high level will help maintain pressure on the Greek government to go ahead with a privatisation programme that could cut the ratio by another 20 points. It will also serve as an incentive to further reform. What’s more, a new benchmark of 100 percent would limit contagion to other weak economies such as Ireland and Portugal — whose peak debt/GDP ratios are forecast at 118 percent and 107 percent respectively. Why would Dublin or Lisbon bother to restructure for such limited benefit?

Second, recapitalise the Greek banks. A failure to do this would destroy the country’s financial system and cause depositor runs elsewhere. The answer is simple: bailout money. About 15 billion to 20 billion euros of extra money should do the trick — much less than the 130 billion euros Greece would save by haircutting its debt.

Third, recapitalise weak banks elsewhere as soon as the latest Europe-wide stress tests are published next month. The Irish have already had a capital injection; and the Portuguese will get one as part of the bailout plan currently under negotiation. That leaves French and German banks, which have some $541 billion of exposure to peripheral economies, and Spain’s savings banks, which could cause trouble given that Madrid itself isn’t totally out of the woods. If Greece restructures its debts, there won’t be any prizes for others who twiddle their thumbs.

Finally, provide banks with medium-term funding if they can’t raise money in the market. It’s often forgotten that government guarantees for banks’ medium-term debt were a key element in shoring up the global financial system after Lehman went bust. Injecting capital on its own is not enough. Look at how Irish banks still struggle to raise funds.

Ideally this would be the job of the European Financial Stability Facility, the zone’s bailout fund. But sadly, this idea has been caught in a game of pass the parcel. The ECB’s attitude is that providing medium-term funding is the EFSF’s task, while governments think it’s the central bank’s role. The result is that Portugal’s banks, for example, won’t receive medium-term funding from either. Instead they will get guarantees from their own government, which won’t really do the trick given its poor credit.

If Europe carries on like this, it may well face its own Lehman moment.

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