El-Erian says Greece will default

April 29, 2010
Mohamed El-Erian has an important piece on Greece in tomorrow's FT; if you want to boil his 750-word article down to 3, it's basically "Greece will default".

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Mohamed El-Erian has an important piece on Greece in tomorrow’s FT; if you want to boil his 750-word article down to 3, it’s basically “Greece will default”.

El-Erian comes to this conclusion using three logical steps. The first:

A number of things have to happen very fast over the next few days to have some chance of salvaging the situation. At the very minimum, the government in Greece must come up with a credible multi-year adjustment plan that, critically, has the support of Greek society; EU members must come up with sizeable funds that can be quickly released and which are underpinned by the relevant approval of national parliaments; and the IMF must secure sufficient assurances from Greece (in the form of clear policy actions) and the EU (in the form of unambiguous financing assurances) to lead and co-ordinate the process.

And a squadron of flying pigs dropping 100-euro notes from helicopters across both the Greek and Iberian peninsulas would probably help too. The fact is that far from all of these things happening in the next few days, the base-case scenario is that none of them will. (The “sizeable funds” might appear, but don’t believe for a minute that national parliaments won’t object.) And on top of that, El-Erian notes drily that “the official sector has yet to prove itself effective at crisis management” — or, to put it another way, if you really think the IMF can cope with a Greek crisis, just look at how it coped at previous crises in Asia, Russia, and Latin America.

The second part of the argument is this:

The disorderly market moves of recent days will place even greater pressure on the balance sheets of Greek banks and their counterparties in Europe and elsewhere. The already material risks of disorderly bank deposit outflows and capital flights are increasing. The bottom line is simple yet consequential: the Greek debt crisis has morphed into something that is potentially more sinister for Europe and the global economy. What started out as a public finance issue is quickly turning into a banking problem too; and, what started out as a Greek issue has become a full- blown crisis for Europe.

This, in a sense, hardly needs saying: all public finance crises are also banking crises. The world has never seen an insolvent country with solvent banks, and Greece won’t be the first. But of course it’s not just Greek banks we’re worried about here, it’s also other banks across Europe — French, German and Swiss banks in general, and Fortis, Dexia and SocGen in particular, seem to be particularly at risk. Greece has always borrowed heavily from abroad, and its lenders are now in a very tough spot; needless to say, all those banks will get bailed out before they’re allowed to fail.

Finally, concludes El-Erian:

Absent some remarkable change in the next few days, things will get even more complex for the official sector. It may have no choice but to combine its own exceptional financing efforts with talks on a controversial approach that will be familiar to veteran emerging market observers – PSI, or “private sector involvement”.

PSI is the polite way to talk about the restructuring of some of the sovereign debt held by the private sector. It is based on a concept of burden-sharing in a disorderly world. It can appeal to governments as a seemingly easy way to ensure that massive public sector support to crisis countries does not flow back out in the form of payments to private creditors. Yet PSI is also hard to design comprehensively, harder to implement well and involves collateral damage and unintended consequences.

This is the “Greece will default” bit. El-Erian doesn’t quite come out and say so directly, but that’s how I read his “may have no choice but to” language: it’s about as close as the CEO of Pimco can come to saying that Greece will default without being accused of inciting panic. He even provides the requisite euphemism for the public sector to use: “private sector involvement”.

Consider the alternative, which is that the bulk of any EU/IMF bailout package would go to paying off in full all those speculators who have been buying Greek debt at 18% interest rates. It’s the too-big-to-fail problem all over again, exacerbated by the fact that if Greece gets a bailout, you can be sure that other countries are going to want one too, starting with Portugal, and working on from there. At some point, the German population simply won’t abide it: they’ve got their fiscal house in order, and they understandably don’t want to spend their hard-earned euros on paying off the debts of countries which, as Tyler Cowen puts it, “have been pretending to be much wealthier than they really are and to make financial plans on that basis”.

A Greek bailout package — any bailout package, really — is much more palatable when there isn’t anybody obviously being bailed out: when the distressed and insolvent borrower has to endure painful austerity, and when its lenders too suffer a certain amount of pain. To put it in US terms, we’re looking for something much more like GM or Chrysler, and much less like Bear Stearns. But of course GM and Chrysler were put into bankruptcy, and there’s no such thing as sovereign bankruptcy, which makes the whole problem that much more difficult and prone to what El-Erian calls “collateral damage and unintended consequences”.

El-Erian talks about how this approach “will be familiar to veteran emerging market observers”, but there’s a lot going on here which we haven’t seen in emerging markets before: a debt-to-GDP ratio of well over 100%; a country facing default which still has two investment-grade credit ratings; and, of course, the formal economic and monetary ties to risk-free developed nations.

It’s worth remembering Mexico’s tequila crisis of 1994-5. That was a liquidity crisis, not a solvency crisis, but even then the US bailout (a now-tiny-seeming $20 billion) had to come from a little-known Treasury slush fund since there was no way that it was going to receive Congressional approval. What’s more, the US ended up making a profit on that bailout, while as every German knows, any Greek bailout funds are unlikely to be repaid in full. And the US aid was extended only after Mexico had devalued and thereby become competitive again.

It’s impossible for Greece to devalue without defaulting, given that all of its debt is in euros. El-Erian doesn’t talk about devaluation in his article, but it’s clearly still a possibility. A default, meanwhile, is increasingly looking like it’s probable in the short-to-medium term, and near-certain in the long term. Countries have come back from high debt-to-GDP ratios in the past. But not with interest rates at these kind of levels, and only through devaluation.

I think I’m going to go join Paul Krugman under that table.


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