Greek Loan Extensions to Punch Hole in EU?
By Staff News & Analysis - May 05, 2011

Greek Restructuring Isn't Straightforward … Markets are betting on a Greek debt restructuring sooner rather than later, with yields on bonds maturing in 2012-2014 at sky-high levels as a €27 billion ($40.04 billion) funding gap looms in 2012. But a restructuring might be harder to achieve than some suggest. – Wall Street Journal

Dominant Social Theme: A little extension is not going to bother anyone, not even the Germans.

Free-Market Analysis: The EU is reaching a deal with Portugal on a "bail out," which is illegal under EU rules (but who's counting?) What's more important is an upcoming, potential Greek debt restructuring, which is also illegal under EU rules. It doesn't make sense to us, and in this article we will explain why. If we are correct, the larger ramifications for the EU and the euro are serious indeed.

The restructuring, in fact, is a very strange occurrence as it crosses big, bright red line that the German electorate has drawn in the proverbial sand. Eurocrats can restructure (extend) debt at will it seems regardless of the rules but the German electorate can also vote out Ms. Angela Merkel, their chancellor, as they have already started to do piecemeal. The Northern states generally can make their displeasure clear via the voting booth and it is the newly elected politicians that shall apply the pressure Brussels must heed.

Any agreement that further alienates the German electorate would seem to be counterproductive to the survival of the EU as we know it. Thus we wonder how it can be accomplished. At the same time, the markets seem to consider it inevitable and keep valuing Greek debt lower and lower. Portugal and Ireland will no doubt come in for the same treatment and we believe Spain is on the same track to the same destination eventually.

What does it really mean? Perhaps a death knell for the EU as we know it. The "two track" EU is coming along with a two-track euro, or maybe the "no euro" for certain countries that remain in the EU without the euro. It is hard to see a way out of this situation as we have long been reporting. At least three PIGS are probably not going to be able to service their debt and pay it down as matters stand now. That means an extension (at the least) is necessary. But such an extension is a restructuring and this will eventually lead to Ms. Merkel's demise.

Merkel is not the only politician being hurt by this extension/restructuring talk. Several other EU countries are starting to peel away from the center and a frank restructuring of any sort will bring unrest not just from the PIGS but from the reliable Northern heart of the EU.

Eurocrats can do pretty much what they want in Brussells, but they cannot control the reaction abroad. They can implement a restructuring but the result may be a far more hostile group of Northern EU countries. Already there is a constitutional challenge pending in Germany to the current bailouts. One would think that the pushback will grow more severe as those in Brussels continue to tinker with rules that forbid the kinds of bailouts now ongoing.

The idea was that a financial crisis would bring EU nations closer together. This is in fact occurring as Brussells is gradually and without fanfare acquiring additional budgetary powers over the EU nations. (We have reported on this in the past.) But a Greek restructuring would be disastrous in ways that are not being mentioned in any articles we can find. It is in Germany, the locomotive and beating industrial heart of Europe, that the impacts would likely be most profound.

First, the impact would presumably be significant on German banks that hold a good deal of Greek debt and this would eventually be costly to some if not all of the German electorate. Second a restructuring, even one that merely lengthens maturities, is bound to have a negative impact on the euro itself, also affecting the Germans along with everyone else. Finally, if the restructuring is voluntary, there is a big question as to whether any bondholders would wish to avail themselves of it. Here's more from the Wall Street Journal:

First, an involuntary restructuring, forcing bondholders to take a haircut on their debt, is extremely unlikely. An outright default would pose huge risks to both the Greek and wider euro-zone economy, including the still-fragile banking system. The European Central Bank, now a major creditor of peripheral European economies thanks to its bond purchases, violently opposes any restructuring fearing a bond market meltdown.

A default would also be politically unpalatable given the euro-zone's commitment that any restructuring prior to the introduction of the European Stability Mechanism in 2013 would be voluntary. Plus a haircut would trigger credit default swaps—and thereby reward investors whom politicians have previously condemned as speculators.

Sure, a voluntary restructuring—in particular an effort to ensure private creditors either extend or roll over their holdings of bonds and thus reduce the funding pressure—might make some sense. But it would only buy time and would do nothing to reduce Greece's debt pile, likely to reach nearly 160% of gross domestic product by 2012. And it begs the question of how to get investors, who might fear that a haircut is only being delayed, to take part.

The Journal points out that the "stick is not a credible option." There are logical reasons. As an involuntary restructuring is acknowledge as impractical (given the potential for a bond meltdown), any extension must be voluntarily accepted as well. This goes for banks as well as private investors.

The Journal suggests that those bondholders at Deutsche Bank (holding €159 billion of Greek debt at the end of 2010) will need incentives. Euro zone guarantees might help; alternatively the bonds could be collateralized. But as the Journal notes, this does nothing to tackle the real issue, which is that Northern states want LESS exposure to PIGS debt and the risks it carries. A euro-zone bond issuance would run up against the same problems; any direct involvement of the Eurozone inevitably involves the North – and the Germans – in a further bailout. And there are already questions about the constitutionality of what has take place thus far, which is relatively mild.

The Journal article concludes that the Greek leadership has done all that has been asked of it. The entire IMF spectrum of antidotes has been applied. Greece has announced a US$100 billion "privatization" program and has begun spying on citizens' swimming pools in a US$25 billion tax evasion crackdown. It has reduced public expenditures slashed public services and raised taxes as part of its austerity program. The trouble is that these IMF remedies often don't work and are even – in the case of tax increases – counterproductive.

"Politics in Europe will no doubt play their part in determining the outcome for Greek creditors," the Journal article points out. We agree with that as we do with the perspective that Eurocrats "should think carefully before initiating a restructuring that they may not be able to deliver." But in this article we again ask what exactly are the choices that the EU member countries have?

We have been consistently pessimistic about the EU's chances of survival in it current form once the 2008 economic crisis hit. We think a restructuring of the EU is just as likely as a restructuring of Greek debt. It will NOT be driven by Brussels, which will break every sacred rule in every extant treaty to salvage the "union." The pressure will be applied by a slew of fresh faces – politicians that have been elected by infuriated citizens of the North who won't stand for any more manipulation. This process is already beginning.

We examine the situation logically and unlike the world's large mainstream publications, we always end up at the same place. The electorates of the Northern EU nations will not willingly take on the responsibility for what is seen as Southern profligacy. The Southern PIGS will begin to experience significant unrest later this year as the weather warms up. Between Northern intransigence and Southern unwillingness, we do not believe the political will can be mustered to market the necessary changes.

After Thoughts

Eurocrats don't want the market to dictate the fate of the PIGS but it looks to us as if that is exactly what is going to happen. The political will not be mustered. And once the market begins to run the EU rather than the other way around some sort of recalibration of the EU's political structure is all but inevitable. Either the political process runs the markets or the other way round. The political process increasingly looks tenuous and the market processes inexorable. If so, the ramifications for the EU and world markets will be significant indeed.

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