September 14th, 2011
in Op Ed
by Elliott Morss
There is great concern over what will happen in the Eurozone and the repercussions worldwide. These concerns stem in part from a general fear over what will happen. Below, I try to allay some of these fears by tracing out the most likely outcome. I also say what I would like to see happen. Follow up:
Setting the Stage
The Eurozone is a monetary union of 17 countries using the Euro (€) their currency. By agreeing to use a single currency, the member countries ceded control over monetary policy to the European Central Bank (ECB). This means one monetary policy for all countries, weak and strong. It also means that when their governments run deficits, they don’t have their own central banks to buy the debt.
The crisis started with a growing sense that the governments of certain members would have difficulty paying their bills. First it was Greece, but concern over Ireland, Portugal, Spain and Italy soon followed (for more on this, see my earlier article). Thing have deteriorated: according to the IMF: “Banks in Greece, Ireland and Portugal have significantly increased their government debt exposure during 2010. Shunned by financial markets and faced with deposit withdrawals, they survive only because the ECB meets in full their demands for liquidity against collateral of rapidly declining quality.”
Greece and Ireland have also agreed to austerity measures imposed by the ECB and the IMF in return for which they get low-interest money. The austerity programs are quite severe, and with unemployment already high in both countries, (Greece 16.6%, Ireland 14.4%), there is real question whether political pressures will force austerity program compromises.
There are economically strong and weak countries in the Eurozone. The strong countries (Germany and The Netherlands) are not happy with what is going on. In particular, they don’t like to see the ECB buying the debt of the weak Euro countries.
But most interesting and troubling, what started as a set of countries “living beyond their means” has now become an international banking crisis: for reasons described in my last article, banks foolishly bought large amounts of the weak Euro countries’ debt. So defaults on the debt could lead to a number of bank insolvencies. Sound familiar? Mortgages, sovereign debt, does it really matter what the risky instrument is?
Commercial banks in both the strong and weak Eurozone countries stand to lose a lot if Greece or any other Euro nation defaults on its debt. And the ECB is behaving more like a for-profit company than a central bank because it is also fretting about losing asset value if Greece defaults. And Germany is bothered by the large amount of weak company debt being bought by the ECB.
Most outside observers believe Greece has no option other than to default (see earlier article). I agree. Sooner or later, Greece will default. How much of a default? 25%, 50%, or what? No prediction from me, but current bond market prices are indicating that traders believe a substantial portion of Greek debt will default. However the market for Greek bonds is thinly traded and very volatile; prices could change drastically in a very short time, so the current bond market is not that reliable as a longer term indicator.
I hope Greece announces that at least for the next 5 years, it will stop making any debt payments, interest or principal. To provide perspective on what this would mean, the IMF estimates that amortization payments on the Greek government debt in 2011 will be approximately €100 billion. The government’s total revenues are about the same.
Such an announcement will cause an immediate panic. The market for the debt of other Euro “weak sisters” will take a hit.
Many are worried about what impact this will have on banks. Table 1 records bank claims on government. It indicates how much government debt banks of different countries are holding broken down by debtor nation. For example, the table shows that Germany is holding €14 billion of Greek government debt, €117 billion of Irish debt, etc.
But how big and how serious are these numbers for the banks? In Table 2, I address this question. The first row in that Table is the total external position of banks – read bank exposure) in billions of Euros. The columns below that are bank exposures by country as reflected in Table 1 as a percent of total foreign exposure. Some of the numbers are quite high – France, Germany, and Spain. The bottom reflects the extreme – complete contagion….
It is notable that Italy, UK, and US exposure is very low.
Given such large exposures, the European banks can be expected to do all they can to keep the Greek default to a very low level.
I pick up on my letter to President Papoulias from an earlier piece: “Let the banks, including the ECB, hang by their heels for a few years. And if they want to boot Greece out of the Eurozone, fine, let them. You can still use the Euro (or the US dollar if you want) as your currency. The President might ask “we still need financing, who will provide it?” My response: “You just eliminated government debt payments of approximately €100 billion annually. That includes a €16 billion interest payment. Without this burden, your bond rating will shoot up. There will be plenty of private finance available. You are a member of the IMF. Tell them you still need financing and are prepared to work for it under a modified austerity program.”
It will be interesting theater.
About the Author
Elliott Morss has a broad background in international finance and economics. He holds a Ph.D. in Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires. During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries. In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar. He has co-authored seven books and published more than 50 professional journal articles. Elliott writes at his blog Morss Global Finance.