Beware, the Day After Tomorrow Is at Hand

Wall Street Journal

It is now clear the euro zone stands at a crossroads, forced to choose between greater political integration and disintegration. And judging by the debacle over efforts to agree a new bailout package for Greece, it’s hard to dispute the growing consensus that the forces of disintegration are on top. Last week’s apparent agreement among the troika of the International Monetary Fund, the European Central Bank and the European Union to offer a new $60 billion aid package is already in doubt as member states haggle over the details. Yet the further European leaders descend into petty nationalism, the more likely the crisis will end with closer political integration.

European leaders are still divided over whether and how to make bondholders share the pain of bailouts, thereby easing the burden on euro-zone taxpayers. That’s a laudable aim, but no one has come up with a workable solution—hard restructuring, soft restructuring, reprofiling, maturity extension, haircuts—that doesn’t create more trouble than it was designed to avoid. The latest plan is to ask Greece’s existing bondholders to roll over maturing debt. That may yet offer a short-term fix, but it also raises the risks that further bailouts requiring much more radical solutions will soon be needed.

On the face of it, the bond rollover idea has obvious appeal. European banks already have an agreement with the ECB not to sell Greek government bonds, so asking them to maintain their exposure when existing bonds mature is a logical extension of that deal, according to a senior ECB official. Only a third of existing bondholders need to agree to roll over their exposure to the €90 billion ($132.2 billion) of bonds maturing in the next three years to cover the shortfall in the current bailout plan; Greek banks alone could make up much of this. Agreements by lenders to maintain exposure to struggling economies have been a successful feature of past bailouts, including those in Eastern Europe in 2008.

But past rollovers involved loans rather than bonds, making the current situation far more complicated. The key question is whether ratings agencies would classify a rollover agreement as a default. As things stand, the agencies are unclear; discussions with the ECB continue. The usual criteria to determine a default are that the bondholder must suffer a loss, or that there has been coercion such as subordination of old bondholders. A rollover might work if the terms of the new bonds were no worse than the existing bonds and if the arrangement were voluntary. The problem is the huge credit deterioration in Greece since the previous bonds were issued: if the ratings agencies believe that without the rollover Greece would default, they may conclude the exchange is coercive.

But even if euro-zone officials persuade the agencies, a rollover still risks many of the problems that have made the ECB resistant to any form of restructuring. In particular, a rollover, unless very carefully communicated, is likely to reinforce the belief that the euro zone will insist on private-sector involvement in all future rescue packages. This is dangerous territory. Whenever talk of private-sector involvement has surfaced during the euro crisis, yields on peripheral countries’ bonds have soared—notably during last year’s negotiations over the creation of the European Stability Mechanism to handle post-2013 bailouts and again when talk of Greek debt restructuring began in April.

Talk of automatic debt restructurings post-2013 under the ESM has been particularly toxic, ECB executive council member Lorenzo Bini Smaghi warned in a speech this week. Inevitably, it makes investors wary of buying any bonds that mature after that date. Worse, forcing the private sector to take losses as a first rather than a last resort will probably cost taxpayers more as they will bear the bill for recapitalizing banks; it rewards speculators who have bet against the euro at the expense of long-term investors who held on to their bonds; and it will prolong the time a country remains shut out of markets as investors will wait for conclusive proof that they are no longer at risk of debt restructurings. For the euro zone to continue pursuing this idea, says Mr. Bini Smaghi, suggests « strong masochistic tendencies. »

But the masochistic tendencies of euro-zone leaders may also explain the otherwise hard-to-fathom masochism of euro-zone banks that agree to support the roll-over plan. After all, banks have responsibilities to shareholders; it would take considerable moral persuasion to make a private-sector company voluntarily buy bonds that could well be subject to a haircut of up to 50% within a few years.

Banks may be gambling that the pain of debt restructurings will prove too great even after 2013, so they will escape without a haircut. « A lot can change in three years, » the chief executive of a Greek bank told me this week. Greece could deliver on its plan and Athens might be able to access markets again. There could be further bailouts. Or the euro zone may have accepted the need for common euro-zone bonds, allowing Greece to roll over future funding at low rates.

That may seem politically impossible. But the euro crisis is far from over: if the global growth slowdown continues, the market may start to doubt whether countries such as Spain, Italy and Belgium, currently just outside the danger zone, can meet fiscal targets. With the threat of private-sector involvement in any bailout hanging over the market, sentiment could change quickly. Any bailout of these countries would be well beyond the capacity of existing emergency facilities: new measures including a euro-zone bond and a euro-zone bank bailout fu\nd, plus all the political authorities needed to administer such a project, might be the only way to exit the ensuing crisis.

Last week, ECB President Jean-Claude Trichet caused commotion by proposing a European Ministry of Finance with powers to intervene in national economic policies. He called it a proposal for the day after tomorrow. If European leaders keep dithering, they may find that day arrives sooner than they would like.



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