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Is a Greek default so bad for Greece?

2011-06-29 10:22:28

Robert Peston Business editor

Sir David Tweedie, the retiring head of the International Accounting Standards

Board, told this morning's Today programme that he feared banks were still not

putting aside enough money in provisions to cover the significant risk that at

some point Greece will default.

As you might expect, he blamed the banks themselves for a wilful refusal to do

what's right and prudent, rather than accounting standards which some argue

have been defective for not putting more pressure on banks to set aside money

to cover the risk of losses on loans that the banks intend to hold to maturity

(or loans in the so-called banking book).

The bank accounting issue has been explored here a few times before.

But the important point today is that it explains why eurozone leaders and the

European Central Bank are so keen to avoid what bankers call a "credit event"

in respect of Greek government debt: if there were a default by the Greek state

even on a tiny element of what it owes, bankers would be forced in one fell

swoop to write down the value of their loans to the government and probably

take losses on associated credit too.

Now total loans by non-Greek banks to the Greek public sector are $54bn on the

basis of the latest figures from the Bank for International Settlements and a

further $11bn has been lent by international banks to Greek banks.

It's reasonable to assume, most analysts say, that banks would have to write

down the $54bn and the $11bn by half in the aftermath of a Greek default -

since half of what it owes may be what Greece can afford to repay in the long

term, and because a Greek default would probably force Greek banks into

insolvency.

Or to put it another way, international banks would at a stroke face losses of

around $33bn.

Now the head of one major bank told me his institution had already made a 15%

provision to cover the risk of default by Greece.

So on the assumption that its behaviour has been typical, the immediate loss

for banks from a Greek default would be around $23bn.

But that's by no means the end of the story.

Continental concern

It's very interesting that a memo from the Federation Bancaire Francaise (the

French Banking Association) on the voluntary scheme proposed by France to roll

over Greek government debt - leaked yesterday to FT Alphaville - says that it

is "critical" that the roll-over scheme should "prevent credit event (sic) on

Greek CDS".

A CDS or credit derivative is a contract that pays out to the holder when a

creditor defaults: it is insurance against loans going bad.

So plainly there is a fear among eurozone governments that the losses faced by

the banking system would multiply from claims made on CDSs.

That said, it is difficult to quantify the potential additional hit. BIS

figures say international banks' potential exposure to Greece is $61bn -

including $44bn of guarantees extended and $7bn in derivative contracts.

And as I've mentioned before, more than half of that potential exposure, or

$34bn, is with US banks.

Anyway, long story short, in a worst case where Greece defaults and banks are

forced to take writedowns on all their loans to Greece - including private

sector and bank loans - and where there's damage too from potential exposure,

the international (non Greek) banking sector is looking at losses of more than

$100bn.

Which is a non-trivial sum to lose for banks that are long way from being back

to full health after the great crash of 2007-8.

Domino effect

And if you are curious about why France and Germany appear to be the bosses of

the process of attempting to secure Greece's financial future, it is not just

that they have the biggest economies in the eurozone: their banks have the most

to lose from a Greek default, with French banks most exposed.

Also, as I've mentioned before, that $100bn of potential losses for non-Greek

banks becomes multiplied by many times if a Greek default were to spark more

acute financial woes for the dominoes next in line, Ireland and Portugal.

George Papandreou Mr Papandreou has a majority but some deputies are under

pressure from constituents to vote no

And if the Spanish domino also started to wobble, well let's not dwell on that

hideous possibility.

So it is blindingly obvious why eurozone governments would prefer that Greece

didn't just run out of money to pay its creditors in an unplanned and chaotic

way.

But what about Greece itself? Well here's the curious thing. It may well be

insane - or indeed "suicide", in the words of Greece's central bank governor -

for the Greek parliament today to vote against the proposed austerity package

and thus in theory cut itself off from the eurozone's and IMF's credit

lifeline.

Apart from anything else, it is quite hard to argue that Greece would be

advised to continue living way beyond its means, which its intractable

public-sector deficit of around 10% of GDP shows that it is doing.

However the fundamental reason for doing what France and Germany want, right

now, may be slightly different from the official explanations.

Wait and see

Here's the thing: if the Greek government were to miss a payment on a bond as

it fell due, the immediate impact on the finances of the Greek government would

be considerably less than the trauma that such a default would cause for the

international banking system.

According to bond-market experts, banks and investors who've provided much of

the 340bn that the Greek government has borrowed in total would have to

whistle for the rest of their money - because a default by Greece would not be

the equivalent of a default by a private-sector company.

When a company defaults, the creditors are automatically in the driving seat,

and - usually - can demand all their money back.

The legal advice to creditors of Greece however is that they have no such

power.

If Greece were to miss a payment of interest or principal on a Greek bond,

creditors could sue for the missed payment.

But there seem to be no clauses in the prospectuses for Greek government bonds

that would trigger accelerated payment of the rest of what's owed on any

particular bond in default or that would put other bonds into default: in the

jargon, there are no accelerated payment or cross-default clauses.

So in the aftermath of a default, creditors would in theory have to sit still

and wait over many years to find out what Greece either could or would want to

pay back.

And, what may be even more troubling for Greece's creditors, most of the bonds

are issued under Greek law, not international law.

So in theory if cross-default or accelerated payment clauses were unexpectedly

to turn up in bond documentation, the Greek parliament could legislate to make

them null and void.

Or to put it another way, in the immediate aftermath of a Greek default, the

Greek government would have quite a lot of power to dictate restructuring and

repayment terms to its creditors.

Greece could choose to pay back more-or-less what it thought it could afford to

pay back.

Why then is the Greek prime minister so adamant that default must be avoided?

Is this a manifestation of fraternal solidarity with his eurozone partners?

Possibly not entirely.

Domestic costs

Right now Greece needs to borrow money from the rest of the eurozone and from

the IMF not just to service the interest and principal payments on its debt.

It also needs the emergency credit to pay the wages of its civil servants and

to keep the lights on in schools and hospitals.

Greece has what economists call a primary fiscal deficit, in that what it

raises from taxes does not cover the basic running costs of the state, let

alone its borrowing costs too.

So Greece can't afford to stick two fingers up to Germany, France and the

eurozone and announce a unilateral decision to default. If it were to do that,

the vital apparatus of the Greek state and the Greek economy would grind to a

halt.

That's true now. If however Greece's austerity measures were to turn out to be

successful in reducing Greece's primary deficit - such that it was able to pay

all the costs of the police force, schools, hospitals and so on from tax

revenues - then at that point Greece would be less dependent on the putative

generosity and charity of its eurozone neighbours.

You will know that there are economists who believe that there's no chance the

austerity package will reduce the primary deficit to nil, because of how it may

be putting the Greek private sector into a death spiral.

But let's assume those economist are wrong and the Greek premier is right.

If that were the case, it could still be misguided to see a vote today for the

austerity package as the moment when Greece avoids default.

If Greece's parliament goes for the package of cuts, tax rises and

privatisation, that may be the start of a process to make a Greek default

affordable and bearable for Greece.

Or to be more explicit, the moment that Greece reduces its primary deficit to

zero - the moment that the government can fund itself from revenues levied on

its own people - is the moment when Greece is most likely to decide to default

on what it owes overseas investors and banks.