1. To provide debt reduction and solvency relief for Greece – but it is important to note that a potential debt restructuring would not necessarily remove the need for fiscal austerity and structural reform, as both these are necessary to achieve a primary surplus and recover competitiveness – nevertheless, it can reduce the execution risks.
2. Win political support in creditor European Union (EU) countries – particularly in Germany, Netherlands and Finland – and with the International Monetary Fund (IMF) for continued financial support for Greece.
3. Identify the unintended consequences of restructuring, namely potential contagion and the accompanying policy measures that could counter a disorderly process.
1. Greek BanksThe Greek banking system would be the most affected by any restructuring because of its large holding of Greek government debt. According to the Bank of Greece, Greek banks held €47 billion in Greek government securities in May 2011 compared to only €28 billion of capital and reserves (excluding bad loan provisions).
The first problem for Greek banks is the ECB’s insistence that Greek bonds would be ineligible as collateral in a repo transaction if downgraded to a “selective default.” This is a big deal as Greek banks currently borrow €98 billion, mainly backed by Greek government bonds or government-guaranteed paper. A withdrawal of ECB liquidity would therefore trigger a bank run in Greece and raise the odds of something similar occurring in Ireland and Portugal. But the policy response here is relatively straightforward. If the ECB refuses to waive its collateral standards for regular open market operations, it could provide liquidity for other non-government collateral, such as loans, through the Emergency Liquidity Assistance (ELA) program. This is currently being used in Ireland where Irish banks are receiving Eurosystem funding via the Irish Central Bank for assets that are not eligible for regular ECB open market operations.
The second issue is a recapitalization of the Greek banking system. Regulatory forbearance means that Greek banks are not marking Greek government bonds to market and hence retain the fiction of healthy regulatory capital. This could continue after a restructuring but it would prevent Greek banks from returning to the market and means that the Greek international trade would be constrained by the increasingly worthless letters of credit from Greek banks.
It also means that the steady depositor outflows would continue, draining the system’s lending capacity and creating the risk of a sudden loss of confidence and a bank run. The ideal policy response would be a recapitalization of the Greek banking system alongside a sovereign debt restructuring. Ideally, the capital will be invested directly in the banks by an EU entity, such as the European Financial Stability Facility (EFSF), as lending money to the government to invest in banks will increase sovereign solvency pressures.
2. European Banks and the Payments and Settlement SystemThe direct exposure of the European banking system to Greece appears manageable and the detailed data in the bank stress tests should allow investors to precisely identify the potential direct losses and related capital raise.
European banks have reduced their exposure to the Greek government and banks over the last year (see Figure 3). Aside from Germany, the total exposure of the main European banking systems to Greece, Ireland and Portugal is now well below 10% of capital. However, contagion is often more about risk aversion in the face of what is not known rather than what is known. As such, we would expect investors to hoard liquidity both in euros and in the USD funding markets. Some banks may need to raise more capital to reassure investors.
The policy response to a liquidity crisis is now well established following the failure of Lehman Brothers in 2008. It typically involves unlimited liquidity, loosening of central bank collateral standards and a reutilization of the Fed-USD swap lines.
Some banks may be able to raise equity from private markets but for banks that are forced to turn to their governments for their funding needs, the ideal vehicle would be a Europe-wide bank recapitalization fund. With a small change in its terms and conditions this function could be performed by the EFSF. A Europe-wide bank recapitalization fund would avoid a repeat of the Irish problem, where the cost of recapitalizing the banks raised doubts about the sovereign’s solvency, ultimately raising the cost of credit and resulting in the loss of market access for the whole economy.
Finally, to reduce the risk of bank runs in case of future sovereign crises, a Europe-wide deposit insurance scheme backed by a single European regulator and guaranteed by all eurozone governments should be introduced. Without such a deposit insurance scheme the cost of credit to eurozone households and corporations will vary from country to country, thereby placing at odds with the single monetary policy set by the ECB. This would also help reduce the counterparty credit risk in the payments and settlement system.
3. European Sovereigns
Contagion to other European markets will be the most politically challenging channel to contain. Repeating the policy prescription for Greece, Ireland and Portugal (i.e., combining fiscal austerity with liquidity support) will not restore confidence and overlooks the problem with increasing the size of the EFSF to fund Italy. Instead, European leaders need to take steps toward greater fiscal integration. The obvious example is the proposal for a common eurozone bond, but less radical measures include making the EFSF a joint and several liability system where the liability is shared between member states, increasing its size substantially and allowing it to buy bonds without the sovereign necessarily being on an IMF program (i.e., a flexible credit line). Alternatively, governments could guarantee other sovereigns’ debt issuance in a way similar to the post-Lehman government guaranteed bank issuance schemes. The objective has to be to ensure that higher rates and volatility associated with a liquidity crisis do not create self-fulfilling prophecies and trigger solvency crises.
Clearly there has to be political compromise. In return for fiscal union governments will also have to accept limits on their own fiscal sovereignty. Such pooling of sovereignty will take time to legislate and in the interim the ECB is the only institution with the size and credibility to contain the crisis by executing a large-scale asset purchase program in a similar fashion to the Federal Reserve, Bank of England and the Bank of Japan.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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