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(no subject)  James Cumes
 Jun 21, 2011 01:24 PDT 

21 June 2011

European Debt Crisis: Backsliding
Satyajit Das

Skin in the game

The EU bailouts have always primarily focused on protecting European
banks from the effects of a default by borrowers such as Greece, Ireland
and Portugal. In total, banks in Germany, France and the UK have
exposures of over 500 billion euro to these three countries. If exposure
to Spain is included, the total increases to around 1 trillion euro.

Much of this debt – in the form of sovereign debt, lending to banks and
also structured securities based on mortgage and corporate loans – is
held by smaller banks in France and Germany. If Greece, Ireland,
Portugal and (ultimately) Spain have to restructure the debt, then these
banks will suffer significant losses. Default or restructuring of
European debt, in all probability, will require state involvement in
recapitalising these institutions. In essence, attention will switch
from bailouts of sovereign nations to bailing out affected national

Default or restructuring would also affect the ECB, which holds around
50 billion euro of Greek debt alone. The ECB's total exposure to Greece,
including lending to Greek banks and loans against Greek government
bonds, is much higher – 130-140 billion euro.

If Greece defaults, then the ECB could suffer losses as high as 65-70
billion euro (say 50 per cent of the amount advanced). The losses would
almost certainly require recapitalisation of the ECB itself by Euro-zone
members. As at January 1, 2011, the ECB had paid up capital of 5.2
billion euro (due to be increased progressively to 10.8 billion euro).
The ECB is owned by the 17 euro-zone central banks with the combined
capital of around 80 billion euro.

The ECB's position on whether peripheral countries like Greece should be
allowed to default increasingly appears to be complicated by its own
vulnerable financial position. When Lorenzo Bini Smaghi, an Italian
board member, stated that a Greek debt restructuring would be "suicide"
he may have been referring to the ECB. Statements about Anglo-Saxon
"vested interests" seeking the restructuring of Greek debt are now
matched by the ECB's "self interest" in avoiding the same.


In the near term, the EU and Euro-zone members are likely to persist
with the failed strategy. Further funding needs will be accommodated as
they emerge from the existing facilities as much as possible, until
these are exhausted. German insistence on commercial lenders sharing
some of the burden has wavered. Instead a fuzzy idea of a "voluntary"
commitment of existing lenders to refinance existing, maturing debt is
now under discussion.

Over time, the palpable failure of the bailout strategy will
progressively be revealed. Pressure will emerge to improve the term of
the bailout package.

Already, Greece has received reductions in interest rates on bailout
funding and some extension in the terms of the financing. The need to
provide additional funding to Greece of around 120 billion euro is under
discussion. In all probability, some deal will be done to provide the
funds, against Greek promises that cannot and will not be met. There
will be more and more of the same, in a desperate effort to avoid
default or restructuring.

In the end, default or restructuring will become inevitable, as other
choices are exhausted. Initially, minor changes, such as lowering
coupons and extending maturities, perhaps as part of debt swaps, will be
sought to manage the problem. Ultimately, a major restructuring,
involving a significant write off of outstanding debt is likely. This is
the case for Greece and perhaps the other peripheral countries.

Based on history, a loss of around 30-70 per cent of the face value of
obligations is expected. The longer the time taken over the process, the
greater the likely losses to holders of the obligations. The reason
being that unless the debt burden is reduced early, continuing high
servicing costs and deficits will continue to increase the level of
write-off necessitated to restore solvency.

A political matter

European decision-making increasingly echoes Shakepeare's Richard II's
lament: "I wasted time, and now doth time waste me."

The EU, ECB and major Euro-zone members, notably Germany and France,
lack the political courage or will to tackle the problem. The absence of
an "easy" and "painless" solution means that career politicians and
Euro-crats see no benefit in advocating the complex and messy process of
default and restructuring.

European leaders dissemble that the debt crisis was the result of
traders and financial markets. Anders Borg, Sweden's finance minister
spoke of "wolf-pack markets". José Luis Rodríguez Zapatero, Spain's
prime minister, blamed "cynical hedge funds", "cocky credit-ratings
agencies" and "neoconservative capitalism".

Greek prime minister, George Papandreou, accused traders of visiting
"psychological terror" on his country.

Michel Barnier, the European commissioner for the single market. accused
financial institutions of "making money on the back of the unhappiness
of the people". Zapatero also found fault with a duplicitous Anglo-Saxon
press. In short, it seems anybody but the Europeans are to blame.
Cognitive dissonance looms large.

The denouement to the European debt crisis, probably some way off, will
come via by the "street" or the ballot box.

In the afflicted nations, public protests and disturbances are
increasing as the populace rejects greater austerity. Populist
politicians, willing to reject the need for further "sacrifice" and
repudiate the country’s debt, hover in the wings. The argument that the
country will be an international "financial pariah" does not carry much
weight when you are already one with no-one likely to lend you money any
time soon. It also has less weight when you don't have a job and the
country is on the brink of social breakdown.

For the countries that must provide the bulk of the bailout money, there
is angst that the increased level of financing required by the problem
borrowers has turned the EU into a "transfer union". Discontented and
angry voters in Germany and other saving nations will at some stage also
decide to call time on the fruitless and self-defeating support for the
overly indebted Euro-zone members.

Having falsely linked the problem of over-indebted states with the
canards of the Euro and the survival of the Euro-zone itself, Europe is
increasingly drifting towards an inevitable, disastrous and
destabilising debt crisis. Rather than amputating a gangrenous limb,
European leaders risk poisoning the entire body fatally – weakening the
financial positions of the stronger Euro-zone members and their
economies, which are paying for the bailout and will suffer the losses
when the inevitable defaults come.

The effect on wider money markets and global economy of any defaults is
unpredictable. Depending on the quantum of losses and the
recapitalisation requirements, the event could create concerns about
affected Euro-zone banks, providing a channel for contagion in financial
market. This could destabilise markets, transmitting the shock through
high cost and reduced availability of financing, in a manner similar to
what happened after the bankruptcy filing by Lehman Brothers in 2008.

Satyajit Das is author of Extreme Money: The Masters of the Universe and
the Cult of Risk (due to be published by Penguin Australia in August
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