GREEK CONTAGION SPREADS - TIME FOR PLAN B / ROUBINI GLOBAL ECONOMICS WEDNESDAY NOTE ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

RGE's Wednesday Note: Greek Contagion Spreads—Time for Plan B

Greetings from RGE!

Even as the IMF and the eurozone have virtually finalized an unprecedented three-year financing package of €110 billion for Greece, financial markets remain unimpressed. The common currency continued to plunge this week and long-term government bond yields in Greece and in the periphery countries, including Italy, spiked upward again after a short relief rally before the agreement. The market’s lukewarm reaction to the financing package confirms RGE’s view that a traditional financing package (Plan A), extended at unsustainable interest rates, will not allay solvency fears but rather will lead to a disorderly outcome and contagion. RGE has therefore consistently argued for a preemptive debt restructuring via maturity extension (Plan B) as the preferable solution for Greece. On May 4, Greek authorities confirmed that they contacted the investment bank Lazard for financial advice, but they categorically ruled out debt restructuring as an option under discussion.

Plan A includes the following core elements: €80 billion in bilateral loans will be provided by the eurozone at annual interest rates of about 5%, according to a previously negotiated formula, and €30 billion (i.e. 32 times quota) by the IMF through a standard stand-by arrangement. Although some eurozone member states—including Germany, which is facing regional elections on May 9—still have to ratify the unpopular disbursement, a new consensus has emerged among authorities and opposition that the main issue is not Greece per se but the gathering contagion to the rest of the eurozone. Unanimous approval by eurozone heads of state is due on May 7 at a special summit, following fresh reports that the Slovak government is holding up the disbursement for domestic election purposes.

The additional measures agreed by the Greek authorities will result in a front-loaded fiscal retrenchment of about 11 percentage points of GDP over three years with the aim to reducing the deficit below 3% of GDP by 2014. About half of the deficit reduction will come from expenditure cuts, the other half from tax increases and a broadening of the tax base, including from previously undocumented income. Greek authorities have accordingly revised down their growth forecast to -4.0% in 2010 and -2.6% in 2011 for a cumulative GDP volume retrenchment of 8.6% starting 2009. The debt ratio is expected to continue increasing, peaking at almost 150% of GDP by 2013 before starting to decline in 2014. The IMF will monitor the implementation of the program through quarterly reviews.

In the banking sector, €15 billion of the rescue package is earmarked for a “financial financial stabilization fund” aimed at credibly backing up the remaining €17 billion of the total €28 billion pledged by the authorities after the Lehman fallout. The major banks have already been downgraded to junk status by S&P, and other rating agencies might follow suit. Importantly, against previous assurances that the ECB would not ease the rules for one country alone, in an unprecedented U-turn the ECB has decided to suspend the minimum rating threshold for any Greek collateral with the ultimate aim to encourage investors to hold on to their investment. Indeed, as of the end of 2009, European banks hold claims of US$193 billion on Greece and more than US$1 trillion of further claims on Portugal, Ireland and Spain. It cannot be ruled out that the ECB will eventually have to resort to more aggressive measures such as buying government bonds in the secondary market in order to stop the contagion. While remaining reluctant, Jean-Claude Trichet has refrained from categorically ruling out anything at this point.

Conspicuously absent in a package of this magnitude is a private sector involvement (PSI) mechanism. One example would be to formally require banks to keep rolling over their loans to Greek banks and to the government rather than taking advantage of official financing to reduce their overall exposure. Indeed, S&P calculated that losses on Greek bonds might amount to over 50% in case of a default. In view of a potential request by the German opposition to include a mandatory PSI before agreeing to the disbursement, Spiegel magazine reports that Deutsche Bank CEO Josef Ackermann has reportedly offered to pledge as much as €500bn in credit to Greece on the same conditions as for the German government. Allianz is in talks about €300bn and Munchner Re might provide €200bn more. Other companies and countries might follow suit on a voluntary basis.

A “Plan B” model like the one RGE supports would give the periphery countries the opportunity to put their fiscal houses in order and push through the necessary structural reforms while benefiting from the enhanced financing package. The EMU also needs to revamp its institutional framework by devising an orderly debt restructuring mechanism at the least. It is important to be clear that if the planned fiscal adjustment under plan A fails to materialize, there might not be enough funding left to implement Plan B; thus, it is better to use official resources to absorb the collateral damage of a debt restructuring rather than wasting official resources to finance the exit of some private investors that will eventually not prevent an unavoidable debt restructuring.