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Europe and the path to default

Europe and the path to default
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First Published: Sun, Jul 24 2011. 11 41 PM IST

Photo: Jock Fistick/Bloomberg
Photo: Jock Fistick/Bloomberg
Updated: Sun, Jul 24 2011. 11 41 PM IST
The European Union’s (EU) “confidence boosting” short-term “liquidity enhancement” programmes, unfortunately, have failed to resolve deep-seated structural problems that underlie the European debt crisis.
The deeply flawed strategy entailed providing financing to meet maturing debt and budget deficits at a time when markets were not open to the borrower or, at least, at reasonable rates. The “temporary” measures would provide a country with the opportunity to reform its public finances and economy to make its debt burden more manageable. In time, the measures would allow the borrower to regain the confidence of commercial lenders and regain access to markets.
The premise that it was a “liquidity” rather than a “solvency” problem was incorrect. Breaking ranks with other European central banks, Mervyn King, governor of the Bank of England, stated uncategorically that in his view it was an issue of solvency.
There is no way that any of these nations would ever be able to service or repay current and projected levels of borrowing. The EU facility provided a means for the distressed nations to repay maturing debt and finance their deficits. In effect, the EU and official bodies have replaced commercial lenders as debt providers.
Photo: Jock Fistick/Bloomberg
The bailout plan did not lower the nation’s interest costs or their access to markets. Interest rates on borrowing for Greece and Ireland are higher now than at the time of their bailouts. Despite the likelihood of EU support, Portugal’s cost of funds is unsustainably high. Spain and other countries, such as Italy and Belgium, seen as vulnerable by investors have seen their borrowing costs rise inexorably.
The bailouts have made it less, not more, likely that these countries will regain access to markets in the near future. As existing debts mature, the funding provided by official sources, is increasing. As these countries need additional financing, the absence of private financing will increase this proportion even further, leaving them to bear the bulk of losses in any restructuring.
The lack of confidence reflects the failure of the rehabilitation plans and the continued unsustainability of the debt levels of these countries. The lack of economic growth and deteriorating public finances is not likely to reversed soon.
The EU and euro zone members seem 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. A fuzzy idea of a “voluntary” commitment of existing lenders to refinance existing, maturing debt is under discussion.
Over time, the failure of the bailout strategy—extend and pretend— 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 is already 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. 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% 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.
European decision making increasingly echoes Shakespeare’s character Richard II’s lament: “I wasted time, and now doth time waste me.” The EU 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 Eurocrats see no benefit in advocating the complex and messy process of default and restructuring.
Having falsely linked the problem of over indebted states with the canards of the continuation of the euro and the survival of the euro zone itself, Europe is increasingly drifting towards an inevitable, disastrous and destabilizing 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.
When global markets lose confidence and optimism, things can turn quickly. Greece’s slide from a cherished, solvent member of the European familia took less than six months—in November 2009 Greece was borrowing at low rates; by May 2010 it required a bailout. As investors and markets focus, again and belatedly, on debt-laden and structurally weak economies, contagion effects may gain momentum rapidly.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk
Comments are welcome at theirview@livemint.com
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First Published: Sun, Jul 24 2011. 11 41 PM IST