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An analysis of the second Greek bailout, warning that while a compromise is likely, Greece will require further assistance before long. Such action will increase the political cost of the crisis by spreading discontent in those countries, which continue to fund Greece. Greece must write down its debt before it is too late.
21 June 2011
EU member states have, in total, amassed quantifiable exposure to Greece of €311 billion (via their banking sectors, the bailout packages and the European Central Bank’s liquidity programme). France and Germany have exposure of €82 billion and €84 billion respectively, while the UK only has €10.35 billion exposure – although this figure is misleadingly low, as Britain’s huge exposure to other European banks leaves it vulnerable to any escalation of the crisis in Greece through indirect exposure and undermined market confidence.
On the surface, the interconnectivity of Europe’s economies and banking sector may seem like an argument in favour of another bailout. In a best case scenario, to carry Greece over until 2014 a second Greek bailout would have to cover a funding gap of at least €122 billion, in addition to the money the country is already receiving from its first rescue package. This assumes a scenario in which Greece can make good on its deficit targets and privatisation commitments. However, it is far from clear that Greece will meet these targets, not least given domestic resistance to more austerity measures. Therefore, the country’s funding gap leading up to 2014 could well be in the area of €166 billion, potentially requiring Greece to make a third request for external aid.
Despite a second Greek bailout being EU leaders’ preferred option, it is only likely to increase the economic and political cost of the Eurozone crisis. No country in modern economic history has faced similar debt levels to those of Greece – a debt-to-GDP ratio above 150% – and avoided a default. Even with the help of a second bailout and a debt rollover, Greece is still likely to default within the next few years, as the country’s poor growth prospects and growing debt burden mean that it will be unable to fund itself post-2014.
It is, therefore, better for Greece to restructure its debt as soon as possible. Then an honest discussion needs to be had about whether the country can realistically stay inside the Eurozone. A restructuring of Greek debt would require the Eurozone to enter unchartered territory – and it is impossible to fully identify all the consequences of such a move. However, these doubts will very much remain even under a second bailout – the various uncertainties associated with the bailout packages and attached conditions mean that the threat of an eventual default will not go away in any case.
The cost of restructuring will also increase with time, as Greece’s debt burden will only rise over the next few years. To bring down Greece’s debt to sustainable levels today, half of it would need to be written off. In 2014, two-thirds of Greece’s debt will need to be written off to have the same effect, meaning a radical increase in the cost to creditors.
Unfortunately, this is a debt crisis and someone will have to take losses. We estimate that the first round effects of a 50% write down on Greece’s debt would cost the European economy between €123 billion and €144 billion (uncertainty regarding the ECB’s exposure accounts for the range). Of this cost, €23.55 billion would be a direct cost to taxpayers through bilateral loans under the first Greek bailout as well as indirect costs of between €44.5 billion and €65.75 billion via ECB guarantees. €28 billion will be absorbed by Greek banks, while €27 billion by other private investors. However, these are only first round losses. It cannot be emphasised enough that the main cost from a debt restructuring comes in the form of contagion and the knock-on effects of losses throughout the European banking system.
Although this is a substantial cost, we estimate that in 2014 following a second bailout, a haircut of 69% would be needed, equal to €175 billion, to reach the same debt level. Even more critically, via the bailouts, so-called official sector (taxpayer-backed) loans are gradually replacing private sector exposure. We estimate that, under a second bailout, the share of Greece’s debt underwritten by foreign taxpayers (via the EU, ECB and the IMF) will go from 26% today to a massive 64% in 2014. Put differently, each household in the Eurozone today underwrites €535 in Greek debt – by 2014 and following a second bailout, this will have increased to a staggering €1,450 per household. On top of this, there are also numerous European banks which are largely taxpayer owned which have significant exposure to Greece (for example the Belgian-French Dexia and German Hypo Real Estate). This makes a second Greek bail-out far more politically contentious than any of the existing rescue packages, given the likelihood of debt write-downs with taxpayers footing a huge chunk of the bill.
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