22 April 2015

Default is not necessarily black or white

While default sounds definitive it is rarely so clear cut. Default is often subjective and murky, even more so when it involves different obligations of a sovereign state. Different creditors have different definitions of default, some of which are linked to each other and some of which aren’t. Ultimately, it depends who Greece ‘defaults’ on and whether it eventually makes amends – i.e. is the default temporary or is it a permanent write off. For the purposes of this blog we take ‘default’ at its most basic level – non-payment to creditors.

Could Greece default on IMF and stay within the Euro?

  • We have already described in detail what happens if Greece misses a payment to the IMF here. The short version is that the immediate economic/financial impact may not be huge. Greece would have at least a month to get back on track. If it did not then the Eurozone countries would face a choice about whether to declare their loans also to be in default. The knock-on effect of doing so could be huge and lead to Grexit, so we suspect they would err on the side of caution, at least in the short term. Of course, the role of the ECB is crucial as always.
  • The ECB would face a choice over whether to cut off the Emergency Liquidity Assistance (ELA) to Greek banks. The rules allow significant room for manoeuvre but it seems likely the ECB would at the very least refuse to increase ELA further. Given that a missed payment to the IMF could increase uncertainty and therefore increase deposit outflows, this could precipitate the need for bank holidays and capital controls. Such mechanisms are only short term stop gaps and may harm the functioning of the economy.
Eurozone 60%
IMF 10%
ECB 6%
Greek banks 3%
Foreign banks 1%
Bank of Greece 1%
Other bonds 15%
Other loans 3%

Who owns Greek debt?

Following a series of bailouts and a debt restructuring a large majority of Greek debt is held by public institutions. This means that any renegotiation will be a very political exercise and will require approval and concessions from Eurozone partners.Source: Greek Finance Ministry, Bank of Greece, ECB & Open Europe.
  • Of course, this is all in terms of a temporary missed payment, not a full-on write down or rejection of any repayments. These courses of action seem very unlikely and would be entirely unprecedented since no-one has ever completely defaulted on the IMF. Furthermore, as the graph above highlights, the IMF only accounts for a small share of overall Greek debt (10%). When it comes to the IMF the problem relates more to cash flow than headline debt.

Verdict: Yes, Greece could probably deal with missing a payment to the IMF in the short term. The exact fallout would depend largely on decisions by the ECB and Eurozone. That said, given the lack of goodwill towards or patience with Greece this would likely only be plausible in the short term.

Could Greece default on the Eurozone loans and stay within the Euro?

150220_Open_Europe_Greek_exposure_graph_ itemprop=

  • The first point to make here is that this is an unlikely proposition in the short term. There are no payments on the loans – be them the original loans from the bilateral Greek Loan Facility or the EFSF loans – until 2020 due to the significantly extended maturity of the loans and the deferred repayment of interest.
  • That said, if any of these payments were missed then the situation could quite quickly become bad, though there would again be a political element to the decision as described above. In the end, defaulting on the Eurozone loans would make it very hard for Greece to strike a deal with its creditors to stay inside the Euro as well as the ECB to keep its banks supplied liquidity.
  • Related to this is the question of a wider debt write down for Greece on these loans. This could be done inside the Euro but would require significant good will of the Eurozone partners and may require some changes to the Treaties to ensure it is legally sound. As the graphics above show, the Eurozone accounts for 60% of Greek debt and its total exposure is close to €300bn – ultimately discussions of sustainability will come down to this.

Verdict: Not an issue in the short term since no payments go to Eurozone and broader debt restructuring rejected. Hard to imagine willingness to keep Greece in if they unilaterally default on existing loans as shown by rejection of restructuring. Some kind of restructuring may be plausible but not in the immediate future.

Could Greece default on the ECB and stay within the Euro?

Open_Europe_graph_Greece_payments_ itemprop=

  • As shown above, Greece faces significant repayments on the bonds held by the Eurosystem (ECB and national central banks) including €6.7bn this summer. Failing to make these payments would probably quickly create a downward spiral for Greece. In such a situation it seems likely that the ECB would cut the Greek banking sector off from ELA, leaving it with a minimum €74bn funding gap. Even capital controls, bank holidays or payment in IOUs would only help stabilise the system for a short period in the face of such a shortfall.
  • That being said, ECB Vice President Vitor Constancio said recently, “If the state defaults, that has no automatic implications regarding the banks,” so even here it is not definitively clear cut. We have pointed out before though that the solvency of Greek banks is in fact directly connected to the Greek state, with the ECB itself showing concerns over this.
  • As noted in our post on IMF payments, the bonds held by the ECB are thought to be issued under exactly the same terms as the original ones purchased but just exempt from the restructuring. Looking at the terms of the newly issued restructured bonds, while they do have cross default clauses, these seem to apply directly to the other newly issued bonds and indirectly to EFSF loans via the co-financing agreement. As such a missed payment to the ECB may not necessarily mean a default on other privately held bonds.
  • As for the EFSF loans, this is a bit less clear cut. They do include cross default clauses which reference “any agreement for the provision of a loan or any other financial assistance” between Greece and “any EU institution”. It is not clear that bonds purchased by the ECB on the secondary market qualify under such criteria. Again on top of that, the EFSF terms make it clear the Eurozone is not “obliged” to consider the loans to be in default.

Verdict: Very unlikely. Defaulting on the ECB would almost certainly mean the end of ELA. Short term stop gaps could keep Greece from crashing out of the Euro but it would need to get ELA turned back on quickly to have any chance of being in a sustainable position. Silver lining of a very dark cloud, it may not trigger cross default on other bonds/liabilities.

Could Greece default on private bondholders and stay within the Euro?

  • As with the Eurozone loans, this is less of an issue as no payments to restructured bonds fall due before 2023. There are a few holdouts from the restructuring whose bonds come due in the next few years. As previous discussions on this topic in 2012 suggest, Greece could probably default on these without defaulting on its other private bonds – though the situation on ECB funding and the bonds held by the ECB isn’t as clear cut. In the end, given the limited benefit at this point in time, it’s not clear defaulting on holdouts would be worth the risk.

Verdict: Not an issue in the short term. Default on holdouts seems to offer little benefit. ECB again would be the crucial deciding factor.

Overall verdict

In any scenario, a default or missed payment by Greece would increase animosity between the two sides and put the country’s position in the Euro in jeopardy since it needs further cash from the Eurozone to secure it. That being said, a missed payment to the IMF would probably be manageable from an economic/financial standpoint, though the politics may be different. However, a missed payment to the ECB could well trigger a downward spiral towards Grexit. In all scenarios, the response of the ECB is likely to constitute a key turning point, once again highlighting just how important and political its position has become (intentionally or not).

Ultimately, a temporary missed payment is something which in most scenarios could be managed at a political level (assuming the willingness exists). However, the same cannot be said of a decision to unilateral write off a large amount of the loans. We have to remember that this remains a fundamental goal of the Syriza government and, as we have long argued, it seems likely that Greece will need some debt restructuring for its position to be sustainable. As we warned in 2012 and as the permutations discussed above show, this has been made all the more difficult by the fact the large majority of debt is now held by official creditors.

In the end, this is the elephant in the room amongst all the short term negotiations to keep Greece afloat for the next month or two. This is all just a precursor to the bigger negotiations over how Greece will fund itself once the bailout expires at the end of June. Will such an agreement involve a debt write-down? Will it be another bailout? Will a Syriza-led government agree to the necessary conditions and be able to sell them at home sufficiently to maintain their power? These questions seem gargantuan given that the two sides can’t currently agree on a short term reform list.