My Thoughts on the French Restructuring Plan for Greece

I want to take a look at the latest news concerning the Greek situation using the political framework I laid out earlier in the month.On the whole, things are proceeding pretty much as anticipated. Before my appearance on CNBC yesterday, I put together some thoughts on the latest Greek bailout which will happen if a crucial vote on austerity passes the Greek Parliament. As I restated in that post, “a voluntary reduction of interest rates and an extension of maturities – will happen sooner than later."

Indeed, since then, the French have put forward a proposal to roll over maturing debt into much longer-dated 30-year paper. 70% roll-over participation at 5.5% over 30-years are the terms I have seen. This deal also has credit enhancement which echoes the Brady bond plan that I advocated yesterday. "While this is necessary, it will certainly not be enough. Eventually, principal reduction will occur."

But I like this deal because it transfers some of the credit risk to the core banks and also sees some maturity extension and interest rate reduction. And it is in line with my expectations. "I expect a soft restructuring sometime in 2011 followed by a certain degree of dithering and a hard restructuring down the line in part to avoid a credit default event. This also gives more time for planning and recapitalization since many EU banks are expected to fail the stress tests."

The Political Economy of Another Bailout

So how does this all look using the political framework I laid out?

Here are the core political issues I see:

• Dithering on restructuring and default: “The ECB is not in favour or restructuring and haircuts” because they are heavily exposed to Greece and the periphery. They would lose capital. This is why the ECB and core banks are hyping the potential for a European Lehman after a hard resructuring. Therefore, the French solution, while it does bail in core banks to a degree, is still very much in line with the dithering soft restructuring approach. The good thing is that contingency planning is going on in private. And since crisis will come again until we get a resolution via hard restructurings and defaults, that means the Europeans are better prepared for that eventuality.
• Opposition to bailouts outside the periphery: The French plan is a good first step to dealing with bailout fatigue in the core. It sets up a deficit reduction, credit risk quid pro quo between Greece and the core while giving incentives to bondholders to voluntarily make exchanges. There is still some residual political risk that a core country would veto any deal like this as a “bailout”. But I think the chance are high this kind of deal will pass through – en route to a true Brady Plan-like deal that sees principal reduction.
• Resistance to austerity: Let me reiterate what I said before, that “the austerity plans now in place in Greece and elsewhere are not sustainable without debt relief. Austerity is not a good way to solve unsustainable fiscal trajectories because fiscal contraction reduces output and tax revenue, and therefore increases budget deficits. You need a Herculean level of budget cuts and asset sales to overcome this effect. And even then, the lower level of output and the permanently diminished tax base from asset sales will make any debt burden that is constant or increasing in nominal terms that much harder to finance. This is why default is seen as inevitable in Greece where debt to GDP already approaches 160%. The Greek Prime Minister is now seeing defections in his party from MPs who are opposed to his austerity budget.” These new austerity plans are even more severe. So there is a risk the Greeks will reject it. The socialists only have 155 seats of 300 in the parliament. With defections in a party line vote, austerity could be rejected. We will find out tomorrow.
• Likelihood of more political unrest in the periphery: Workers are striking around the clock until the vote on Wednesday. Greeks will not abide the privatisations, the wage and price cuts and are trying to influence socialist defections against this plan. Because this is an anti-growth strategy, I expect these protests to recur even if the vote passes. And in all likelihood, Greece will be unable to meet its austerity targets. I should also mention that people are pulling money out of Greek banks. Austerity would exacerbate this trend. Eventually, principal reduction will become politically practical then.
• Potential for contagion: if the vote in Greece is rejected, contagion will occur. We will then have to see if the EU’s Plan B is a good one. “The only reason we have not had a cataclysmic crisis is because Spain and Italy have decoupled from the periphery. However, market observers like Felix Zulauf fear a rumoured bank run in Italy and additional property loses in Spain. If Spain or Italy were to recouple, a major financial crisis and economic downturn would ensue.”

The CNBC video is below. While I talked a very little about how the EU has the means to solve this, I did emphasise that this is almost entirely a political scenario. So investment in EU sovereign periphery bonds is a purely speculative endeavour. If you want exposure to those economies, Chuck De Lardemelle is right to suggest that internationally-diversified corporates would be the way to go.