Thoughts on the French Restructuring Plan for Greece

By Marc Chandler

When it comes to heading up the IMF, the French position is that Christine Lagarde should be supported not because of her nationality, but because of her experience. Fair enough. Mexico, now joined by Chile, Peru, Australia and Canada, seems to be making the same case for Mexico central banker Agustin Carstens. The three countries with the most votes (US, Japan and China) have not tipped their hand. In Western Europe, where, ironically, financial stability was its first mandate, the IMF’s efforts have failed. Insofar as the IMF has not stabilized interest rates in Greece, Portugal or Ireland, if there is to be a head of the IMF not from Europe, this is the moment.

While Lagarde’s nationality ought not matter, when it comes to the ECB, apparently it does. French President Sarkozy has reportedly held up confirmation of Italy’s Mario Draghi as the next ECB president on the condition that Lorenzo Bini-Smaghi, another Italian, step down from the ECB board to make room for someone from France. If Lagarde were not the French finance minister, perhaps that would be a position for her.

Silvio Berlusconi appears to have promised to deliver this compromise. Yet, the only way this can happen in a way that preserves the ECB’s independence, is to offer Draghi’s current job as head of the Bank of Italy to Bini-Smaghi. Various deals in Italian domestic horse trading are likely required; and given the recent setbacks the prime minister has suffered, it is not clear yet precisely how this will be orchestrated. But it probably will be.

To operationalize private sector participation in a second aid package to Greece, which Germany in particular has demanded, France unveiled the broad outlines of a plan, ostensibly crafted by the banks, but clearly with the support of the government. It involves a 70% roll-over of bonds that expire in the next three years.

Half of a participating bank’s Greek exposure would be rolled into 30-year bonds with a coupon around 5.5%. Interestingly, the bonds would have a sweetener. Similar to the Argentine warrants tied to GDP, the participating banks would get a bonus payout tied to Greek growth up to 2.5%. The remaining 20% would be invested in a special purpose vehicle that would serve as collateral for the banks. Although the details are not immediately clear, this appears to be similar to Brady Bonds in some respects.

The precise bank holdings and duration are not very transparent. A rough ballpark estimate would suggest European banks have around 20 bln euros of Greek sovereign bonds maturing in the next three years. Greek banks may have 20-25 bln euros of Greek sovereign bonds maturing in the same period. The EU goal had been at least 30 bln euros coming from the private sector.

While the euro traded higher, rallying more than 1% from lows set in Asia early Monday, Greek bonds still sold off with the 2-year yield rising more than 100 bp. The 5-year CDS also rose. It seems that the euro’s rise may have been more an issue of short-term market positioning rather than a judgment of the likelihood of success of the French proposal, which is just one of many. The fact that other proposals have not received the media attention that the French proposal has may be more a question of marketing than merit. Fait accompli?

The bonus GDP link has much to commend itself. I suspect that going forward there will be more such innovations. John Williamson, previously at the IMF, has been a vocal advocate of such GDP links and not just for emerging markets, but also for advanced countries. However, there are some conceptual and operational difficulties that need to be worked out.

For example, if a large percentage of the private sector exposure is protected via CDS or some other guarantee, participation may be disappointing. Isn’t there also a free-rider problem? If French, German and Greek banks can do the heavy lifting, why should, say, Spanish or Italian banks, the latter having been recently placed on credit watch by Moody’s? It will also be interesting to see if the rating agencies view the French proposal as a "distressed exchange".

The more immediate problem for Greece, ironically, is political not financial. The problem is the vote on the austerity measures. The opposition continues to press for re-negotiation and rejects the government’s plan. The government survived a vote of confidence recently only after a reshuffle of the government and even then it did so with a 4 vote margin. While passage is still the most likely scenario, a very narrow margin may not elicit a sigh of relief.

There is a reason why the EU and IMF wanted broad support, though they appear to have backed down. The Socialists are already lagging in the polls. Governments often do not survive one aid package, as was the case in both Ireland and Portugal. Can the Greek Socialists survive two? And the new government will demand to re-negotiate.

In addition, if the EU/IMF does this for Greece why not Ireland and Portugal? It is difficult to envision Ireland being able to go back to the markets next year as originally intended. Therefore, it too will likely require another round of assistance. Rather than serving as a catharsis so we can finally achieve closure, European developments continue to portend a long summer ahead.