Greece has reached the end of the line. Its debt repayment schedule is so large in early June that it will definitely run out of money without a deal. And judging from the latest negotiations, a deal that is mutually agreeable is not on the table as yet. Default is likely. The question now is whether Tsipras tries to sell this deal to his MPs and what the ECB does if he fails to do so and Greece defaults.
It has been clear for three years now that Greece was still insolvent even after the private sector involvement (PSI) in 2012 that reduced Greece’s debt burden and extended maturities. Megan Greene wrote a good post back then on how official sector involvement (OSI) was likely. Here’s how she put it:
Ever since the introduction of PSI (private sector involvement) in Greece, there has been talk of OSI (official sector involvement) occurring down the line. Mention of OSI in Greece has only intensified since the IMF openly advocated it last week. This was not the first time the IMF had spoken in favor of Greek OSI, but the fact that it was mentioned against a backdrop of protracted negotiations between the Greek government and the troika (the ECB, IMF and European Commission) made some wonder if OSI is imminent. I do think we will see OSI in Greece, but I expect it to accompany Greece’s exit from the Eurozone rather than returning Greece to public debt sustainability within the common currency area.
I think this concept of OSI as a means of forcing a Grexit made some sense in 2012 as there was more uncertainty about long-term outcomes at that time. But the events since that time have shown that you can get OSI and still have Greece remain within the eurozone. And this makes a lot more sense simply because re-denomination risk creates contagion to other periphery countries that is otherwise absent as it stands now. The institutions should be keen to isolate Greece as a deadbeat debtor and accept writedowns even though Greece remains within the eurozone as this is the route which creates the fewest externalities from Greece and is also politically viable if each side can blame the other for the collapse in negotiation.
How the writedowns proceed is crucially dependent on the ECB. As I wrote in late April, in the most obvious solution, “which I consider a base case, Greece defaults and remains within the eurozone. In this scenario, the ECB continues to act as lender of last resort because the large majority of Greek bank assets are not Greek government bonds. And the degree to which Greek government bonds impair Greek bank capital, the Greek government is able to help recapitalize their banks in some fashion. But there will be some key points here.
“The ECB would ostensibly refuse to accept defaulted bonds as collateral and this is why ECB officials have repeatedly said that the Greek banks are solvent for now, suggesting that their solvency will come into question were the Greek government to default. The first question is which bonds the Greek government will default on and whether this default makes other bonds held by the Greek banks lose enough value to cause insolvency. Since 85% of Greek debt is owed to the official sector, I believe that the Greek government could default on bonds to the institutions formerly known as the Troika and continue to service other bonds. The test would come via ECB rules on Greek issuance of short-term funding, ECB rules regarding acceptance of any Greek government collateral for ELA and the ECB’s decision regarding Greek bank solvency.
“The Greek government might be able to function without issuing 3-month bonds into the market if it uses a parallel currency or currency scrip IOU’s in lieu of currency to make payments. These IOUs would be payable for taxes like the Tax Anticipation Notes suggested by Rob Parenteau in February. However, if the ECB wants Greece to continue in the eurozone, it would have to accept Greek banks as solvent and allow them to continue to receive ELA from the Greek central bank. Deeming the banks insolvent, and, thus, cutting them off from ELA would collapse the Greek banking system and force Greece into a situation that would make Grexit much more attractive.
“But even if the Greek banking system collapsed, given that there is no formal mechanism for Grexit, it is still not clear to me this necessarily means Grexit, something that involves a unanimous vote of eurozone members including Greece and the printing a new currency plus thousands of other preparatory moves. This second option, Grexit, would have to, thus, be scripted, not just the currency controls and the scrip but the preparation for the Drachma and the formal voting process to remove Greece from the eurozone, deal with the Target2 issues and with the legal issues surrounding whether contracts made in euros under Greek or European law could be forcibly converted into Drachma contracts at a 1 for 1 ratio. Thus, in my view, it is precipitous to say that Grexit can follow based on an uncontrolled crisis situation, rather than based on a more methodical plodding approach.”
And apparently, the ECB does get this. Today Reuters is reporting that the European Central Bank’s top banking supervisor Daniele Nouy said Greece’s banks remain solvent. No further comment was given but it is clear that not receiving ELA would be a big blow to those banks and the whole Greek banking system.
I am going to leave it here. What we know now is that a deal has been agreed between all the institutions formerly known as the Troika and they are in the process of presenting the details of this deal to the Greek government. Meanwhile, the Greek government has also tabled a competing deal, ostensibly with very different terms. I am not particularly optimistic that either deal will form the basis of an agreement that will prevent default. But we do have an opportunity for them to do so. Greece says it can make the next debt repayment due this week. But all bets are off after that. By that time, the path will be clear and it may be time for the ECB to show its hand.