Defend or default? It’s the three trillion euro question

Is a partial default one of the steps to recovery for Greece? AAP

Will Greece default and exit the Eurozone?

The best-case scenario is a managed, orderly, partial default with the European Financial Stability Facility (EFSF), a fund created in 2010 to manage Eurozone bailouts, assuming the role of a “mini-IMF”, backed by the European Central Bank (ECB) in Frankfurt.

The EFSF has only about 300 billion euros ($411 billion) left in the kitty, and the IMF is scraping the bottom of the barrel with $US384 billion ($527 billion).

If we were talking about foreign currency exchange markets, the EFSF and IMF’s capital would amount to less than six hours trading.

Global markets are betting on the much-vaunted, widely-rumoured figure of up to 3 trillion euros that the Eurozone members are expected to provide for a more muscular EFSF. But the real question is: how the hell did we get into this mess? And who’s going to clean it up?

Greek bond yields are sitting as high as 25%. AAP

My name is Bond … short-term bond

The most obvious sign of trouble is Greece’s short-term and long-term bond yields. If you bought a one-year bond today, with yields at 114%, you’d double your money in 12 months.

Athens’ 10-year bonds are not much better: in May, Greek notes paid around 16%. Now it’s 25% and counting. Not even Venezuela, not the market’s favourite People’s Republic, churns out numbers like this.

But there’s worse news. Central banks are still (slowly) buying Greek bonds, but the Bank of Finland is getting bearish and is demanding partial collateralisation to back up what is largely viewed as worthless paper.

Conversely, commercial bank purchases of Greek debt now barely register a pulse on the market ticker, primarily because the reinsurance rate for banks is rising. In plain English, banks have to pay a premium to insure their bond purchases against default.

Right now, it costs over $6 million in insurance to buy a 5-year, $10 million Greek bond. And that’s not good business.

Why Greece shouldn’t leave

If Athens was compelled to exit the Eurozone – and no EU legislation exists currently to make this possible – the results would be catastrophic, not only for Greece, but for the EU and, by extension, the entire global economy.

What would be gained? Greece could revive the dramatically devalued drachma, but confidence in the entire Eurozone would be shattered.

The logic goes like this: if the EU cast asunder a small economy on Europe’s southern periphery, why should markets believe that the other PIIGS economies (Portugal, Italy, Ireland and Spain) would be treated any less ruthlessly?

German chancellor Angela Merkel points, unsurprisingly, to the “domino” effect of even one exit from the Eurozone. It may not be the end of the world for the Eurozone if Greece leaves, as one of Merkel’s ministers put it unhelpfully, but it would be the end of the Eurozone.

Asian markets learned from the region’s 1997 financial crisis. AAP

Currency unions still make sense

Meanwhile, over here in the Asia Pacific, Indonesia, Thailand, and even that manufacturing colossus, South Korea, crashed and burned in the Asian financial crisis (AFC) of 1997–98, as debt and devaluation temporarily transformed the world’s fastest-growing region into a wasteland.

The IMF was called in, prescribed harsh medicine and doled out structural adjustment loans to tide over parts of crippled East Asia.

East Asian debt in 1998 scarcely compares with the scale and magnitude of Eurozone debt circa 2011. But following the AFC, another very important, little-noticed initiative took place.

In 2000, Japan, China, South Korea and the ASEAN countries met at Chiang Mai, Thailand, and quietly signed the Chiang Mai Initiative (CMI), a currency swap stability fund with tiny seed capital of $US17 billion.

After a decade of lying dormant, the CMI was revived in 2009 as the CMI Multilateralisation (CMIM), boosting its reserves to $US120 billion, over 50% of which was contributed by Japan and China.

This is a convoluted way of saying that Japan and China took steps to protect their investments in North and Southeast Asia from 2000. Neither acted out of altruism, but the CMIM made a statement to markets: Asia’s economies are backed by the wealth of Tokyo and Beijing.

The result? Asia is the world’s fastest-growing and most dynamic economic region. And it’s stable: the IMF has not come a-knocking for over a decade.

The ball is now well and truly in Berlin and Paris’ court, as they, along with another 15 Eurozone countries, horse trade over who will pay to restructure the EFSF into a genuine regional monetary fund.

But France and Germany have the biggest bank exposure to Greek debt, and their banks will be forced to take a haircut and accept a partial default on at least a proportion of Greek debt. The magic number seems to be 50%.

But a 50% write-down for any bank holding Greek debt – and most of them are in the Eurozone – would also cast doubt on the asset basis of European banks, which have significant exposures to sovereign debt.

This is the type of malicious contagion that the EU will endeavour to avoid assiduously. And although Britain, as a Eurozone outsider, will not be compelled to contribute to a multi-trillion euro rescue fund, its banks would be exposed significantly to a partial Greek default.

The Bank of England may point out that British banks hold only £2.5 billion in Greek debt, but this is wholly misleading; the reality is that UK financial institutions could see more than £100 billion in potential losses as the City of London is deeply mired in the derivatives and debt underwriting markets.

If these begin to unravel, then the English Channel will be no barrier to the financial fallout.

In the future, Eurozone countries may surrender fiscal as well monetary sovereignty. AAP

The end of fiscal autonomy

Make no mistake: Greece is out of the fiscal autonomy business. Athens is finished as an independent policy maker. In future, Greece will face severe restriction in terms of its budgetary, banking or pension policies.

Every Eurozone country surrenders its monetary sovereignty when it adopts the euro, but retains considerable freedom to manage its own finances.

No longer. Although the much-mooted EU fiscal union is unlikely to come to fruition, the Greek tragedy augurs a new regime of constant debt inspections, fiscal transparency, external governance reviews and a raft of other accounting measures.

Berlin and Paris will be running Athens’ public finances from this point on, albeit behind closed doors, affording Greek politicians the polite fiction that they are still in charge of their own public policies.

And what of the mooted 3 trillion euro EFSF? This will allow the ECB to effectively print money and flood the market with euros in an attempt to stave off the impression that Italy or Spain might default as well.

The danger is higher inflation, and the markets are already punishing the euro exchange rate in anticipation of market saturation.

It’s essentially the same strategy the US has employed for decades: when in debt, print dollars. The problem is that Europe’s gamble depends upon a currency that is not the world’s reserve currency.

But high-stakes-all-in-poker is about all Europe’s got left. After all, as that baron of 19th-century banking, JP Morgan, well knew, you’re only gambling with other people’s money.