The Institute of International Finance's (IIF) confidential report into the implications of a disorderly Greek default, dated February 18, has been widely leaked on Tuesday, as the deadline approaches for private sector bondholders to sign up to or reject the Greek government’s voluntary exchange offer. A friendly banker duly passed Euromoney a copy.
Euromoney reports elsewhere how the possibility of a pay-out under credit default swap (CDS) hedges might deter some investors from taking a big loss by submitting to the voluntary exchange. The IIF wants to pitch to bondholders – and any regulator or policymaker that can influence them – why an outright failure of the exchange offer will be damaging to the whole financial system.
The IIF’s headline figure is that it could come at a cost of at least €1 trillion. That comes from a further €73 billion loss from a generalized default by Greek private and public sector creditors; sizeable losses on the European Central Bank’s (ECB) holdings of Greek government bonds that the IIF now calculates at €177 billion; €380 billion to insulate Portugal and Ireland from contagion; another €350 million to protect Spain and Italy; maybe €160 billion of equity capital that governments would have to inject into a badly damaged European banking system which might otherwise deleverage too quickly. And that’s all before calculating the consequences of weaker growth, lost government tax revenue and higher debt service costs.
After listing these financial costs, the IIF then pulls out its trump card:
“There is a more profound issue, however. The increased involvement of the ECB in supporting the euro area financial system has been such that a disorderly Greek default would lead to significant losses and strains on the ECB itself. When combined with the strong likelihood that a disorderly Greek default would lead to the hurried exit of Greece from the euro area, this financial shock to the ECB could raise significant stability issues about the monetary union.”
Is this the IIF over-stating its case? In recent months, market sentiment has been softening towards the idea of a Greek default. Neelie Kroes, vice-president of the European Commission, told a Dutch newspaper that while she was not a supporter of Greece leaving the euro, “it is absolutely not a case of man overboard if someone leaves the eurozone”.
Obviously, the contagion effects would be felt most immediately and strongly in Portugal, whose government bond yields are already elevated on such concerns. The IIF looks further:
“Borrowing costs paid by Spain and Italy could be expected to increase as financial market participants begin to price in potential exits from the euro area, which would no longer be unthinkable following a Greek exit, and because growth outlooks for both countries clouded by the need for sizeable procyclical fiscal adjustments to reassure rattled financial markets.”
The IIF report adds that a disorderly default by Greece “would immediately unwind what positive-sentiment market remains about the adequacy of the financial support mechanism that Europe has put in place”.
The consequences would be transmitted far beyond Europe’s borders through the interdependencies of a still fragile banking system.
If the report is correct and if the Greek voluntary exchange founders badly, all this could be set in motion by March 20.
Is the IIF report credible?
“Obviously, the report is written on a worst-case basis to try to encourage participation in the exchange,” says Gary Jenkins, principal at Swordfish Research. No one wants to believe the worst. Jenkins adds: “The most likely outcome may well be that Greece passes its 75% target and then uses CACs [collective action clauses] to ensnare the reminder, thus triggering CDS.”
European policymakers have been so worried about the contingent liability on an already weakened banking system from CDS payouts that they have tried to dress up an orderly Greek debt restructuring as a voluntary exchange that doesn’t trigger them. They might have been worrying about nothing. Triggering CDS would be a lot better than the whole deal collapsing.
