Is the ESM another €700bn bazooka pointed in the wrong direction?

We’ve just got our hands on the draft treaty establishing the European Stability Mechanism (ESM), which comes into force in 2013 and is the follow up to the original eurozone bailout packages - dubbed the €750bn bazooka back in 2010.

As expected, the ESM will have an effective lending capacity of €500bn, but to maintain a Triple-A rating it needs to be backed up by €700bn in capital – pretty huge figures. This means that Germany will be on the hook for guaranteeing €190bn! We can’t imagine German taxpayers will be too happy about having that potential liability hanging over their heads for the next 12 years (at which point the fund will be reassessed). Moreover, given the structure of the fund, €80bn in capital must be paid in initially, meaning Germany has to pay in €4.3bn per year for the next five years – this could even increase if someone – yes we’re looking at Greece – puts in an early request for funding.

We were also wondering what would happen if one of the countries – this time we’re looking at all of the PIIGS – was unable to cover its share of the fund. The draft treaty seems slightly contradictory. First it states:

“The liability of each ESM Members shall be limited, in all circumstances, to its portion of the authorized capital at its issue price. No ESM Member shall be liable, by reason of its membership, for obligations of the ESM. The obligations of ESM Members to contribute to capital in accordance with this Treaty are not affected if such ESM Member becomes eligible for or is receiving financial assistance from ESM.”

This would suggest that no country would be forced to shoulder anyone else’s burden. However, it later adds:

“If an ESM Member fails to meet the required payment under a capital call…a revised increased capital call shall be made to all ESM Members with a view to ensuring that the ESM receives the total amount of paid-in capital needed.”

So in actual fact, if one or more members failed to put up their share, all the other members will be asked to cover it (with the expectation of getting it back, but, as we're beginning to see, that’s far from guaranteed in the eurozone crisis).

The treaty also contains some tough conditions for investors. First, ESM loans will be senior to all other loans except the IMF, which we expected. Second, the disbursement of any financial aid from the ESM will require “adequate and proportionate” private sector involvement (read debt restructuring or at least rescheduling) and thirdly, all eurozone government bonds issued post July 2013 must include a standardised form of Collective Action Clauses - which stop a small minority of bondholders holding up any restructuring deal by waiting for better terms.

Although this is intended to help shift the burden from taxpayers (a good thing in principle), giving investors such substantial warning is likely to turn the market for some European sovereign debt into a ghost town. Why buy new debt when you're being explicitly told that you're first in the firing line?

How this will help wean Ireland, Portgual and especially Greece off their current ECB and EU bailouts is far from clear and could turn the ESM into a self-fulfilling bailout fund.

As the conditions for bondholder involvement highlight, the ESM might eventually bring a necessary eurozone debt restructuring to fruition but by that point the write downs will need to be huge and such a large amount of the debt of peripheral countries will be owned by the taxpayer that the private sector burden will still end up being minimal.

*** Update 11am 20 May 2011:
Writing in the FT Quentin Peel suggests that the latest version of the treaty does not stipulate that ESM loans will be senior to private creditors. Having reviewed the version we have it looks as if its still mentioned in the preamble but not the body of the treaty, so it is possible that it could be removed, which would be big news. But since negotiations are ongoing its not completely clear whether it will be removed or not. We'll keep you posted on the situation...

Spring cleaning

The EU has today released its spring forecast, which updates last autumn’s economic forecasts for EU (and related) countries.

Despite our (relatively) chirpy title it’s far from happy reading.

The EU now expects Greek debt to reach 157.7% of GDP in 2011 and 166.1% in 2012. We can’t help but think that this backs up our (and many others') claim that the bailout has been a complete failure in Greece (combine this with talk of a second bailout only a year after the first and they’re almost making our point for us).

It’s not just Greece either. Irish debt is expected to reach 112% this year and 117.9% next. While Portugal’s debt is forecast to hit 101.7% by the end of the year and go on to 107.4% in 2012. Only a few months ago Portugal’s debt was expected to be around 82% this year, that’s a whopping 20% increase in only a few months!

All in all the figures and the report make fairly grim reading. Over the past year we have seen these sets of figures continuously revised upwards, yet the EU and the ECB continue to maintain that the adjustment programmes they’ve laid out for these countries are achievable and are having a substantial impact.

We think it’s about time the EU started accepting the reality of its own figures and added a debt restructuring to its tools for cleaning up the eurozone debt crisis this spring.

Greek Anger Over Austerity Measures
Auditors from the International Monetary Fund and the European Union have arrived in Greece to assess the country's economic situation after last year's bailout.

Greece owes $155bn and paying all that money back has meant tough austerity measures and public protests.

Al Jazeera's Paul Brennan reports from the capital, Athens.

Deja Vu

The EU looks set to celebrate the one year anniversary of the Greek bailout by... giving it another bailout.

The fact that a second bailout for Greece is even being considered almost defies belief. Greece’s credit rating got downgraded again yesterday by S&P, solidifying its position as junk and highlighting the fact that a debt restructuring is by almost all accounts, except the EU powers that be, unavoidable. On top of this, there is also talk of further relaxing the original rescue conditions and reducing the interest rate. At some point one has to ask, to what end?

Not only has the EU failed to grasp the public opinion spreading across Europe (no more bailouts), they’ve also completely lost sight of the end game – finding a solution to the eurozone crisis.

Both the Greek and Irish bailouts failed to achieve anything, except maybe buying time as BBC’s Stephanie Flanders suggests (that’s some expensive time by the way). Both countries have seen their cost of borrowing skyrocket and continue to have massive debt and deficit levels. Furthermore, Greece has ultimately failed to meet the conditions laid down in the first bailout agreement, rewarding it with another bailout as well as relaxing those conditions seems to supercharge the moral hazard created by the original bailout. Combine this with the ongoing resistance to imposing losses on bondholders and it becomes clear just what perverse incentives these actions could be creating.

Relaxing the bailout conditions doesn’t really help anyone, least of all Greece, because the deficit/debt cutting and labour market reforms are vitally important for the future of the Greek economy. Some relief might sound good right now but ultimately these reforms will need to be made if Greece is ever to have a chance of becoming competitive again.

It’s becoming increasingly clear that eurozone leaders are just trying to put off dealing with the situation until 2013, when the new permanent bailout fund (ESM) comes into force, for both political (its after some important core eurozone elections) and economic (Germany thinks its banks will be in better shape then) reasons. Reaching that date seems to be the new end above all else, no matter the cost (restructuring will only get more costly as debt continues to increase) or the futility of their actions.

Unfortunately, we feel like we've made all these arguments before, but at least we feel less alone this time... ( for example see here, here and here but there are countless others)

Greece Denies Eurozone Exit Plan
George Papandreou, the Greek prime minister, is denying his country is getting ready to leave the Eurozone.

Rumours that Athens was quitting the single currency has lead to a fall in the value of the Euro.

Finance Ministers from the Eurozone's biggest economies have been holding talks on Greece's debt crisis.

Greece's sovereign debt stands at $470bn. That is more than a year-and-a-half of its entire economic output.

The European Union and the International Monetary Fund agreed a loan of $160bn in May last year. The terms were eased in the spring.

But the financial markets consider the high repayments as unsustainable, leading to growing fears of a default. That could spell disaster for the Eurozone.

Al Jazeera's Tim Friend has more.

You call that austerity?

We imagine that will be the response by many in Athens and Dublin to the conditions which have been announced along with the €78bn bailout deal for Portugal. Jose Socrates, the caretaker Portuguese PM, was almost boasting on TV last night about how much more favourable the terms were for Portugal compared to Greece and Ireland. In the cold light of day though, most of the details we’ve seen so far focus on what won’t happen rather than what will, raising the question: Where are the necessary savings actually going to come from? That should be slightly concerning for taxpayers across the EU.

The point that has attracted most attention is the easing of the deficit cutting programme. But in actual fact the targeted cut is higher than before, given the change in the level of the deficit.

Previous 2010 estimate and 2011 target: 7.3% and 4.6% = change of 2.7%

New 2010 estimate and 2011 target: 9.1% and 5.9% = change of 3.2%

Most observers, including us, didn’t expect Portugal to be able to achieve its original level of cuts, let alone a higher level - especially when combined with lower growth prospects. That was before we even found out what was not going to be cut…

According to Socrates the conditions will not include cuts to: minimum wages, public sector pay, education spending and healthcare. In addition, there will be no additional public sector job cuts and the retirement age will not be increased. That is a huge list of things that will be left untouched, especially since savings of 3.2% of GDP are expected.

So, seriously, where is the money coming from?

Well, there are expected to be some, limited, cuts to higher scale state pensions as well as a decrease in the amount and duration of unemployment benefit. There is also a plan to raise VAT on electricity. In terms of increasing revenue, there was talk of privatising €5.3bn in public assets but not Caixa Geral de Depositos, the largest credit institution, which was widely expected to be sold to raise funds. So all in all not exactly an earth-shattering plan for saving 3.2% of GDP.

To be fair, there are more details and plans to be announced but considering what has already been taken off the table we’re not overly optimistic.

Admittedly, too much austerity would definitely be bad for the economy and finding the right balance is a hard line to tread. But for those of us who already believe the bailouts to be a waste of money, since they won’t solve any of the long term problems, these kinds of conditions are almost just adding insult to injury.

Up, up and away…

That’s been the story with Greece’s debt and deficit figures for some time, particularly since it’s become almost customary for the figures to receive at least one upward revision on their original estimates. However, Eurostat’s latest figures suggest the problem (of missing targets) looks to be spreading to other peripheral eurozone countries (not that the spotlight isn’t still firmly on Greece).

Eurostat yesterday released its debt and deficit data for 2010 and it included some interesting revisions – upwards as always. Starting with Greece, we see that the government missed its deficit target by 1.1% of GDP (all % are of GDP from now on), coming in at 10.5% instead of the 9.4% which the Greek government proudly predicted in January. To be fair, this still means the deficit fell by around 5% last year, but the figures show that less than 2% of the decrease came from increased revenue. Things continue to look bad for Greece, as we, amongst others, struggle to see where the government will find the money it needs. The programme of spending cuts is already pushing austerity to its limit and the government just doesn’t seem to be able to increase revenue (tax evasion is still massive but the ongoing recession, which is worsened by the austerity, just makes tackling it all the more difficult).

Meanwhile, Portugal also saw its deficit revised upward for the second time in a matter of months. It now stands at 9.1%, way above the government’s estimate of 7.3%. The government still put the difference down to changes in accounting rules enforced by the EU, although it is strange that it seems to affect Portugal so much more than anyone else…in any case Portugal now needs to cut the deficit by close to 5% to meet its target for 2011. Its debt burden was also increased, putting it at 93% in 2010.

Ireland fortunately didn't see its deficit or debt estimate revised, although with the deficit coming in at a whopping 32.4% this isn't much of a consolation (most of the deficit is down to the bank bailouts, but even excluding them the deficit was around 12% - the highest in the eurozone).

All in all the figures weren’t exactly expected to be encouraging but the continuing string of upward revisions and missed targets doesn’t exactly inspire confidence.

THE GUARDIAN: Six Greek citizens are suing a German magazine for its assertion that their country tricked its way into the eurozone

Insulted Greeks are suing a German magazine over a cover story showing the Greek goddess Aphrodite sticking up her middle finger and an article which called them the "cheats in the Euro family".

Six Greek citizens are taking action against journalists working for the weekly German magazine Focus, including the magazine's then editor-in-chief and publisher, Helmut Markwort.

"Will the Greeks make off with our money?" the magazine asked on its front cover last February.

Tapping into growing German fears of a Greek bailout at the height of the financial crisis, the article depicted a country swamped in debt which had cheated its way into the eurozone.

More than a year after the article appeared, a state prosecutor in Athens is now investigating the magazine for libel and insult, according to the German newspaper, Handelsblatt. » | Abby d'Arcy Hughes in Berlin | Thursday, April 21, 2011

Furious Greeks Press for Country to Default on Debt
THE OBSERVER: Violence on the streets as backlash grows over Greece's austerity package and €110bn bailout

A growing chorus of voices is urging the Greek government to restructure its debt as fears grow that a €110bn bailout has failed to rescue the country from the financial abyss and is forcing ordinary people into an era of futile austerity.

"It's better to have a restructuring now … since the situation is going nowhere," said Vasso Papandreou, whose views might be easier to discount were she not head of the Greek parliament's economic affairs committee.

Other members of prime minister George Papandreou's party have said that Greece is locked in a "vicious cycle", unable to dig itself out of crisis with policies that can only deepen recession.

International fears of a Greek default rose last week after the German finance minister, Wolfgang Schäuble, refused to rule it out and markets, sensing upheaval, sent Greek borrowing costs soaring.

The normally mild-mannered prime minister has vehemently rebuffed the prospect of Greece failing to meet its debt obligations, saying restructure would not only be catastrophic for the country – blocking its access to markets for years – but also for the eurozone's delicate economy. "Our problems will be addressed in depth not if we restructure our debt but if we restructure the country," he said, announcing the "road map" that would lead Greece out of crisis.

Amid speculation over the country's ability to avoid default, a wave of civil disobedience is causing many to wonder if Greece is becoming ungovernable. Read on and comment » | Helena Smith in Athens | Sunday, April 17, 2011

Wrestling with a Greek restructuring

The talk of a Greek restructuring has resurfaced again, following Wolfgang Schauble’s seeming acceptance that one might be necessary in the near future. It looks like he’s back tracked today, claiming he was ‘misinterpreted’, but the damage was already done - Greek cost of borrowing has already hit new highs and the euro weakened significantly.

As we’ve noted on this blog many times (here and here, for example) and in our Greece paper, a debt restructuring is unavoidable, Greece is essentially insolvent. It’s been trying hard to enact the necessary austerity but the evidence is against the government – tax revenues have barely increased, spending cuts are proving hard to enact and the population is already fed up with austerity in all its forms.

There are a couple of points which have been raised with us recently on the negatives of a Greek debt restructuring: it will take down the Greek banking sector and there is significant moral hazard. Undoubtedly, it is a risky proposal but from what we can see, there are few other options to tackle the long term (and in this case short term) problems.

On the risk to the banking sector, there is no doubt that Greek banks hold huge amounts of Greek sovereign debt but that just serves to underline that they’re unsustainable. All the large Greek banks need to be restructured and recapitalised. Combining this with a sovereign debt restructuring is just good sense. They may need some capital injection and a lot of ECB help, they may even need to be nationalised while all this takes place but in the end the newly streamlined banks will serve the economy far better than the bloated inefficient current ones ever could.

As for the moral hazard, it is a valid concern that it could encourage other nations to seek debt relief but unfortunately we’re now in the realm of lesser evils. With bailouts or fiscal transfers you get a double moral hazard – firstly to the governments, who are not being reprimanded for their profligacy, and secondly to banks, who took huge risks which they could not cover – at least a restructuring shares the burden between the two.

It looks like Greece is coming to the end of the road, a decision needs to be made otherwise a chaotic default could be on the cards before 2013 and nobody wants that. Greece is priced out of the markets for the foreseeable future, the public is fed up with austerity and taxpayers across Europe are tired of paying to support ailing economies; what more is there to lose from a debt restructuring?

Witness - Greece: Protesting the Protesters
This unusual take on the Greek protests centres on a small group of 'anti-activists' who think the austerity measures undertaken by the government are in fact a good thing for the crisis-ridden Greek economy. We follow Fotis and his friends in their Liberal Party as they mount their own campaign, while around them the masses gather on the streets for the huge protests that regularly rock the capital.

Is the ECB becoming a bad bank?

Its common knowledge that the ECB has been providing massive amounts of liquidity to eurozone governments both directly (through the purchase of government bonds) and indirectly (by taking on large amount of government debt as collateral for lending to banks). The extent of this – and therefore also the implications – are less clear, mostly thanks to the ECB’s reluctance to publish any data on its holdings of collateral or government debt.

FT Alphaville highlights a note from JP Morgan, which suggests that the indirect exposure of the ECB to the Greek state is massive - and then we mean massive. JPM estimates that Greek banks have posted almost €140bn in state related collateral with the ECB (€85bn of state guaranteed bank paper, €45bn of Greek government bonds owned by Greek banks and €8bn of zero-coupon bonds which the Greek government had lent to Greek banks in 2008). Combining this with the direct holdings of government debt (thought to be around €60bn, as we noted in our paper on Greece) you get total exposure of the ECB to the Greek state of around €200bn.

That is a phenomenal amount.

Though these amounts are slightly speculative at the moment, there are some interesting and possibly disturbing implications here, particularly for those of us who believe that Greece will need to restructure its debt at some point soon (not that we’re alone, this group includes nearly all investors and apparently the IMF). This exposure to the Greek state is in the direct firing line if a restructuring occurs. First, there are likely to be large write downs on the direct holdings of Greek government bonds (at least 35% to have any significant impact on the debt burden) and secondly, the state backed paper could become close to worthless. Potential losses are still hard to quantify but would easily be upwards of €40bn.

Comparing this loss to the capital and reserves which the ECB holds, around €79bn, shows the potentially difficult situation which the ECB could find itself in following a Greek restructuring. Essentially the ECB would either have to ask eurozone governments for an injection of capital or or try to print their way back to an acceptable level of capital and reserves.

Therefore, following a Greek restructuring the ECB may have may face a difficult choice: completely ignore its primary mission (i.e. price stability) and print money or go hand in cap to governments - like the bad banks in the financial crisis - and ask for cash (almost like a bail-out).

Two questions: how in the world did the ECB allow itself to get so deep into this mess? And do German politicans/economists/opinion formers understand how incredibly exposed the ECB - once dubbed the world's strongest central bank - actually is?

Portugal and Greece Downgraded on Debt Worries
BBC: Ratings agency Standard & Poor's has downgraded struggling Greece and Portugal on further debt worries.

S&P says investors in their bonds could lose out under the terms of a new eurozone bail-out package.

The move pushed up the countries' borrowing costs as lenders demanded a higher rate of return for buying government bonds.

The downgrades left Portugal one notch above junk rating and Greece's creditworthiness below that of Egypt. » | Tuesday, March 29, 2011

Permanent euro bail-out fund failing before starting?

Standard & Poor’s yesterday downgraded both Greek and Portuguese debt by one notch and kept them on negative outlooks. That hints at further downgrades in the near future, although given the extent of the problems in both countries that could be as soon as next week.

More interesting to us, is the reasoning behind the downgrade. S&P directly puts its decision down to the agreement which was reached on the permanent bailout fund (ESM) at last week’s EU summit. In particular, the fact that, as expected, ESM debt will be senior to all private debt and taking loans from the ESM may be conditional on restructuring debt. S&P suggests this could be “detrimental to commercial creditors”.

Investors feared ESM uncertainty, but if there’s one thing markets hate more than uncertainty, it’s having their fears crystallised by government policy. The ESM undoubtedly makes peripheral government bonds more risky to hold and was always going to be met with a downgrade and higher borrowing costs. The real questions remain: Why did EU leaders decide to announce this two years in advance, thereby massively prolonging and increasing the pain of peripheral economies? And at the same time why did they put off dealing with the temporary bail-out fund, the EFSF?

There's still no agreement on how to top up the EFSF, which in turn makes investors doubt the EU's capability to deal with future bail-outs. Sorting out the EFSF might have helped limit the fallout from the ESM decisions; in any case it makes no sense to delay the more pressing of the two issues. Flagging up the fact that debt restructuring may be possible down the line somehow manages to simultaneously ignore the fact that it should be done sooner while also increasing the need for it.

Eurozone countries continue to complain about rating agencies' actions – which are admittedly far from perfect – but maybe they should stop throwing fuel on the fire.

While the principle behind it is very much welcome - putting the burden on taxpayers rather than investors - due to poor sequencing and timing, the ESM has managed to fail before it even came close to starting. That’s impressive even for an EU policy.

Greek Debt Price Soars as Moody's Cuts Credit Rating Below Egypt
THE DAILY TELEGRAPH: The Greek government has reacted angrily to Moody's decision to cut the country's credit rating below that of Egypt, a move that prompted investors to dump the debt of other struggling European economies.

The country's debt was lowered to B1 from Ba1, as the ratings agency warned that Greece faces a shortfall in tax revenue and huge challenges in reforming state-owned companies and its costly healthcare system.

"The sheer magnitude of the task is becoming ever more apparent," said Sarah Carlson, an analyst at Moody's.

The Greek Finance Ministry yesterday described Moody's move as "totally unjustfied".

"Having completely missed the build-up of risk that led to the global financial crisis in 2008, the rating agencies are now competing with each other to be the first to identify risks that will lead to the next crisis," it said. Continue reading and comment >>> Richard Blackden | Monday, March 07, 2011

Studying the cost of Greece leaving the euro

The "European Economic Advisory Group", CESifo, is a joint venture by two of Germany's most respected research institutions. Earlier in the week, it published an interesting report examining the various potential policy responses to the eurozone crisis.

One of the authors is CESifo Director and heavyweight economist Dr. Hans-Werner Sinn (pictured). When he speaks, Germany listens.

Here are some of the key points in the report:

On establishing a permanent "transfer union" - in which taxpayers in stronger economies subsidise weaker countries, such as happened between Western and Eastern Germany - the report notes:

The persistent flow of public funds has in the end helped eastern Germany only a little, if at all. It has made it another European Mezzogiorno – a region stuck in a low-development equilibrium.

(...)

Whether the EU budget should be expanded for this purpose is a distributional question that will have to be decided by the political process. Politicians should not overlook, however, that there is the risk of Greece becoming addicted to the transfers, since it seems to have become addicted to the capital flows of the past.

It warns against the harmonisation of wages across the EU, citing regional differences in Italy as an example:

The Italian Mezzogiorno has been caught in such an equilibrium for half a century and more. Its GDP per capita is about 60 percent of that of the rest of Italy and does not show any sign of convergence. In Italy, the causes for this situation can be sought in a common wage policy, mainly dictated by the conditions of the North, which has always resulted in wages that were way too high for the South and resulted in persistent mass unemployment.

The under-development has forced the state to help out with transfers from the North. These transfers have provided an alternative income source in the South to which the political system and the economy have grown accustomed, perpetuating the situation, as it seems, even more.

They also explore the alternative to a transfer union - devaluation.

There's a distinction between internal and external devaluation. The former means tough austerity measures and squeezes on wages and jobs at home, as in Latvia (whose economy, as CESifo notes, shrunk by 19 percent in 2009).

The other option is external devaluation, which would involve Greece leaving the eurozone. From page 118 onwards, the report looks at such a scenario, with special focus on Greek banks. They note that if Greece did decide to leave the eurozone there would undoubtedly be a bank run, amongst other problems, therefore the ECB would probably need to guarantee all Greek bank deposits.

After demonstrating that Greece would take a big hit should it embark on external devaluation and head for the exit, they make an important observation: Greek banks might suffer just as much if no devaluation occurs, while private sector companies would be clear winners in the case of an external devaluation:

As Greek banks are net borrowers abroad and net lenders at home, the external depreciation will probably hurt them by shrinking the eurovalue of their assets more than shrinking the eurovalue of their liabilities.

However, this analysis forgets the additional write-off losses on claims against the companies of the real economy that will be driven into bankruptcy after an internal depreciation. If these write-off losses are taken into account, it is not clear whether banks fare better after an internal depreciation than after an external one. It is only clear that companies of the real economy will fare better after an external depreciation.

In view of these uncertainties in the analysis, the EEAG has decided not to opt for a particular policy alternative but only to inform policymakers of the relevant arguments. Definitely, there is no alternative that clearly dominates the other in all dimensions.

This is not a call for Greece to leave the eurozone, but the distinguished economists are clearly toying with the idea - though stressing that every scenario involves huge costs.

Meanwhile, FAZ today reports today that more than 200 German Professors, amongst them Dr. Sinn, have warned in a petition to the German Government, against extending the eurozone bailout. They call upon the German government to prepare

for a possible failure of the eurozone aid scheme and (...) prepare a detailed insolvency plan for eurozone countries with excessive debt

This is the only way, they argue, to avoid

collectivising the debt of member states, which leads to higher taxes and higher inflation in the EU as a whole.

It's not getting any easier for Angela Merkel.

The ECB's herculean assumptions on Greece

An interesting presentation given in London last week by Italian ECB Board Member Lorenzo Bini-Smaghi, titled "Sovereign Risk and the Euro", looked at two possible scenario's for the eurozone: Plan A and Plan B (ECB board members aren't known for their imagination)

Plan A: Fiscal adjustment Plan B: Default / Restructuring & Exit / Split the euro

First, Mr. Bini-Smaghi showed how plan B would create direct "wealth effects, a credit crunch, social/political repercussions", etc. None of that is disputed.

Hardly surprising, he expressed his preference for plan A, claiming it "is painful, but most likely it is less costly than the alternative." (emphasis added - it's interesting to note how he qualifies that statement).

He described Plan A, which is the official EU / IMF strategy, as follows:

In the case of Greece, the primary surplus required to stabilise and reduce the debt after 2013 is ± 6%

That's assumption 1.

That Greece would be running a massive 6 percent budget surplus after 2013 isn't plausible, which Mr. Bini-Smaghi also himself sort of admitted:

if the primary surplus needed to achieve sustainability is considered too high because the market interest rate is high, there are two ways to restore sustainability:
- reduce the interest rate burden (and lengthen the maturity), while keeping it non-concessional
- haircut on debt

So if the necessary budget surpluses cannot be achieved then debt must be ‘reduced’, assuming this can be done successfully is assumption 2.

He went on to say that the proposal for a bond buy-back program - under which the eurozone's permanent bail-out fund is used to buy back Greek bonds directly or indirectly - could be a way to cut debt:

Under discussion: buy back at market prices (lower than nominal), by the member state or through the EFSF, subject to strict conditionality

We commented in our recent briefing on a possible Greek default that this, in turn, rests on two sub-assumptions:

1 – Although a large number of bonds are being held by the ECB (around €60 billion nominal value) just buying these bonds back at a discount will only reduce Greece’s debt burden by at most 4.15%. Not to mention the fact that the ECB has stated that it plans to hold all bonds to maturity.

2 – Therefore bonds would have to be purchased on the secondary bond market or in reverse auctions. It also seems that many banks are holding bonds to maturity to avoid declaring losses on already fragile balance sheets. But even if they were willing to sell it might not help. As we have already said: "the sudden increase in demand for Greek bonds, as a result of Greece itself having a €50 billion pot of money with which to purchase its own bonds, could actually lead to an increase in prices".

However, Bini-Smaghi himself admitted that having assumption 2 (reduced debt) might not be enough if assumption 1 (budget surpluses) isn't also realized, saying:

If the debt were cut by one-third, the primary surplus would still be relevant.

In other words, the ECB is relying on two pretty heroic assumptions. Greece needs find around €148.6 billion to refinance its debt by the end of 2014(not including the cash needed for interest payments), according to the Greek Ministry of Finance. Dreaming the debt away won't work.

Bini-Smaghi went on to say that in any case, "growth is key", noting that in order to restore competitiveness, this will need to happen "mainly through domestic adjustment".

He makes a list of all kinds of laudable measures that are needed for the Greek economy to grow again, ranging from" deregulation of transport and energy sectors" and "opening up of closed professions" to "increase in retirement age to 65".

Assuming that this is economically and politically feasible in Greece is assumption 3; in this case he adds no caveats. Given the well documented political unrest in Greece and the significant strength of vested interests this seems like a very large assumption as well. The country has no doubt come some way - but it still has a massive distance left to travel if it wants its economy to become sustainable.

And as an indication of the difficulties ahead, over recent days, we've heard of pretty stiff opposition from the Greeks to the proposed EU-IMF privatization plan (which could free up around €50 billion in an ideal world). A spokesman for the Greek government captured the mood: “We asked them for help...not to meddle in our internal affairs” (more on this here).

Even if the first three assumptions were proved right, and all their goals achieved there is still one more implicit assumption to this whole discussion. It is that once this is all done, the eurozone (specifically the one-size fits all monetary policy which could facilitate boom-and-bust cycles or wipe out achieved competitiveness gains) will not lead Greece down this road again.

Assuming that all of these measures will solve Greece’s long term problems within the confines of a monetary union is assumption 4.

Interestingly, Bini-Smaghi gave another speech recently commenting on precisely this issue, labelling moves towards a political union of eurozone countries "risky". Instead, he said, stronger financial supervision should be pursued in order to stop boom and busts cycles.



However, Bini-Smaghi demonstrates the enormity of his fourth assumption with the fact that he sees this new financial order as

a system of rules and procedures which binds the financial system, in the same way as the Stability and Growth Pact binds national fiscal policies.

The SGP has proven, shall we say, difficult to implement in practice, begging the question why a system for financial supervision based on the same model should be any more succesful.

The point here is that the ECB is throwing around a huge number of assumptions. A business plan being this speculative would never make it past the board in any company (well, perhaps a few). But in the eurozone this is apparently called Plan A.

If the ECB was to re-consider its assumptions, would it also have to re-consider whether plan B might actually be an alternative?

Will Greece lightening strike twice?

Today saw a drop in the borrowing costs for Ireland, Spain, Portugal and even Greece, as markets apparently took heart in rumours that EU leaders will soon strengthen the main bail-out fund, the EFSF, to back up eurozone countries in trouble

News of more stability in the markets are welcome, the reason underpinning them (EU leaders consider putting even more taxpayers' cash on the line to save countries that mismanaged their finances) are not - a contradictory feeling that those of us who saw this coming will have to deal with.

But notwithstanding positive developments of late, there has been something very familair about the last couple of weeks - as Greece is again coming back into the spotlight. We hear increasing worries about Greek debt levels and leaked rumours over a possible restructuring combined with a bailout.

It may not be as much hype, but looking at the numbers, in fact, it's feeling alot like last Spring.

Leaked reports claim that EU leaders are now considering a restructuring plan for Greece's debt, which would see the country buying back some of its own debt at a cheap price, using some €50 billion from the EU's bail-out fund, in combination with a lengthening of the pay-back period of the EU loans Greece has already recieved.

As we argue in our latest briefing, Greece will find it almost impossible to make it through the next two years without some sort of additional help or restructuring. Just consider the facts and figures:

• Greece's debt to GDP ratio is set to reach 152% this year, equal to €341 billion
• It will have to find at least a total of €53.35 billion to plug its huge funding gap (this includes debt maturing, interest payments and money needed to plug the budget deficit - and this figure is likely to prove an underestimate)
• Disbursement of EU/IMF bail-out funds this year will only amount to €46.5 billion, leaving Greece €6.85 billion short
• Greece's cost of borrowing is still around 11% for long term debt, meaning that it cannot go to the market to raise the extra cash (as that would be wholly unaffordable).
  

EU leaders are therefore right to consider ways to restructure Greek debt. However, as we also argue in the briefing, the proposal contemplated isn't in itself much of an answer. As the table below shows, even if Greece were to make it through this year, or even 2012, it would continue to face daunting re-financing targets, which, again, aren't matched by available bail-out cash.

So even if the rumoured restructuring plan were implemented we estimate that Greece’s debt to GDP ratio would still top 145% in 2011, though if private bondholders agreed to take part in the plan (which is far from certain), this could be slashed considerably more. For Greece to get back on the path towards sustainability its debt to GDP ratio needs to be below 100%. This, in turn, would require a write off of more than one-third of all Greek debt. A substantial jump from the 2.4%-4.2% expected with the current plan (without private bondholders included).

There is also no indication as to how Greece would deal with the €148 billion of debt maturing by 2014, nor the interest payments on its debt, which accounted for a whopping 20% of all government expenditure last year.

The scheme proposed by the eurozone leaders also fails to address some other familair problems. Greece has a massively overvalued currency, poor growth prospects and little international competitiveness. Until these issues are properly dealt with, Greece’s long term prospects look bleak.

The markets may be looking up right now - which is good news - but for Greece, alas, little has actually changed, despite some considerable austerity efforts. Even with a mild restructuring/another bailout, the Greek debt crisis is likely to rear its head again.

Maybe a third lightening strike will force eurozone leaders to try something different.

To restructure or not to restructure...

About this time last year, we wrote, "to bail out or not to bail out that is the question", as Greece hovered over the abyss.

A year later, and with Greece now on the dole, "Bail out" has been replaced by "restructuring" but Greece is still close to the abyss.

The European media has been awash with rumours about plans for a Greek debt restructuring. This is no surprise at all, given that in a best-case scenario Greek public debt will "only" reach 150 percent of GDP in 2013, so something must be done.

According to other reports, a German government plan would see Greece buying back its own bonds using money from the EU's temporary bailout fund at preferential interest rates. The German government and all the usual suspects (led by the Commission) have denied the claim, so it's probably true.

So under such a scenario:

Greece borrows money on the markets by issuing bonds. When faced with reality - which is that it cannot find money for new loans to pay back the old loans because it doesn't have any real source of income (i.e. no tax base or competitive growth) - friendly neighbours lend money to Greece at better rates so it can pay back its creditors (mainly major financial institutions - these might face a haircut in future but not until 2013). Then, Greece would still be in debt but to European taxpayers, not financial institutions - taking moral hazard to a whole new level.

For any household, financing old debt with new debt, without the income to back it up, would be unacceptable. That's how the sub-prime crisis came about.

In the eurozone, this is now apparently called a "solution".

George Papandreou Risks Sparking Class War Over Austerity Cuts
THE GUARDIAN: A mob attack on a politician in broad daylight has highlighted how desperate Greeks are becoming about political decisions imposed on them

Riot police clash with protesters in September outside the Thessaloniki International Fair where the Greek prime minister, George Papandreou, was delivering a keynote speech. Photograph: The Guardian
Stung by fury on the streets, criticism within his own party and rising poverty, the Greek prime minister, George Papandreou, addressed an emergency session of his socialist MPs yesterday as parliament prepared to debate one of the toughest budgets in the near-bankrupt nation's modern history.

Amid mounting hostility over austerity measures that last week sparked some of the ugliest scenes of violence since the eruption of Europe's debt-crisis in Athens, he appealed for calm in navigating what he has increasingly come to call a "state of war".

"These are critical times for Greece," said Kostas Panagopoulos, a political analyst. "It is going through its worst period in 30 years."

An attack in broad daylight on Kostas Hadzidakis, a minister in the former conservative government, has highlighted fears that Greeks are at a tipping point. He was set upon as he walked through Athens during one of the capital's biggest ever anti-austerity demonstrations. Protesters were seen shouting "thieves, thieves" and "let the parliament burn" as they punched him in the face, threw stones at him and tried to attack him with sticks. >>> Helena Smith | Sunday, December 19, 2010