One year after the European initiative to help Greece with its daunting and self-inflicted debt crisis the issue remains, if anything, as intractable as ever. In the intervening 12 months the crisis has not only deepened but widened. The European initiatives to assist the beleaguered Greeks, Irish and Portuguese have already committed sums that run into a stupefying 50% of the combined GDP of these three countries.

Yet this is not enough as Greece again faces the prospect of default within months if not weeks. The Greek effort to consolidate its massive budget deficit has failed its targets. Nothing has been done in terms of privatization, tax receipts, hampered by severe recession and tentative collection have lagged and an assessment is pending as to the compliance of the agreed spending reductions.

At the centre of the Euro zone public and political opinion shows increasing reluctance to continue to expand assistance in the face of Greek failure to comply with targets and the ever rising need for assistance. Mrs Merkel, which has always had her latitude constricted by the need to justify German financial assistance and make it conditional to target compliance by Greece, has recently seen her margin of manoeuvre further limited. The junior partner in the coalition in Berlin, traditionally a pro-european party is now moving towards a more conditional and stern attitude as a result of the collapse of its standing in recent state elections. Finland has seen support for the national and euro-skeptic formation of the True Finns soar at the recent elections.

In the core countries voters are understandably reluctant to bail out faltering peripheral countries unless compliance to strict consolidation targets is secured and credible.
Still the problem goes beyond politics and failure to provide a solution to Greece’s faltering ability to repay its maturing debts will lead to default and carry major and potentially devastating systemic risk.

If default is to be avoided the choices can be simplified to two basic options: restructuring of debt or rescheduling its maturities.

Restructuring implies the admission that the country is insolvent. Short of debt repudiation, restructuring Greek debt would entail a debt write-off (‘haircut’) that reduces the value of debt by a minimum of 30% and probably a more realistic 50% (if the debt ratio to GDP is to be reduced to about 80% from the current level exceeding 150%.
A 30% reduction in the value of Greek debt would in all likelihood still leave the country with a solvency problem and need to be accompanied by a further funding package to ensure solvency and liquidity. Private sector debt in Greece is also bloated and largely insolvent with Greece’s very low rate of savings.

While the temptation to write-off debt animates some discussion, the solution would have devastating consequences. Bank equity would be wiped out leaving the domestic banking system bankrupt overnight and in need of a thorough recapitalisation that could only be funded with foreign capital. Foreign holders of Greek public debt, namely German and French banks would take a severe hit on their balance sheet. The ECB would require re-capitalisation after purchasing in excess of Eur 70 billion in Greek sovereign debt over the last year. Should private sector debt be included in a potential write-off, the problem would be magnified and Greek capital markets would require massive foreign intervention to avoid a total freezing of credit feeding into a potential chain of insolvencies. This of course would not even begin to take into consideration the massive disruption faced by international financial institutions that have been massively selling credit default swaps (CDS’s) and would be facing massive calls in the event of a debt write-off. The collapse of AIG is a clear illustration of the potential disruption for sellers of such derivatives.

Restructuring of maturities by preserving the basic integrity of principal and extending duration of debt appears a more fluid and safer strategy to avoid acute losses on balance sheets, ensure that interest service is continued and minimize the need for additional funds to be loaned to Greece, since no re-payment would immediately be forthcoming.

In the meantime the Euro will remain unstable and prone to fluctuations with the flow of events. Agreement on a bailout for Portugal and a possible reduction of the interest rate for Ireland (in line with that recently consented to Greece) can temporarily reduce pressure on the European currency but rallies will likely remain limited until clarification of the proposed solution for the critical problems of Greece is assessed and further downside pressure can follow a constricted rebound. Finally, and to enhance uncertainty further, a Dollar recovery can also be on borrowed time if a timely agreement to expand Federal debt limits looks contrived.

A satisfactory solution for the Euro would require that a new train of measures regarding Greece is essentially centred upon a rescheduling and not a restructuring involving a write-off of debt. Failure to deliver this can inflict losses that can expand below 1.375 and eventually extend towards 1.305 and possibly 1.260.
An extensive rescheduling of Greek debt, if accompanied by further fiscal consolidation (including a speeding up of privatizations to the tune of 50 billion euros, and better compliance on spending cuts and tax receipts) can limit euro damage to medium term proportions with potential support seen at 1.375.

While the disruptive damage of the Greek crisis for the Euro still on the balance it should not be forgotten that the Dollar is still suffering from the major structural handicaps (absence of a medium term fiscal consolidation strategy, a large current account deficit) and extremely low levels of interest, all of which tend to feed into potential weakness that can only be reversed to the extent and duration of events that increase markets risk aversion and temporarily paralyse the underlying diversification of reserve assets away from the Dollar.

May 16th 2011.