EUROPEAN CRISIS: TIME FOR PLAN B

TIME FOR PLAN ‘B’

Mr Papandreou is playing poker. Greece’s government decision to call for a confidence vote in Parliament to be followed (if the vote is won)by a referendum on the acceptance of second bail-out plan has changed an already uncertain game and not for the better.

First the confidence vote: if the government loses Greece will immediately move into unfettered political crisis, new elections will have to be called and all bets will be off the table. If the government manages to win yet another confidence vote a referendum will follow in January or February. At best this means that complete paralysis will grip the Greek side until at least the outcome of the referendum will be know perhaps in 3 months time.

Coming at a moment when Europe was laboriously making way towards more comprehensive measures and means to address the crisis, Mr Papandreou’s call virtually puts Greece out of any role in implementing the commitments that it has itself negotiated with its European partners.

We can now say that if Greece still has a government by next weekend, that government has placed itself in a situation where it is now unable to substantively address its commitments and responsibilities before, at best, sometime in the mid to late winter.

Markets do not wait. The consequences and costs of Mr Papandreou’s gamble will now rapidly roll and markets, as much as politicians, must now face the realistic probability that a paralysis of at least 3 months in implementing the second bailout for Greece will lead into unmitigated Greek default and for sure raise further the costs of any eventual solution.

It’s time for plan ‘B’ (ust).

Europe now urgently needs to prepare for the situation it has strived to contain, if not avoid. A Greek default will have several obvious consequences.

Firstly the equations used to recapitalize banks are obsolete. We need to consider not 50% write downs on Greek sovereign debt but possibly 100%. This could add a further 100-120 billion of the effort of recapitalization.
The Greek banking system will, of course be bust and this will affect European banks in two ways.
Those (mostly French banks) that have invested in a stake in Greece’s banking system will have a large and painful bill. Big as it will be, only a couple of large banking institutions will be directly affected. They now will almost for sure need direct state intervention to underwrite the losses to their balance sheets.
The other consequence to be faced will be the counterparty risk entailed by the default of Greek banks towards foreign (mostly European banks). Counterparty default by Greek banks will, in all evidence, affect the European banking system in a much more widespread way. European governments will probably need to implement generalized guarantees on bank debt if a swift implosion is to be avoided.

Another obvious major systemic risk is how to contain the spread of a looming Greek collapse from devastating Italy, and the other vulnerable European economies. The re-tooling of the EFSF agreed just a few days ago is already appearing inadequate to act as an effective ‘firewall’ to potentially devastating contagion.

Three major elements need to be mobilized in short order:

Italy will need to deliver a further set of credible measures to consolidate its finances and gain the market’s confidence that its implementation will be swift and decisive. Will Mr Berluscoli’s frayed coalition be able to deliver?
The European Central Bank will need to be seen ready to enter commitments to sustain Italian (and Spanish) debt by further potentially larger purchases than it has been reluctantly made to accept. Only the ECB has the immediate firepower to intervene in what could become a rapidly deteriorating situation. Mr Draghi will have a hot seat from the start.
Finally at this weekend G20 gathering Europe will have to persuade major reserve rich countries (with inevitably a higher profile for the IMF) to commit significant resources to fund the rapidly escalating costs of the European crisis. China, which has much to gain from circumstances, will require clarification of terms conditions and guarantees to be offered prior to any commitment which is likely to come only later.
A Special Investment Vehicle with IMF involvement and EFSF guarantees to investors will need to be offered if sovereign wealth funds and other large reserve asset holders are to be tempted to commit significant amounts of capital to the purchase of beleaguered European assets.

Faced with the enormity and complexity of the issues (and the lack of precedent of this historic crisis) markets can legitimately be seen to lack confidence in the ability of Europe’s arcane, fractious and often erratic decision making instances to face up to the titanic challenge.

All however is not to be perceived as a hopeless endeavour. Urgency and the incisive nature of necessity focuses the mind and mobilises efforts. The next days and weeks will be telling.
Last but not least Europe has, over the last 2 years, already set aside something like €270 billion in two packages to bail out Greece. Of these only about €40 has been committed to date. If Greece falls out of the process to address its own problems with European solidarity, Europe can eventually re-direct the remaining €220 to contribute to the funding of the Greek induced systemic crisis now gripping the Eurozone. The size of this envelope can no doubt go some way into financing the contingencies of Plan ‘B’.

A.Ferreira
November 1st 2011