The Greek Tragedy: Could a ‘Haircut’ Help?

Debate has been raging as to whether the Greek economy can avoid bankruptcy. Just how big is the problem, what are the options and how is this impacting financial markets? 

Background to the Problem

Greece is around €300bn in debt. Putting that into context, its budget deficit is one of the highest in Europe and last year amounted to more than four times the Eurozone limit at 13.6% of GDP. This more than supports the country’s inclusion in the infamous ‘PIIGS’ acronym (Portugal, Ireland, Italy, Greece and Spain) used to refer to the areas of sovereign debt concern.

What’s Going On?

Despite the jobless rate reaching 16% (and a horrific 42.5% for youth), the Greek economy has seen only marginal deleveraging. Instead, people are depending on consumer credit to maintain their levels of expenditure and service their debts (i.e. paying credit card bills with other credit cards). Moreover, whilst many in the UK struggle to obtain loans from banks, the overall banking sector in Greece actually increased their credit availability, with the most significant increase going to the government itself.

Attempted Solutions

Last Thursday, Jean-Claude Trichet, President of the European Central Bank, announced that they would lend Greece €45bn in new loans. However, this alone, they acknowledge, is not enough. The ECB wants to see structural reforms and a good deal of privatization, with the claim that €50bn could be generated over 3 to 5 years to reduce debt/GDP from 160% to 140%.

What are the Complications?

Loans to ‘bailout’ struggling countries are partially funded by taxpayers from different countries within the EU. Therefore, the problem is not an isolated one. Furthermore, even after this loan and the privatization contributions, there will be a financing gap of €170bn between 2012 -14 which will need filling. European banks have to refinance €1.3tn maturing debt by end 2012 and are owed over €200bn already by the PIIGs for refinancing ops.

Could a Good ‘Haircut’ Help?

With so much talk of a ‘restructuring’, i.e. bond holders sharing some of the pain, it is interesting to hear the views of Lorenzo Bini Smaghi, an ECB executive board member on the subject. He maintains that these are not the tools by which Greece can save its economy but could cause a “Depression” and “banking system collapse”. Furthermore, those pointing to a compromise of a voluntary or ‘soft’ restructuring appear to be fooling themselves. According to him, there is “no such thing as an ‘orderly’ or ‘soft’ re-structuring” since ‘haircuts’ (a percentage knocked off the par value of a bond) would have to be forced by governments. Crucially, any type of restructuring would cause a panic in the markets and cause credit events reducing the value of these investment vehicles either way.

Yield on a 10 year Greek Government Bond (Orange), 10 year German Government Bond (white) and the spread between the two (yellow) - showing the higher premium demanded by investors for holding Greek debt, near historical highs - highlighting a heightened risk perceived by the markets.

So, What Are the Options?

As previously mentioned, a default on some of its debts would have dire consequences but the prospects for sustainable financial solvency appear weak with such a substantial deficit and the habits of borrowers and lenders not much improved. Most worrying, from the perspective of European stability is the recent comments from a Greek EU Commissioner that “The scenario of removing Greece from the euro is now on the table”. Therefore, although in stark contrast to statements by Greece’s Prime Minister and with France and Germany still heavily exposed to EU laggards, which together make a break up of the euro unlikely in the short-term, it is a fear weighing on investors minds.

How are the financial Markets Reacting?

Risk aversion is back on the rise. Investors are worried and, understandably, demanding higher premiums to lend to Greece. That’s not all. Other markets are suffering. “All sophisticated indicators of systemic risk, cross correlations of CDS and yield spreads show a high sensitivity to restructuring moves and are at levels higher than in September 2008”.

The Investment Insight: What Can You Do?

This has two consequences. Firstly, investors should be more cautious of an indiscriminate sell-off but secondly, this can be used as an opportunity to pick up high quality assets at a lower price. Be wary but remain opportunistic.


  1. This is a solvable problem. My suggested solution to this problem:
    I. European Banks exposed to large holdings of national bonds of Greek & PIIGS can stay financial healthy if :
    1. EU & ECB rule that all banks under their supervision can use newly converted Greek national bonds, resulted from postpone of maturity date of Greek national bonds/replacement of near maturity Greek bonds to longer term maturity Greek national bonds, as collateral for funding from ECB, while Greek national bonds to be expired in 2011 (or up to 2013) which are not converted to newly issued bonds would not be allowed to be used as collateral in ECB for borrowing of short term funds, and European banks which do not participate in this Greek national bond exchange exercise will need to raise capital by certain percentage point, as a penalty, as safety cushion for their risk exposure.
    2. European banks are not allowed to trade “old” Greek national banks which are not exchanged to “new maturity” Greek national banks, otherwise, these banks need to raise capital ratio for their “risky” trading practice. This shall encourage banks and private investors in “old” Greek national bonds to exchange to “new maturity” Greek national bonds, as this conversion will not make bond holders to lose principal and interest in the short term, and the secondary market of “old” national bonds will suffer from loss of many potential buyers in the market, and large write-off in book values may result if “old” bonds are not exchanged to “new maturity” Greek national bonds.
    3. If European banks which participate in this bond conversion exercise will suffer loss because of Greek default in payment, ECB will issue ECB bond to exchange for shares of these European banks, raising the capital ratio of these banks to financial healthy situation. Though bank shareholders may suffer from stock dilution, it is better than massive write-off now, and these banks can stay financial healthy in the market. Banks can use these ECB bond to obtain funding from ECB for liquidity purpose, while ECB do not need to borrow money from the market to save these banks. The operation is just printing of new ECB bond, while ECB obtain shareholdings of these European banks, while allowing these European banks to buy back their shares from ECB, by returning their “ECB bonds” to ECB, at a pre-determined rate.
    4. This practice can be applicable to national bonds of PIIGS if similar crisis occur in the future.
    5. ECB and EU will implement this bond conversion exercise only when Greek can control their national financial budget in a healthy way.
    6. If Greek cannot control their national financial budget in a healthy way, (3) can still be implemented to ensure financial healthy of European banks.

    II. ECB can buy Greek bonds at quantity approved by EU, by increase in money supply for this particular Save Operation, if and only if Greek can pass and control a healthy financial budget acceptable by all EU countries and EU treaty. By increase in money supply in one-off operation, it will not be inflationary as long as it is one-off and not continuous to support unhealthy expansion of Greek’s national deficit, in fact, this increase in money supply is counter-deflationary rather than inflationary, and taxpayers of other EU countries will not suffer because of Greek’s inability to control their budget. It is counter-deflationary because Greek will suffer from serious recession and deflation if they could not obtain tempoary finance from selling national bonds, while the increase of money supply by ECB will not be used to finance Greek’s expansionary spending plans. Increase in money supply is interpreted as “inflationary” because most governments did not have mechanism to stop the pattern of increasing money supply when there is inflationary risk, for avoid riots from voters and citizens because of loss of jobs, income, etc. When this increase in money supply is predefined as one-off, then Greek should know that they have to balance their budget by themselves, and can not count on ECB’s increase in money supply to solve their financial and economic problems in the future.

    III. By establishing this Save Mechanism, uncertainty and fear in the market may be reduced, as other friendly countries and their central banks may follow the practice mentioned in (I) (3), to save their banks’ financial situation and as a concert efforts to save friendly countries which are willing to take up their own responsibility to repay their bond holders in a constructive way.

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