Euro Crisis Enters New Phase With Credit Squeeze: Daniel Gros

The life-support system for Greece, Ireland, Portugal and Spain is now under threat. The highly indebted nations of the euro area can’t survive the deficit crisis without access to central-bank credit.

Last month’s Franco-German agreement at Deauville, France, and the statement of European leaders on Oct. 29 have changed the ground rules for euro-area debt.

All 27 member states have now signed up to the need for a revision of the Lisbon Treaty in exchange for a permanent crisis-resolution mechanism. The key new element is that Europe’s leaders have specifically said that future rescues might involve private creditors. Nothing is known about the magnitude of their required contribution, but it’s now certain that they might be asked to participate.

The agreement by European leaders is reinforced by two additional recent developments.

First, the German resolve to “bail in” private creditors is much more credible now because the government-owned or controlled banks, which held much of the euro-area periphery debt owed to German financial institutions, have now transferred these assets to bad-bank programs. This means that these politically well-connected lenders no longer lobby the German government for a full bailout of highly indebted nations such as Greece, Ireland and Portugal; and that Germany is no longer hobbled by the knowledge that the stability of its own banking system would be jeopardized by a default in the euro area.

Renewed Meltdown

Second, the EU’s Oct. 29 statement speaks about “the role of the private sector.” Taken literally, this implies that all official creditors on the 110 billion-euro ($153 billion) Greek rescue package and any funds disbursed from the European Financial Stability Facility would be protected from losses.

This concentration of the risk to narrowly defined “private” creditors would represent a change in policy. The loan agreements concluded earlier this year with Greece didn’t give the government-to-government credits any preferred status.

This raises the question of whether the ECB should be considered part of the “private sector.” The problem is that the ECB’s Greek bond holdings are so large that there may be little left for private creditors if a restructuring is needed.

The ECB, the International Monetary Fund and other official creditors probably account for more than half of all Greek public debt. And this proportion is increasing. This implies that an overall “haircut” of 20 percent may translate into one of more than 40 percent for private creditors.

Increasing Spreads

The spreads on the outstanding longer-term bonds of Greece, and other peripheral countries, may increase even further if the preferred-creditor status of the European Financial Stability Facility and the ECB were to be confirmed.

After the Oct. 29 statement by EU leaders, the ECB will now have difficulty continuing its purchase program of Southern European government bonds, even though the perceived need has increased as spreads have widened. Even more importantly, the ECB will also have to become more prudent in its collateral requirements on lending from peripheral countries as the prospect of a restructuring with losses for private creditors has now become official policy.

This threatens the periphery’s life-support mechanism. The importance of the availability of credit from the ECB is seen in the sizeable current-account deficits that Greece, Ireland and Portugal continue to run, implying that they need new capital from abroad (and a rollover of credit lines that expire).

Huge Transfers

The banking systems of Greece and Ireland have each received about 100 billion euros in external funding via the ordinary monetary-policy operations of the ECB over the past two years. Without these huge transfers -- which amounted to about 40 percent of gross domestic product for Greece and 75 percent for Ireland -- the economies of these two countries would have been subject to the same type of “sudden stop” of capital inflows as happened in Central and Eastern European nations such as Bulgaria, Estonia, Latvia and Lithuania, whose banking systems don’t have access to the refinancing windows of the ECB.

Banks and enterprises in Greece and Ireland are practically shut out of the international capital market. If access to the ECB’s windows became much more difficult, residents of Greece or Ireland would no longer be able to finance their current level of spending, and these economies would collapse.

It is clear that incomes and consumption would plummet in debt-ridden countries if the euro-area periphery were to be forced to the same external adjustment as countries in Central and Eastern Europe. Government revenue would then also plunge, making the fiscal adjustment even more difficult.

The political systems of Greece, Ireland and Portugal, in particular, need to muster the same resolve as those countries in Central and Eastern Europe that have so far continued to service their debt regularly. Without a life-support mechanism in the euro area, the task before them will be daunting.

(Daniel Gros is the director of the Centre for European Policy Studies in Brussels. The opinions expressed are his own.)

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