Elga Bartsch says in the present situation, it is important to understand the angle by which policymakers will approach the issue and what the hurdles - - both legally and politically - - are that they would need to overcome in order to provide financial assistance to the Greek government.

1. The MS base case is that Greece will be able to muddle through.The case is that Greece will be able to turn around its fiscal situation without actually receiving financial aid. The political commitment by EU leaders to provide support underpins this base case to the extent that it reassures markets and keeps them open for Greek funding needs. The European Commission and ECOFIN (council of EU finance ministers) have formally endorsed the Greek stability programme. Next to that, European institutions have imposed tight deadlines on the Greek government to specify more details of the programme and to implement it. The Greek government has also been asked to present additional measures to fend off some of the perceived risks to the programme by mid-March.

In addition to a highly ambitious austerity package, the Commission issued recommendations on a broad range of economic reforms, notably structural reforms needed to revive the country's long-term growth prospects and to strengthen its competitiveness. These broad economic policy guidelines are nothing short of the complete overhaul of the Greek economy ranging from labour market reform, to product market deregulation to liberalising the network industry. Bartsch says such a combination of fiscal austerity and structural reforms is key to minimising - - over the long term - - the negative effects of the proposed budget savings on domestic demand. If the government manages to convince the Greek population that the austerity programme marks a turning point towards a better long-term growth outlook, this could crowd-in private sector demand.  Such non-Keynesian effects of fiscal policy - - which work via altering the long-term expectations of companies and households - - are rather common. They are more likely given Greece's high level of government debt.

Fiscal fundamentals aside, the question is whether the markets will give Greece enough time to prove that it can turn its fiscal position around. This is where the risk surrounding debt rollover comes in. Bartsch says markets seem very focused on the liquidity risk at the moment. Yet, the next few weeks are probably equally relevant regarding the medium-term solvency risks because it will become clear whether the Greek government will be able to push through its ambitious austerity package.

The political commitment by European leaders, even though the details of the financial assistance haven't been finalised yet, should have limited the liquidity risk considerably. However, more than the yield level, investors are likely sidelined by current market volatility. Here the elevated noise-to-news ratio out of European capitals does not help to calm down markets. Another liquidity crunch could potentially loom next year, when the redemptions almost double compared to this year and when there is a non-negligible risk that Greek government bonds could no longer be eligible as collateral at the ECB. That said, so far, peripheral countries, including Greece, have been able to come to the market in recent weeks. And if needed, they could also resort to additional measures, such as issuing bonds that trade well below par, to give investors some protection against the risk of default.

2. In the more likely of the two outside scenarios, Greece would get financial assistance from other Eurozone governments.Due to legal constraints, Bartsch says that emergency lending would be more likely than an outright bailout, if Greece needed external financial assistance. This is because a bailout would be a violation of the EU Treaty. Meanwhile, emergency lending would be compatible with the Treaty and has been extended to other countries in the past. For example, an EMU-sponsored initiative to provide financial support is more likely than an IMF-led assistance. But the latter cannot be ruled out either. 

After several EMU-outs seemingly refused to support a financial rescue operation, it is not possible anymore to use an EU lending vehicle such as the balance-of-payments assistance facility or the European Investment Bank (EIB).  Against this backdrop, a concerted bilateral aid package such as the one reported by Der Spiegel is a feasible alternative. The European Commission has already indicated that it stands ready to coordinate such a concerted effort, if needed. A bilateral aid package gives donor governments flexibility to choose the appropriate action within their national framework.

In all cases, Bartsch says policymakers in the donor countries will assess the best option with a view on whether a rescue operation would boost their chances of being re-elected. Hence, it is important to also bear in mind the political landscape in countries such as Germany, France or Italy to get a sense of how likely governments are to put taxpayers' money on the line. Given the domestic political pressure and faced with sizeable budget cuts themselves, governments might be tempted to issue a guarantee instead of lending directly. The advantage from the governments' point of view is that unless the guarantee is drawn, it remains off-balance sheet and outside the regular budget. However, guarantees need to be approved by national parliaments. Given the press reports about widespread corruption and tax evasion in Greece, legislators might be reluctant to support a bailout.

At the end of the day, it will be exposure of the domestic financial sector that will likely win the argument in favour of granting support.In any case, an emergency loan would likely only come in exchange for additional commitments on the part of the Greek government. Hence, the ability of putting such a rescue operation together will rest on the ability of the Greek government to make such commitments and to deliver on them. 

An attractive alternative to avoid the moral hazard issue and the conditionality question would be to create a lender-of-last-resort facility for Eurozone sovereign issuers. Bartsch says such a lender-of-last-resort facility would need to be funded by other Eurozone governments. Like a central bank, who acts as a lender of last resort to banks, the funding could be provided at a penalty rate. Similarly, if Greece or other peripheral countries would like to obtain a guarantee for one of its bond issues, they would be charged for such a guarantee; exactly like banks were charged during the financial crisis. The charges earned by a lender-of-last-resort facility could be used to prefund a rescue fund for a future financial crisis.

By charging governments for the usage of this emergency liquidity, the pressure would stay on these governments to reduce their budget deficits quickly. However, it would be unwise to take away the disciplinary effect of rising funding costs. As promising as this idea might sound in theory, it would be the first time that an emergency lending facility would be charging above market rates. Usually, emergency lending comes at subsidized interest rates.

Did you know that Greece has been ‘bailed out' by the EU before?Elga Bartsch says that in December 1985, Greece obtained a loan of 1.75 billion ECU from the European Union under the Balance-of-Payments assistance facility. Although its currency only formally joined the European Exchange Rate Mechanism in March 1998, it was suffering a balance-of-payments crisis in the mid-1980s despite an extremely strong USD, which eventually led to the Plaza Accord in July 1985. At the time, the feeling in Europe was that "the economic situation of Greece has shown a marked deterioration in the balance of payments, a fall in the foreign exchange reserves and a rapid increase in external indebtedness."

Even though it was acknowledged at the time that the problems were mostly of a domestic nature, the loan was approved on a number of conditions, notably a reduction in the budget deficit of 4pp in both 1986 and 1987. The pressure from the European Union only temporarily reduced the Greek budget deficit. The bailout failed to make any meaningful difference for the debt dynamics over the medium term. At first sight, the size of the loan is quite small. But applying the Greek inflation rate to the sum shows that it would correspond to €12.5 billion in today's money. Rescaling it to the size of the economy gets to the €20-25 billion range talked about at the current juncture.

3. MS believes that a debt restructuring is the least likely outcome. But it is not totally impossible either. Greece only defaulted five times since its independence in 1829 according to the Reinhart/Rogoff study This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises published in 2009. This compares to eight times for Germany and France and 13 times for Spain since these countries gained independence.

Elga Bartsch says there is a historical precedent for a default in a monetary union: the default of the US states in the 1840s. She says even a debt restructuring is highly unlikely to break up the euro. A debt restructuring would likely cause some serious volatility in the Eurozone financial system. Greece is not only highly indebted, but its debt is also, to large extent, held by foreign banks. Beyond the data on cross-border bank exposure via lending to the government or via lending to Greek banks, there is no reliable macro data that would allow prediction of the potential fallout from default.

Nonetheless, she says Europe needs to have a plan on how to contain the fallout on the rest of the EMU both in terms of the other sovereign borrowers and in terms of bondholders, notably banks and insurance companies. Bondholders would likely have to take a haircut on their holdings relative to par. Historically, the median haircut in sovereign debt restructurings over the last 15 years was around 35%.

Bartsch says it is clear from the EU Treaty that the ECB cannot fund government deficits or debt directly. It was for this reason that the ECB decided not to purchase government bonds directly when both the Federal Reserve and Bank of England did. However, a continuation of the unlimited liquidity provision by the ECB would probably help. But there are risks attached to such a strategy - - from a monetary policy point of view (creating the next asset bubble), from the financial stability point of view (further delay in cleaning up the European banking system) and from an operational risk point of view. At the moment, banks can still get unlimited liquidity from the ECB. Banks can and have used this liquidity to buy government bonds via the banking system.

But now the ECB is gradually reducing the maturity over which the liquidity is available.This will also gradually reduce the extent of indirect QE (quantitative easing). Having already phased out the one-year tender back in December 2009, the ECB will likely do the same with the six-month tender in April. Eventually, the ECB will probably also dial-back the additional three-month tenders. While Eurozone banks will still be granted unlimited access to the weekly main refinancing operation, MRO, the reduction of the maturities causes longer-dated EURIBOR contracts to rise back above the benchmark rate even though the EONIA overnight rate remains anchored near the deposit rate for now by the unchanged conditions on the MRO.

As a result, the overall liquidity in the system is still entirely determined by the bidding behaviour of banks.Only once the ECB decides to switch the MRO back to a variable tender or once it starts to mop up excess liquidity through reverse refis, etc. will the liquidity available to banking system becomes limited again. Despite still providing unlimited liquidity, the steepening in the money market curve caused by the reduction in the maturity spectrum amounts to a monetary policy tightening, driving up funding costs for banks.

How does it all end? Eventually there won't be a backstop for a global sovereign crisis.Elga Bartsch says it is the nature of a global sovereign crisis that there is no backstop. Initially, of course, small countries such as Greece can be contained by larger countries, such as Germany and France or a concerted EMU action. Eventually, however, markets might start to question the ability of large industrial countries to stem the crisis. After all, this sovereign crisis is global in nature as it follows an unprecedented global financial crisis .

In the MS view, the crisis comes in two flavours: inflation risks and credit risks.On the one hand, there are countries that have their currency and can print to meet redemption and coupon payments. On the other hand, there are countries that don't have this option. These are the countries within the Eurozone. In the first case, the sovereign crisis should eventually lead to higher inflation premia being priced into the bond market. In the second case, the sovereign crisis plays out in higher credit default risks being priced into the bond market.

As different countries around the globe grapple with the aftermath of the financial crisis, their institutional set-up and social preference will be keyin determining their ability to take tough decisions in the years ahead. Institutional features such as the degree of central bank independence, the ability of the electoral system to generate clear political mandates and the extent of autonomy at lower levels of government will shape the eventual outcome.

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