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Analysis/Comment Last Updated: Jun 24, 2011 - 6:22 AM

The unforeseen consequences of voluntary debt reprofiling for Ireland
By CheckRisk commentary
Jun 24, 2011 - 2:58 AM

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George Papandreou (back to camera), Greek prime minister, José Luis Rodríguez Zapatero, Spanish prime minister and Pedro Passos Coelho, the new prime minister of Portugal, at the EU summit, Brussels, June 23, 2011.

This is a commentary from CheckRisk, a UK company which provides pre-investment market risk analysis for to investors.

The most recent EU “hope” has come from the possibility of a so-called voluntary reprofiling of debt. It is not clear, however, that the ECB and EU have thought through the consequences of voluntary reprofiling of sovereign debt for countries such as Ireland and Greece. In fact there are many unintended consequences to such a move which could be much more dangerous and costly than accepting an outright default, according to CheckRisk, the research and advisory service.

It is clear that the ECB and EU are struggling with the possibility of a complete debt collapse in Greece. So far the solution has been to pile more debt onto Greece, but delaying the inevitable is not a long-term solution. The central problem is that a solvency issue cannot be treated with liquidity solutions. Only debt reduction can solve a bankruptcy problem, which means someone has to take a loss. We have written at length on the transfer of risk from the private sector to government, and the current move toward a soft solution in Europe is symptomatic of a misunderstanding and naivety with regard to the risk of such actions, warns CheckRisk founder Nick Bullman.

What the EU and ECB would like to achieve, before August, is a restructuring that avoids the terminology of default being attached to it. This, as far as the EU and ECB is concerned, is a solution because it allows more time for Greece to make far reaching austerity measures and for the economy to recover through the stimulus of further loans. Whilst this is unrealistic, it is the position that Europe wishes to take. Given that funds are already stretched at the European Financial Stability Bond level, there are €450bn available for bailouts but Greece might use at least €150bn of this fund and thus leave it very underfunded for Portugal, Ireland and Spain which are lurching toward the same fate.

The guarantees member states have given to the EFSB (European Financial Stability Board) are also problematic. The ECB, is therefore, understandably defending the castle wall with regard to the term default. The ECB has unique access to the details of sovereign finances and the trouble they are in, but more importantly the ECB is acutely aware of the problems at individual bank level. Proof of this may be found in the European Bank Authority (EBA) , which was set up by the ECB and EU to conduct financial service company stress tests.  The EBA is currently conducting stress tests that will be published in July, notably the possibility of a Greek sovereign default is excluded in the testing standards. It is not surprising that two banks, Allied Irish Bank and Bank of Ireland have both needed additional funding despite passing the last round of EBA stress tests a year ago, when such loose tests are applied.

The EU and ECB are under the utopian delusion that because an investor accepts a voluntary change that no default has occurred. But we believe this is fundamentally a poor and incorrect interpretation that has massive risk consequences for the credit default swap market (insurance) for bonds. 

Quite apart from the semantics it is very clear that Greece is bankrupt and that no matter what austerity measures are introduced the burden of debt is just too great. The Greeks are being asked to endure greater pain, not because it will lead to a solution, but more because they must suffer to protect the core banking system of Europe. France and Germany are likely to extract the same sacrifice from Ireland and is here that geopolitics will clash with economics.

It is unlikely that the average Greek will be up to the challenge.  This week’s parliamentary vote of confidence in Greece is not really relevant. The vote to watch is the passing of austerity measures and then the implementation of them. It is also unlikely that the Irish will relish such a role. The denial of creative destruction, by the EU, the ECB and government intervention has cut capitalism dead in its tracks.  The inability to allow debt to be written down by accepting that losses must be incurred is putting the existence of the euro on the line and is a massive bet which is, for those that understand risk, not worth taking when compared with the cost of letting Greece go.

Greek Euro Exit Not the Answer: Economist: "The fact of the matter is that some historical processes are irreversible; the euro, like it or not, is one of those," Barry Eichengreen, professor of economics and political science at the University of California, Berkeley told CNBC Thursday. "Greece is going to have to figure out other ways, with the help of Europe, of restoring its competitiveness," he added:

Finfacts op-ed article: Should corrupt Greece be ejected from Eurozone if it rejects reform?

There are other unintended consequences to present EU policy actions. The insurance industry, particularly the US insurance industry, owns massive liabilities in the bond insurance market. Credit default swaps insure against the default of the debtor to the benefit of the creditor or lender. European banks, when they invested in Eurozone debt will have in many cases insured against default by buying credit default swaps (CDS) for this insurance to be triggered a default event must occur. The ECB are determined to avoid default at any cost for this reason. It would force a payout of CDS insurance and a write down of outstanding debt. Again this kind of market manipulation has consequences. If a bank, for example, loses money in a bond but cannot trigger the CDS insurance, then their position is unprotected. Unhedged is the proper terminology. The only choice in such a circumstance is to sell the bonds, which would cause interest rates to spike higher for the weaker nations. The alternative is to allow the market to work and insurance protection to be called on, the EU are hesitating because of fear of contagion. But ultimately until the debt is written down, bond market funding access for Ireland and others will remain closed as the risk of investment with no insurance is simply too high.

The loss of sovereignty that the austerity measures imply will be hard to accept by the Greeks and southern Europeans. The Irish too will not easily trade their economic freedom for a greater European ideal; Ireland is not Greece; but debt does not distinguish between nationalities. Ireland is more likely to come out of the crisis in better shape to handle the future, but at what expense in the present?  The concept of perpetual economic bondage is not easily discussed but is becoming a reality under the current construct. It is easier to understand why this pressure is being exerted when one considers the exposure of the German, French and British banks to the debt of Greece, Ireland, Portugal and Spain.

There are solutions, the most likely, perhaps inevitable, outcome is that France, Germany and the stronger northern European countries break away and form a northern block euro. The weaker southern countries, including Ireland would, with the sponsorship of the northern block revert to their own currencies in the form of a euro punt, euro drachma, and so on. These currencies would be pegged to the northern block euro, but with very wide convergence zones allowing them initially to devalue and eventually, when their fiscal houses are in order, to rejoin. This appears a radical solution but in reality is the cleanest way to stimulate growth. Without such a radical step the euro is doomed. The debt burden is simply too large and will be exposed by the market on a continuous basis. The choices are of a two-decade, maybe longer, Japan style economic stagnation, or a realization of the reality now.

Ireland needs to brace itself against the coming storm.  The key is to renegotiate the bailout terms and include debt forgiveness in the package. The Irish need to decide early what their fate will be, the current Irish Government has performed reasonably well in its first 100 days – however the mountain that has to be climbed to recovery is steep. Clarity of purpose, clarity in negotiations with EU partners, an export driven recovery and an entrepreneurial spirit are the elements that just may differentiate Ireland from the other struggling Eurozone economies.

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