Inevitability Of a Default In Greece

A Greek debt restructuring — a polite term for default — is unthinkable, according to the Greek finance minister.

“It would have a tremendous cost, with no benefit,” the minister, George Papaconstantinou, said in an interview on Greek television. “Greece would be out of markets for 10, 15 years.”

To financial markets, and to many other observers, it is more than thinkable. It is very close to a sure thing. When, how, and how messy it will be are open to question.

It was just a year ago this weekend that Europe bailed out Greece, amid much self-congratulatory talk. Olli Rehn, the European commissioner for monetary policy, said the move was “particularly crucial for countries under speculative attacks in recent weeks,” a reference to Spain and Portugal.

Markets — described by Anders Borg, Sweden’s finance minister, as “wolf packs” — returned to their lairs on the Monday after the bailout. The yield on three-year Greek government bonds plunged to 7.7 percent from 17.5 percent, as the price of such bonds soared 28 percent in a single day.

And how have things gone since then? Just fine in Germany, where growth is accelerating and unemployment is lower than at any time since German unification. The European Central Bank is even raising interest rates to curb inflation there. It’s going more or less acceptably in France and Italy, each of which recorded G.D.P. growth of 1.5 percent in 2010, well below Germany’s 4.0 percent. But it’s not going well at all in the country that supposedly was rescued. Greece’s economy shrank 6.6 percent, far more than the 1.9 percent decline in 2009.

The market wolves are howling again. The yield on Greek three-year bonds is more than 23 percent, not that anyone thinks that yield will really be received. The yields on similar Portuguese and Irish bonds have also soared into double digits. Investors are a little more skittish about Spanish and Italian bonds than they had been, but there is no sense of impending disaster.

Longer-term rates on Portuguese debt did slide a little this week after a tentative agreement on a bailout, but they remain at levels that show widespread doubts about the country’s ability to pay.

The trading patterns of Greek bonds indicate that traders expect a restructuring, and they think it will be messy.

That yields are as low as they are — if you can call 23 percent low — is a reflection of the fact that the bailout has been going on below the surface. The European Central Bank has been lending money to Greek banks, accepting Greek bonds as collateral on loans to other banks, and even buying bonds.

Keeping up the fiction that all will somehow be well if we just wait has its own disadvantages.

“Delays in restructurings are costly,” Alessandro Leipold, the chief economist of the Lisbon Council, a Brussels-based research group, and a former official of the International Monetary Fund, wrote in a paper this week. He warned that the longer the inevitable was delayed, the more potential economic production would be lost and the greater the amount of good money that would be thrown after bad in the form of ever larger bailouts. Ultimately, he said, the result would be larger losses for bondholders.

“The real problem is capital shortfalls in European banks,” said Whitney Debevoise, a partner in Arnold & Porter and a former executive director of the World Bank, who has been involved as a lawyer for countries and creditors in several restructurings. Until the banks have more capital, forcing them to admit to losses would be problematic, to put it mildly.

Stalling has worked before. In the early 1980s, major American banks could not afford to admit that they had lost huge sums in the Latin American debt crisis. “There was,” Mr. Debevoise said in an interview, “a five-year period of temporizing while Citibank and other banks rebuilt capital.” Finally, there was a debt restructuring and the banks admitted to their losses.

Currently, some European banks would probably be hard pressed to take losses, a group that may include some of the German landesbanks, which are generally owned by state governments and are badly in need of new capital.

The European Central Bank itself would hate to report losses, which is one reason that the first Greek restructuring, when it comes, may avoid forcing bondholders to accept “haircuts,” or reductions in principal. Instead, cutting interest rates and postponing maturities could allow the central bank to pretend it had not lost money. Eventually, however, haircuts seem inevitable.

Although there have been plenty of defaults and restructurings by national governments in recent decades — a partial list includes Argentina, Brazil, Uruguay, Russia, Ukraine, Pakistan and Ecuador — there is no agreement on the way to arrange a restructuring. Nearly a decade ago, the I.M.F. tried to put together what it called a “sovereign debt restructuring mechanism,” a sort of international bankruptcy law. The effort collapsed.

As a result, restructurings can be messy. Some bondholders can try to hold out on approving a plan, hoping they will be paid more than those who agree. Lawsuits will be filed.

Europe, in a classic case of trying to solve a problem only after it is probably too late, has decided that after 2013 all European government bonds will have a “collective action clause” stating that a restructuring approved by 75 percent of bondholders will be binding on the dissenters.

In the meantime, Greece’s negotiating position is improved by the fact that about 90 percent of its outstanding bonds specify that Greek law will determine any disputes — and of course Greece can change its laws if needed. There might be an appeal possible to the European Court of Human Rights, but one way to satisfy a judgment of that court is to issue new bonds. So if Greece were ordered to pay damages for not paying off old bonds, it might be able to comply by issuing new ones.

Even in cases that are heard in courts presumably more friendly to lenders, there is an issue of how a country can be forced to pay. Sovereign immunity is not absolute, but it can be powerful.

Still, bond investors evidently think that a Greek restructuring is likely to wind up in court, and that having the bond subject to British or American law could make a difference. The yields on such bonds are a couple of percentage points lower — meaning the prices are a little higher — than on comparable bonds that would be resolved under Greek law.

It also appears that many traders think there will eventually be changes that force all lenders to take either the same interest rate or similar haircuts on the bonds. Among the Greek issues is one maturing in August 2015, with a yield to maturity at current prices of about 20 percent. A similar bond, maturing a month later, has a yield of just 18 percent. The prices make sense only if you assume that traders think there will not be many interest payments before a restructuring.

German officials hinted a few weeks ago that a Greek restructuring might be coming, but have since been quiet, and the German government has joined the European Central Bank and others in saying no such action is under consideration. Instead, they say, Greece should stick to its agreed plan of austerity and reduced budget deficits. The fact it is failing to meet those targets — the 2010 deficit was well above plan — is treated as inconvenient but not crucial.

Sooner or later there will be a Greek default, even if it is officially described as a “voluntary restructuring” approved by most bondholders. Europe wants to delay that at least until 2013, when new rules are supposed to kick in that would let official creditors — such as Europe’s bailout fund — do better in a deal than private creditors. But it seems less and less likely that the inevitable can be delayed that long.

Europe needs to do what needs to be done to keep a default from destroying its financial system, and then accept the reality. Insisting that Greece can get by without a restructuring makes it less likely markets will believe similar assurances about countries that actually might be able to recover and pay their bills.

“Peripheral bond markets risk continuing in their tailspin, remaining virtually shut down and rendering restructurings a self-fulfilling prophecy,” wrote Mr. Leipold of the Lisbon Council, “even where those forced restructurings might arguably constitute a market overreaction.”