Greek default looks more likely; Italy ‘must be protected’
Holger Schmieding, chief economist at Berenberg Bank in London, explains why Europe should not cut off Greece, and reveals why he wants the ECB to prove it means business.
Hopes which followed Germany’s affirmation of the expansion of the European Financial Stability Facility (EFSF) could be dashed, following reports from Greece that its budget deficit is larger and its recession deeper than projected.
This only adds to the list of concerns the eurozone faces.
Late yesterday (Tuesday October 4) Moody’s Investors Service downgraded Italy's sovereign debt for the first time since 1993 by slashing the country's government bond ratings by three notches to A2.
Euromoney spoke to Schmieding for answers to the big questions regarding the eurozone.
He explains why an ordered Greek default is looking more likely as German patience runs out, and the effect that such a default could have on the Greek economy. He also confirms that the EFSF would likely prove to be entirely insufficient in the face of an Italian default, but affirms his belief that in such a situation the ECB would step in to keep the country afloat.
We’ve seen a lot of talk regarding the EFSF. In your opinion, what needs to be done with the EFSF? Is it large enough as it is, or does it need to be increased?
We can take it as a fact that there will be no further German guarantees. We must work with the current size of the fund and use it as efficiently as we can. The use of private capital – leveraging the fund – may boost the effective volume, but we are unlikely to get close to the one trillion mark.
The EFSF is simply not large enough to keep Italy out of harm’s way if we get an irrational panic – that is, if investors rush to sell Italian bonds regardless of Italy’s fairly comfortable fiscal situation. If it comes down to that, only the ECB has the capacity to safeguard Italy. In a sense, the EFSF is secondary – it is big enough to bail out Spain, or to recapitalise the banks, but it isn’t enough for Italy. If it comes to that, then the ECB would need to support Italy by as much as it takes, provided that Italy stay on course to balance its budget in 2013.*
There have been suggestions of adding insurance-like qualities to the EFSF. What is your evaluation of such ideas?
There are merits in an insurance-type solution, but the leverage might remain modest. Some have suggested a 20/80 split. Unfortunately, a guarantee for a 20% first-loss tranche is unlikely to be enough in a worst-case scenario. And the only time we would need the insurance function would be in a worst-case scenario. It is worth studying, but I’m not pinning many hopes on it.
Greece has just announced that its projected deficit for the year is going to be higher than expected, and that the recession is deeper than expected. With this in mind, how likely is a Greek default? What would the fallout of that be?
A Greek default is neither necessary nor inevitable at this stage. Ultimately, it will depend on how long Europe is willing to give Greece credit at a 3.5% or 4% rate. Such an interest rate is sustainable even with Greek debt levels. A Greek default is not economically necessary; if it occurs, it will be because of political concerns. It is a matter of the political will in Europe: with official credit at 3.5% or 4%, we can conceivably get Greece into a similar situation as Ireland in a few years. Investors have started to get back into the Irish bond market again. However, I suspect that Germany may start planning an orderly default for Greece soon. Berlin is getting reluctant to offer more money to Greece without a haircut for private creditors. We are going to see a serious discussion over a Greek default in the next few months.
The key issue in Europe is not Greece. Greece is small. We have to contain contagion risks. If Greece were to default, we have to make sure that Italy does not fall victim to contagion. The ECB would need to make a forceful move to protect Italy in order to impress the markets. So far, the ECB response to a potential Italian collapse has been underwhelming: they buy Italian bonds. But they do it so reluctantly that markets are not impressed. Instead, they need to signal how serious they are.
If an orderly default is looking to be more likely than not, what are the chances of a disorderly default?
There are two circumstances in which a disorderly default could arise. Greece may refuse to conform to European-set conditions, leading to the flow of money being shut off. I find this unlikely. Or the troika could refuse to continue to supply Greece with money, which also seems unlikely for now. The fallout of a disorderly default would be much worse than that of an orderly default: the supply of euros within the country would dry up quickly, and the government may have to issue coupons as a stand-in currency. Public sector jobs and wages would have to be slashed, and the banking sector would probably not be able to survive. In short, the Greek economy would likely collapse.
Do you think that a Greek withdrawal from the eurozone is likely at this point?
Withdrawal from the euro would make very little sense as a voluntary decision from Greece. Money would quickly disappear from the country, bankrupting the Greek banking system and economy. Because it would be so costly, Greece is unlikely to leave the euro. As a small tail risk, a Greek exit from the eurozone could happen after serious policy mistakes.
Greek withdrawal could theoretically occur in the case of a disorderly default. If the supply of euros within Greece were to disappear, Greece would need to create a new currency. Coupons to pay wages and pensions once the government has run out of euros could gradually morph into a new national currency.
How effective has the ECB reaction been to the situation? What does it need to do differently?
The ECB has always, when it came down to it, done the right thing. The problem is that it has always done it very late, and communicated it very poorly. The ECB needs to make clear that it is buying government bonds in order to prevent a financial meltdown; it needs not be shy about that. Talk of buying bonds as a means to safeguard the transmission of monetary policy to the economy is not helpful – it is obscuring rather than clarifying the purpose of such purchases.
We’ve seen calls for the ECB to reverse the two interest rate increases made earlier this year. What do you make of that?
Raising interest rates was certainly appropriate at the time. When the ECB tightened its monetary policy, the eurozone was the best performing economy in the developed world. Now, however, high interest rates are no longer appropriate. The current crisis poses a serious threat to the economy, and interest rates need to be slashed in response. I suspect this will be done by January at the latest.
Is there a situation where one or more countries – namely Greece – may need to be allowed to collapse?
The only situation where it would be necessary to cut off aid to Greece is if they clearly violate the terms of the agreements under which the aid is granted. Missing fiscal targets in a deep recession is not enough to withhold aid. No government is perfect, and no government is capable of meeting all targets all the time. We must support Greece as part of the eurozone family, so long as it does as much as any government can do to reduce fiscal deficits and reform its economy.
What do you think is the most important issue at the moment?
My mantra is that we need to prevent contagion from Greece to Italy, and that the ECB must act forcefully to ensure that Italy does not fall victim to an irrational market panic.
*Note: this interview took place just before the announcement that Moody's downgraded Italy.