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Danger zone

3 Jul 2015 By Hugo Dixon

Greece’s debt issues are acute. They could explode on July 20. Some way needs to be found to defuse the dangers.

At the heart lies a 3.5 billion euro bond owned by the European Central Bank that Athens is due to repay on July 20. Failure to do so could trigger the bankruptcy of the country’s entire banking system.

If the Greeks vote “No” in Sunday’s referendum, the euro zone authorities may just shrug their shoulders and think that Athens had it coming. But if the people vote “Yes”, the euro zone authorities will surely want to avoid such a catastrophe.

Failing to pay the ECB would be far more serious than Greece’s default to the International Monetary Fund on June 30. This is because the ECB both authorises emergency liquidity to Greek banks and supervises the lenders. The central bank turned a blind eye to the IMF default but it couldn’t do the same if it wasn’t paid itself.

The central bank would have to conclude that the government had defaulted. This is a problem because the banks have used state-guaranteed paper as collateral for their emergency liquidity transfusions. It is hard to see how the ECB could then avoid asking the banks to return at least some of the liquidity and, since they couldn’t, they would be declared bust.

An insolvent banking system is an altogether more serious matter than the capital controls Greece is already living with. If the banks were not recapitalised, they would have to be liquidated. People wouldn’t even be able to transfer money electronically from one account to another, as they currently can. The country would have no payments system apart from cash.

The problem is that Athens would have no money to recapitalise the banks, unless it brought back the drachma. But the whole point of voting “Yes” in the referendum would have been to avoid that outcome. The only way to return the banks to solvency would be to “haircut” depositors – forcibly converting a portion of their savings into capital. This would seem like an extraordinary betrayal if the people had just given the thumbs-up to Europe.

So how could the danger be defused?

The simplest option would be for the euro zone countries to give Athens some money to pay the ECB. However, it’s most unlikely they would do this unless the government signed a new bailout plan. The snag is that there would probably need to be new elections to produce a government with which the creditors could do business. That would take at least until the end of July – after the July 20 deadline. There are, though, other options.

One would be for the ECB to authorise yet more liquidity to be pumped into the banks and, at the same time, let them use that money to buy more treasury bills from the government. Athens could then repay the ECB.

The problem with such a money-go-round is that it might well contravene the European Union treaty, which prohibits the central bank from funding governments directly. If Greece was on the point of cutting a deal with its creditors, the ECB might be able to get away with this. But under this scenario, it would still be unclear whether the government that emerged from the elections was going to be cooperative with its creditors or fight them.

A second option would be for Athens to add a “grace period” to the bonds so they only had to be repaid after the election, with the idea that by then there might be a government ready to talk to its creditors. Greece could do this because these particular bonds are governed by Greek law.

The advantage of such a scheme is that the ECB couldn’t be accused of funding the government because it would have been presented with a fait accompli. The disadvantage is that it would look like a default, so it’s unclear whether the ECB would be able to avoid triggering the meltdown of the banking system.

Fortunately, there is at least one other option. This is to realise that the ECB didn’t buy these bonds from Athens at “face value”. It acquired them in the market at a discount. There is no legal reason why it shouldn’t now sell them at a discount.

If the buyer then agreed with Athens to add a grace period to the bonds, this wouldn’t constitute a default because it wouldn’t be a unilateral action. Another scheme that would have the same effect would be for the new owner to swap the bonds for short-term treasury bills issued by Greece.

Who might be the buyer? Well, it could be the United States government, if it wanted to help out. Or it could be a hedge fund or sovereign wealth fund that was prepared to take a risk. After all, if a new cooperative government was formed a few weeks later, there would be a good chance of making a profit as the bond would be repaid at the full face value.

One difficulty with this scheme is that the ECB might suffer a loss on the transaction, if the discount it sold the bonds at was larger than the one it bought them at. Although there’s no legal reason why it shouldn’t suffer losses on market transactions, it might not look good.

But there are solutions to this too. The July bond isn’t the only one the ECB has bought. It acquired others on which it made good profits. What’s more, 1.9 billion euros of these were supposed to be given to Greece as part of its last bailout programme. Since that has expired, the profits, which have been sent to national authorities, could be returned to the ECB. That should cover any losses on the July bond.

Alternatively, the ECB could take account of another bond that is due to be repaid in August. The profits that it expects to make on that could balance the losses on the July bond. By contrast, if it did nothing to help Greece defuse this time-bomb, Athens would go bust and the ECB would lose lots of money on both bonds.

Selling the July bond could therefore be an idea that works for everybody – and avoids the nightmare scenario of the Greeks voting “Yes” on Sunday only to find that domestic bank depositors still pay a huge price.


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