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No time to waste

26 September 2011 By Hugo Dixon

The rest of Europe can and must protect itself against a Greek default. A three-pronged plan is required: 150-200 billion euros to recapitalise banks across the region; extra liquidity, again for banks; and a beefed-up bailout fund to help Italy, if needed. The drumbeats suggest Europe is moving in this direction. But, as always, the fear is that it will be too timid.

There is no time to waste. Athens’ agreement to accelerate its austerity programme is probably sufficient to secure the next 8 billion euro tranche of bailout cash from its euro zone partners and the International Monetary Fund. But the Greek government looks like it is close to bursting point. If it had to agree to more austerity in three months’ time, when another dollop of cash is due, it could collapse. That might trigger a disorderly default and mayhem throughout the European – and even world – economy.

It would be far better for Greece, the euro zone and the IMF to push through an orderly default. Athens would still have to commit to reforming its economy. But, in return, its debts might be halved and the rest of Europe would continue to support Greek banks.

An orderly default, though, is not enough to limit the fall-out. The rest of the euro zone would still, among other things, need to recapitalise its own banks. After pooh-poohing the IMF’s suggestions in August that this was required, various European policymakers – including Jean-Claude Trichet, the European Central Bank’s president – have now come out in favour of the idea.

It’s not clear, though that the governments yet have the stomach to force through the mega recapitalisations that are required. Breakingviews calculates that 175 billion euros would be needed to make sure that banks were strong enough to withstand both their exposures to over-indebted governments and to cope with the weakening economy. While some banks could raise capital themselves, many would need an infusion of taxpayers’ cash and would end up wholly or partially nationalised.

Although proper recapitalisation would help calm nerves, banks might still not be able to raise long-term funds in the market. At the moment, many of the region’s lenders depend on borrowing short-term money from the ECB. While that prevents them from going bust, they feel so jittery that they are reluctant to lend to businesses. The euro zone is on the edge of a new credit crunch. If this problem isn’t solved soon, the region could tip into a deep recession.

The ECB has started loosening its lending policies, for example by letting banks borrow dollars for three months. But either the central bank or the European Financial Stability Facility (EFSF), the region’s bailout fund, needs to find a way of giving banks access to longer-term loans.

If all this happens, the banks will be well placed to withstand a Greek default as well as to play their part in preventing a deep recession. But other countries, especially Italy, will still be exposed. Its dysfunctional government has been so slow to manage its near 2 trillion euros of debt that it could lose access to the bond markets. If that happened, the EFSF – which only has 300 billion euros of borrowing power left in its kitty – wouldn’t be big enough to help. The fund’s firepower needs to be expanded.

After initially turning their back on the idea, European policy makers seem to be warming to it. Since nobody wants to go through another round of approvals by 17 national parliaments, the best way of making do with the current authorisations would be for the EFSF to guarantee the initial loss on new government bonds. If the first 20 percent was indemnified, the EFSF’s effective war chest would rise to 1.5 trillion euros.

Not that such money should be given without conditions. Italy, for example, should be required to agree to a reform programme if it needs the facility. The humiliation might be enough to remove from power Prime Minister Silvio Berlusconi, whose erratic leadership is partly responsible for the country’s plight. That would be a bonus. But even without it, a beefed-up bailout mechanism would ensure that the whole of Europe could withstand a Greek default.


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