By Andrew Lilico
1. Greece is going to fail to honour its debts, some time between now and 2013. It's not if – it's just a matter of when. Even if Greece were itself to attempt to pay, there is to be a new financial architecture in the Eurozone from 2013, with rules for sovereign bankruptcies, debt-equity swaps for banks, a special new bailout fund, and a new Treaty. Greece isn't getting in.
2. The EU and IMF (the latter including EU Members such as the UK) agreed a €110bn bailout package in May 2010. Participation by EU Member States in this bailout was blatantly, explicitly, specifically, and in terms forbidden by Article 125 of the Treaty (an article designed with precisely this sort of situation in mind). This has been acknowledged by senior members of the French government, recognised by the European Scrutiny Committee of the House of Commons, and indeed the European Union was sufficiently nervous about the matter that it has proposed a revision the Treaty, to be ratified by the end of 2012, to set bailouts from 2013 onward on a more secure legal footing.
3. The Greeks, having made some modest (albeit futile) progress on deficit reduction in 2010 have since lost control once again, particularly as tax revenues have fallen. And as to the wider economic situation, the following graph is self-explanatory…
4. Greece had €13bn of debts to service in June 2011. To service those debts, it was totally reliant upon receiving €12bn in IMF funding due on June 29th. There was a question as to whether the IMF would pay, given that IMF rules would require Greece to have financing in place for the following year. Following an investigation, the IMF agreed to pay subject to Greece agreeing further reforms.
5. A key vote to agree those reforms was due this week. The run-up to this vote saw up to 25% of the Greek population involved in anti-cuts protests, a weeks-long permanent protest in a key square in Athens, marches involving hundreds of thousands, and clashes with police.
6. The vote has been delayed (perhaps until July) and the Greek Prime Minister has said he will form a new government with a confidence motion on Thursday. It is unclear what they implications are for the crucial IMF payment and hence for whether Greece will service those debts falling due in June.
7. Given the escalation in its deficit, it is suggested that, in addition to receiving the IMF/EU payments already promised, Greece might need another bailout of perhaps a further €60-€100bn to keep it going until 2013.
8. The Germans and members of the European Commission have argued that any second Greek bailout must include pain for private sector bondholders, perhaps around 30% of the total costs of the bailout. The ECB has been vigorously opposed.
9. Credit Ratings agencies have said that even the most modest of these "burden-sharing" proposals would constitute a technical default.
10. A small technical default, removing perhaps 3% of the burden of its debts, will not solve Greece's problems. Standard & Poors expects a default of 50-70%, by 2013. Financial markets have priced in near-certain default over the next five years.
11. Even a technical default would, under bank regulatory rules, require banks around Europe to change the valuation for their holdings of Greek debt to its market value (as opposed to the assumption that it pays out, which they have operated on up to now). Valuing Greek debts at market levels would imply large losses for a number of French and German banks. More specifically, market rumour and analysis suggests it could mean very large losses for the joint Franco-Belgian-Luxembourgish nationalised bank Dexia and for the European Central Bank.
12. The European Central bank has capital of about €80bn. Greek default of 50%, along with near-total default of all Greek banks, would impose losses on it of about €70bn.
13. If the view of some analysts is correct, Dexia might go below regulatory capital requirements. Given that the Belgians have lacked a government for about a year, and have a very high government debt-to-GDP ratio of about 100%, and have the opportunity to try to press France and Luxembourg to increase their proportionate stakes, there is the risk of wrangles.
14. Greek default would very probably persuade the Irish government to walk away from the debts of its banking sector. Ireland has today announced that it has applied to the IMF to be allowed to impose losses on senior bondholders in Anglo Irish Bank.
15. The key holder of Irish banking sector debt is the European Central Bank. A walkaway by the Irish government would impose further losses on the ECB of about €15-€20bn, rendering it insolvent.
16. An insolvent ECB would not be able to provide the support upon which the Portuguese banking sector is totally and continuously dependent. The ECB is estimated by Open Europe to have about €40bn in outstanding loans to the Portuguese banks.
17. The ECB would in practice be recapitalised by the taxpayers of Eurozone members. If ECB insolvency had been caused by Greek, Irish and perhaps also Portuguese default, it is near certain that the Greeks would not be permitted to participate in recapitalisation and so would be ejected from the euro. It is less clear whether Ireland and Portugal would be permitted to participate. If negotiations dragged on, there would also definitely be speculation and rumour as to whether Spain and Italy would be permitted to belong.
18. The original purpose of the sovereign bailouts was to continue the banking sector bailouts by another name. Their purpose now has become to avoid ECB insolvency and the potential disintegration of the euro.
19. UK bank exposure to Ireland is material, but to Greece is modest (much less than France or Germany) and to Portugal and Spain only small. The UK banks should only experience difficulties if the crisis reaches France.
20. The key to avoiding Britain being sucked in will be to (a) stick to Osborne's fiscal consolidation plan; (b) urgently introduce credible banking sector reform, in particular debt-equity swap mechanisms to the Special Administration Regimes for the banks.