Europe Girds for Greek Default

A whole lot of pixels have been spilled trying to explain why European central bank governors decided to limit Greece’s access to Eurosystem funds, but the reason is very simple: Europe is girding itself for a probable Greek default on debts to the rest of the European Union. The sad result for Greece will be renewed banking crisis and political chaos.

It’s sad that it has come to this, but so many issues have gotten tangled together and nobody seems to know how to untie them. The crisis is taking on a momentum of its own, crashing along towards the day when Greeks will no longer be able to withdraw funds from their bank accounts. What happens then is unclear, except that nobody will come out of this looking prescient or clever.

As I see it, the biggest failure was that both Greece and its donors refused to face up to the scale of the internal devaluation that Greece needed. So they ended up fighting a losing battle for five years trying to resist overwhelming macroeconomic forces, and ended up with Greeks and Germans bitterly blaming each other for the failure of their efforts.

Perhaps in some future age when Europe is much more integrated than it is today, any similar crises that emerge might be met with the kind of large-scale fiscal transfers it would take to avoid internal devaluation. Or perhaps if Greece was as decisive as the Baltic states in accepting internal devaluation early on, Greece could be standing on its own already, with a viable banking system, a reasonable debt burden and no resentment towards the rest of Europe. Or perhaps Greece was in too much worse of a position to avoid the tragedy that’s unfolding. I guess we’ll never know.

The irony is that, before the Antonis Samaras government collapsed in December, Greece had nearly stabilized on a cash-flow basis. It had a huge and still-slightly-growing debt pile, but creditors were steadily rolling it all over into low-interest debt that wouldn’t come due for two or three decades. Greece had a small primary budget surplus, albeit not even enough to cover the interest on its domestic borrowing. On paper Greece had committed to start paying down debts in 2016, even if nobody really expected that to happen.

But in return, creditors insisted on dictating economic policy. And that’s where things got tangled up.

The creditor-imposed economic reforms served two very different purposes, which weren’t clearly delineated. One was to make Greece a bit more like the rest of Europe, with stronger tax collection and a somewhat more liberal business climate. The other was to implement an internal devaluation in the Greek public sector.

Then those two threads got tangled up with a debate over what kind of union the European Union was going to be. The EU had been born so ambitiously in its first decade that many thought of it as already a de facto federal state. From that idealized perspective, the EU was implementing a kind of voluntary austerity by refusing fiscal transfers on the scale Greece and other states would have needed to avoid internal devaluation. From a more earthly perspective, the EU was a collection of independent states with limited commitments to each other, and Greece should have been grateful that the rest of Europe was lending it enough to allow it to devalue gradually.

All along, both Greece and the official bodies tasked with managing its bailout kept underestimating how much internal devaluation was needed. The Greek government tried to appear that it was resisting overly strict demands, and ended up having to do worse a year later. Bailout officials tried to appear that they were minimizing how much the rest of Europe would have to lend, and ended up having to ask to triple their budget.

And then, just when Greece had stabilized enough that at least it wasn’t borrowing much more, Greeks elected a bunch of rebels who refused to accept the creditors’ conditions. Greeks thumbed their nose at Europe, declaring that they wouldn’t mind if the debts weren’t rolled over. It was a stunningly suicidal move. An act of mad frustration.

By refusing the rollover, Greece headed into battle with the very European institutions that ensure Greek banks have enough liquidity to pay depositors. There will be losses on both sides, but the Greek losses will be bigger by far. The savviest Greeks have been deserting since December, pulling their cash out of Greek banks while they still can.

The Fateful Meeting With Draghi

As I wrote last week, the default is likely to come sooner not later. Greece has a tough schedule of debt falling due in February and March, and not much prospect of reaching an agreement anytime soon to roll it over. Between February 9 and the end of March the government is due to pay more than €3.2b on its foreign debts and long-term bonds, including nearly €2.3b to the IMF, €112m to the Eurosystem and about €850m to private investors.

Greece is supposed to pay more than €9b to the IMF, more than €8b to EU institutions (mostly central banks) and about €1.5b to private creditors from Feb. 9 through the end of this year. The Samaras government was expected to reach a deal to roll over all those payments into multi-decade, low-interest debt to the EU, but that now appears extremely unlikely.

When unnamed people-in-the-know – presumably the staff of Greece’s official creditors – tell Bloomberg that Greece could “run out of cash” by as early as Feb. 25, they mean the Greek government will run out unless it conserves cash by defaulting. On Feb. 24 Greece is due to make a €592m annual interest payment to private investors who took part in its 2012 debt restructuring. This Thursday, Feb. 12, the government is due to repay about €740m of its very first bailout loan from the IMF from May 2010.

Further out, Greece is due to repay almost €7.5bn to European central banks in July and August. It was those amounts that were on Mario Draghi’s mind during his fateful Feb. 4 meeting with Yanis Varoufakis. Unwilling to talk to the IMF, the new Greek finance minister asked the European Central Bank chairman to let the Greek national central bank fund the Greek government’s near-term debt repayments.

Varoufakis proposed that the Bank of Greece be allowed to lend €10b to Greek commercial banks so they could buy an expanded issue of short-term government debt, which would be used to cover near-term debt payments. Varoufakis also planned to ask the EU for authority to reallocate €10.9b of funds lent to Greece for bank recapitalization, which weren’t used and are due to be automatically repaid when the current adjustment program expires at the end of February. While spending those funds, he and Greece’s new prime minister, Alexis Tsipras, would negotiate with the rest of Europe on some kind of debt relief.

Most coverage of the story has focused on the new government’s demand for debt relief, but the hottest issue was probably Greek economic policy, which Tsipras especially wants to turn sharply to the left. For all its progressiveness the European mainstream remains fundamentally economically conservative. Draghi wanted to hear how Greeks are going to be successful capitalists and pay back their debts. Varoufakis is a leftist economics professor with a theory that the more productive benefit by subsidizing purchases of their products by the less productive. It must have been an uncomfortable exchange.

Varoufakis’ plea for what he called a “bridge loan” while negotiations proceeded might have been approved if Draghi had heard what he considered to be a credible long-term plan. But evidently Draghi didn’t hear that. He seems to have gone more or less straight from the meeting into a conference call with other central bank governors, where he apparently gave an unflattering summary of what Varoufakis had to say. The council then voted to essentially prepare for default.

How the ECB Tried to Limit Europe’s Losses

The vote has been widely understood as an effort to deliberately create a problem for Greek commercial banks as a way of applying pressure on the Greek government. I don’t believe that was the motive. The ECB council was trying to shield European governments from losses in the likely event of a Greek default.

What the council did was revoke ECB support for Bank of Greece loans to Greek commercial banks that are collateralized with debt issued or guaranteed by the Greek government. Such loans were considered standard ECB-authorized refinancing, which meant that if the bank failed to repay the loan and the government defaulted on the collateral, the resulting losses would be the shared responsibility of all Euro Area central banks. As of Feb. 11, such loans will be reclassified as “emergency liquidity assistance” (ELA), and the BoG will bear full legal responsibility for any losses on them.

The ECB was anyway scheduled to withdraw its support on March 1 for BoG loans collateralized by government-guaranteed debt, for reasons unrelated to the recent dispute with Greece. But at the pace of recent events, even a few weeks mattered. Besides, that deadline might have been postponed if the ECB council had been differently disposed. If Samaras were still in power and creditors were still rolling over Greece’s debts, Greek banks might have been ready by March 1 to do without such loans.

The ECB council also capped the total amount that Greek banks can borrow from the BoG, which limits the EU’s losses in the event of a Greek exit from the euro. I don’t expect Greece to leave the euro – I think the Tsipras government would collapse if it tried – but the threat is hardly an abstract one. BoG loans to Greek banks, whether ECB-authorized or not, are a kind of contingent liability for the rest of the currency union, which could fall on other European governments if Greece were to exit the euro and reject the BoG’s liabilities to other European central banks.

This is due to the way the euro currency union was set up, with the assets that back euros distributed among a network of national central banks. If any national central bank leaves the system and takes its assets with it, the corresponding euro liabilities would remain the responsibility of the currency union. So the rest of the currency union’s governments would have to inject new assets to back them.

How the ECB Doomed Greek Banks

By acting to shield European governments, the ECB council inevitably doomed Greek banks. There was no way to do one without the other.

Greek banks have been relying on loans from the Bank of Greece to pay exiting depositors and money-market lenders as they have steadily withdrawn funds since December. European central bank governors effectively put a cap on the maximum amount of those BoG loans, which means they effectively capped the amount of cash that can be taken out of Greek banks. It won’t take long for depositors to make that connection and grab their money while they can.

In the same ECB council conference call, governors set the limit on Greek ELA at €59.5b, according to another person-in-the-know talking to Bloomberg (for some reason I’ll never understand, the cap is an official secret). On top of that, Greek banks should still be able to borrow up to about €40b from the BoG through standard refinancing using their foreign assets, which consist mainly of €37.3b of European Financial Stability Facility notes received through the EU-funded recapitalization of Greek banks in 2012-2013.

However, some of those EFSF notes are already pledged for private interbank credit, so the effective limit on Greek banks’ borrowing from the BoG could be as low as around €80b. Greek banks’ borrowing from the BoG stood at €56b at the end of December, up from €45b a month earlier. That increase covered more than €10b of withdrawn private funding during December, including more than €5b of deposits. There are credible estimates from major banks and credit agencies putting the current amount of Greek banks’ borrowing from the BoG at €70b-€75b. It appears that Greek banks are very close to running out of cash.

And then, well, I don’t know what happens then. On one hand it would be very difficult for this government to submit to the sort of tough conditions that Europe would insist on to fund a second bailout of Greek banks. On the other it would be very difficult to take Greece out of the euro, as there’s no support for that and this government has categorically promised not to do it. Most likely, bank deposits will sit frozen for a while as support for Tsipras plummets and pressure on him mounts in parliament and on the streets.

What we’re seeing in Greece is a demonstration of the main weakness of pure parliamentary democracy. It’s great at avoiding gridlock, because it gives power to parties that win as little as a third of the popular vote. But that can be a really lousy way to go in a time of crisis. It brings to power radicals who lack broad social trust right at the moment when that trust is most needed.

Enough Greeks voted on Jan. 25 to bring this government to power. But enough Greeks have been voting since December with their bank deposit withdrawals to bring this government down. As I wrote in my previous post, given the ties between two ministers in this government and the darkest elements of the Putin regime, it will be good riddance anyway.

A Grim Schedule

Below is a list of Greece’s major debt payments, larger than €50m, due since Jan. 25 through to the end of the year. This schedule doesn’t include any short-term bills or domestic loans. It also doesn’t include repayment of loans to the European Investment Bank, which I couldn’t find information on, or interest due to the EIB, which I estimate will come to about €300m during the year. Likewise it doesn’t include interest owed to EU governments on loans disbursed during the first stage of Greece’s bailout in 2010-2011, which I estimate will also come to about €300m during the year. The listed payment due to the EU and EIB is for bonds they purchased in the ECB-led bond-buying program in 2012. The amounts listed lump together any principal and interest due to a single creditor group on a single day. Since I haven’t heard otherwise I’m assuming the Feb. 1 payment was made.

Sources include: the IMF, which publishes payments due to it; a Greek government announcement of bonds issued in the original restructuring; Borsa Italiana pages like this one showing amounts of those bonds not bought back; three separate government announcements detailing the bonds that weren’t restructured; a Greek-language government gazette that detailed the bond holdings of the ECB, NCBs, EIB, EU and their totals, and described special bond issues in 2012 that were exempted from restructuring; and a government debt bulletin that lists recent bond issues and the partial roll-over in 2014 of another bond exempted from restructuring.

(UPDATE: It has emerged that European central banks are also refusing to release the €1.9b of interest Greece paid to them during 2014. Greece had an agreement with them that they would refund all interest Greece paid to them at the end of each year, so long as Greece was taking part in its adjustment program. In other words, apparently the ECB governing council also made a determination that Greece has exited the adjustment program and therefore isn’t eligible for the refund. This further confirms that the ECB is girding for default. It also means that in the unlikely event the EU makes some kind of short-term deal with Greece, the €1.9b could cover Greece’s debt payments through early March.)

(UPDATE 2: On Feb. 12 the ECB council voted to increase the cap on Greek ELA by €5.5b to €65b. That indicates Greek banks were near to running out of cash already by that date. It’s likely that some of the funds were somehow funneled to the government to pay the Feb. 12 payment to the IMF. The amount is small enough that Greek banks will remain on the brink of running out of cash and dependent on further cap increases to pay depositors.)