Selecting default

The Economist June 11^th 23:48

FOR THE first time since the start of the Greek debt crisis more than a year ago, the finance ministers of the euro area are ready to consider a default by Greece. They did not say so explicitly, of course, but the omissions from their statement tonight were eloquent.

Amid alarm that contagion was spreading from Greece to Italy and Spain, finance ministers held more than eight hours of crisis talks in Brussels, at the end of which they declared in a  statement (PDF) their “absolute commitment to safeguard financial stability in the euro area”. The new French finance minister, François Baroin, who replaces Christine Lagarde after her elevation to run the IMF, declared that ministers had rediscovered the “spirit of the spring of 2010”, when they had first rescued Greece and created a €500 billion ($635 billion) fund to help other countries.

Such rhetoric should be disregarded. It serves mainly to hide the intense disagreements that endure. The statement last night was filled with many promises, among them the pledge to do more to “improve the euro area’s systemic capacity to resist contagion risk”. But it gave few specific details or a timetable for action. This is unlikely to convince markets that the euro zone’s leaders are anywhere near resolving the crisis.

Until recently, the ministers thought they had averted imminent catastrophe. A looming default by Greece has been delayed by a few months, following the approval of the next tranche of EU/IMF loans, worth €12 billion. Ministers thought they now had weeks, if not months, to figure out the precise form of a second bail-out designed to preserve Greece until 2014—especially the way in which private bondholders would be induced “voluntarily” to help roll over some of Greece’s debt.

But that illusion has been shattered by the spread of financial turmoil to Italy, a country too big to bail out, and to Spain. Yields on the bonds of both countries reached historic highs in today’s trading.

All of a sudden, the ministers are willing to consider measures that, until a few days ago, were deemed unthinkable. Most striking is the seeming abandonment of the commitment to ensure that any private-sector involvement avoid anything that might provoke credit-rating agencies to declare a selective default. Even worse would be to trigger a credit event that would trigger a pay-out of credit-default swaps (CDS), a form of insurance against default.

This is what the finance ministers  said on July 2nd (PDF):

In line with the 24 June European Council conclusions, consultations with Greece’s creditors are underway in order to define the modalities for voluntary private sector involvement with a view to achieving a substantial reduction in Greece's year-by-year financing needs, while avoiding selective default.

And this is what they  said last night (PDF):

Ministers welcomed the decision by the IMF to disburse the latest tranche of financial assistance to Greece, as well as the proposals from the private sector to voluntarily contribute to the financing of a second programme, building on the work already underway. The ECB confirmed its position, reaffirmed by its Governing Council last Thursday, that a credit event or selective default should be avoided

Spot the difference? In the earlier statement, the ministers backed the commitment to avoiding a selective default. Last night they merely recorded that this is still the view of the European Central Bank, but did not endorse it.

This appears to confirm the revival of the original German plan to encourage bondholders to swap existing Greek bonds for new seven-year obligations. Amid objections that this was too harsh, negotiations had then focused on a softer, but more complex French roll-over plan. This was criticised for doing too little to help Greece, and too much to help the banks. In any case, it got the thumbs-down from Standard & Poor’s, one of the big rating agencies, which said even this could prompt it to declare a selective default.

If any creditor involvement will draw an unfavourable opinion from the rating agencies, Germany retorted, we might as well revert to our original plan. The aim now is to ensure that the selective default period is as short as possible—days, if not hours—to minimise disruption. The new red line is now to avoid a credit event for CDSs. The reference to the ECB’s opinion now looks more and more like a dissenting opinion, though France still seems to be fighting a rear-guard action against selective default.

And yet, even though the ministers now seem prepared to be tougher with bondholders, they do not repeat the demand that the private-sector contribution should be “substantial”. What this word means has never been defined, but the figure of €30 billion worth of relief between now and 2014 was often mentioned unofficially. The creditors are unlikely to offer anything close to that figure.

Elsewhere, the ministers promised to seek “steps to reduce the cost of debt-servicing and means to improve the sustainability of Greek public debt”. Olli Rehn, the monetary affairs commissioner, says none of this should be construed as a hint of an outright debt restructuring—ie, imposing haircuts on bondholders.

Instead, one means by which the burden could be lightened is to reduce the interest rate that Greece pays, and to allow the main bail-out fund, the European Financial Stability Facility (EFSF), to buy up the bonds of Greece and other troubled countries on the secondary markets. This power had been excluded earlier this year, when the lending capacity of the EFSF was boosted and the fund was permitted to buy bonds in the primary markets.

Finally, the ministers nodded to Finland, whose government had insisted on Greece posting collateral to secure any new loans. Most other countries thought this would only complicate matters, particularly if it meant tying up Greek assets due for privatisation. Now they speak of a “collateral arrangement where appropriate”. Quite what this means, nobody knows.

When will the details of all this be worked out? The statement speaks of “shortly” and “as soon as possible”. But there are no dates, not even for another emergency meeting of the eurogroup, which seems inevitable in the coming weeks. They can hardly let matters drag out until September: that would guarantee more contagion.

Statement by the Eurogroup 

Ministers reaffirmed their absolute commitment to safeguard financial stability in the
euro area. To this end, Ministers stand ready to adopt further measures that will
improve the euro area’s systemic capacity to resist contagion risk, including
enhancing the flexibility and the scope of the EFSF, lengthening the maturities of the
loans and lowering the interest rates, including through a collateral arrangement
where appropriate. Proposals to this effect will be presented to Ministers shortly.
Ministers discussed the main parameters of a new multi-annual adjustment
programme for Greece, which will build on strong commitments to fiscal
consolidation, ambitious growth-enhancing structural reforms and a substantial
privatisation of state assets. Ministers welcomed the reinforcement of monitoring
mechanisms of the programme of Greece, the nomination of the board of the
privatisation agency, which comprises two observers representing euro area Member
States and the European Commission, and agreed to provide extended technical
assistance to Greece. They called upon the Greek government to sustain its on-going
efforts to meet these commitments in full and on time.
Ministers welcomed the decision by the IMF to disburse the latest tranche of financial
assistance to Greece, as well as the proposals from the private sector to voluntarily
contribute to the financing of a second programme,  building on the work already
underway. The ECB confirmed its position, reaffirmed by its Governing Council last
Thursday, that a credit event or selective default should be avoided.
While the responsibility for resolving the crisis in Greece lies primarily with Greece,
Ministers recognised the need for a broader and more forward-looking policy
response to assist the government in its efforts to bolster debt sustainability and
thereby safeguard financial stability in the euro area.
In this context, Ministers have tasked the Eurogroup Working Group to propose
measures to reinforce the current policy response to the crisis in Greece. The
Eurogroup Working Group will notably explore the modalities for financing a new
multi-annual adjustment programme, steps to reduce the cost of debt-servicing and
means to improve the sustainability of Greek public debt. This reinforced strategy
should provide the basis for an agreement in the Eurogroup on the main elements and
financing of a second adjustment programme for Greece shortly.
Ministers commit to continue negotiating with the European Parliame