After updating yesterday on the Greek financial crisis I thought that maybe it might calm down for a day or two but in fact the issues are escalating and we are now in a full-blown liquidity crisis albeit one which at times feels like it is arriving in slow-motion. There were two further developments on the day one which involved the Greek banks and the other involved the International Monetary Fund which is currently in Athens giving the Greek government some “advice”. I would love to be a fly on the wall as I will explain later. Also we will get at 1:30pm today a statement from the President of the European Central Bank (ECB) on collateral rules which readers of this web site will know have been altered mainly to help Greece and in particular Greece’s banks.
Back in 2008 the Greek government gave various guarantees to her banks in a pattern which I am sure sounds familiar. However the Greek banks at the time did not fully use up the funds. The banks made use of 11 billion Euros of the plan’s funding by issuing preferred shares to the state in exchange for capital injections. But the biggest part of the plan which amounted to a further 17 billion Euros in state guarantees was unused. It was yesterday reported that Greece’s four largest banks (National Bank of Greece, Eurobank, Alpha Bank, and Piraeus Bank) have now requested the money. According to Greece’s Finance Minister George Papaconstantinou
“The banks have asked to use the remaining funds of the support plan … They want to have additional safety, now that the economy and the banking system are under pressure,”
There is more and more talk of capital outflows from Greece and her banks. The Reuters news agency has reported that this year Greek bank deposits have fallen by just over 8 billion Euros or 3.6% so they are short of cash and need liquidity. Not quite a full-scale run on the banks but a drain.
There are alternative explanations for example it could reflect individuals and companies paying higher taxes as fiscal tightening bites or residents buying higher yielding government debt, or residents moving money abroad to avoid future tax increases. These are natural consequences of recent events but a more dangerous explanation is that it could reflect increased concern about bank solvency.
Will it help?
In the short term then Greece’s banks will plainly receive some liquidity from it. However there are two main flaws.
1. The underlying reasons for the flight of cash will not be altered
2. Part of the money will come from the Greek government providing government bonds which can be deposited at the ECB in return for loans. Quite where the Greek government is going to get the money from in this crisis when it is already short of funding itself is the real question here. She is already struggling with her existing funding.
So in the medium-term very little is solved by this.
In such a liquidity crisis Central Banks often step in and use their ability to create fiat money and make loans. For example the UK’s banks have been supported by the Special Liquidity Scheme of the Bank of England to the tune of around £170 billion. Greece does not have her own central bank and so this option does not exist on a national level as her central banking was out sourced to the ECB in 2001.
European Central Bank
Many may be wondering if it is a coincidence that the President of the European Central Bank is giving a speech today on collateral rules. The truth is probably more prosaic as the ECB has a meeting anyway and Greece and her problems would have been on the menu when the agenda was set. For those unaware of the importance of this issue I feel that these rules are much more likely to help Greece than the “rescue plan” announced on the 25/26th March.
This is a technical issue but it is very important so let us look at what was announced.
1.The present temporary increase of the threshold for losing eligibility for sovereign debt will be extended (cue cheers from Athens)
2.The present flat haircut structure for sovereign debt will be changed to a sliding scale. (amber light for Greece).
What this gave Greece was the ability to use its bonds as collateral for loans at the ECB in 2011 which is quite a relief for her and her banks. Apart from the liquidity it provides, estimates of the profits Greek banks made from this in 2009 were in the region of 3/4 billion Euros. So point one is a real gain.
The Problem in this
Consider again point 2. Greece will now face an increased haircut on her bonds if they are used as collateral at the ECB if we believe Mr. Trichet. Just at the time she needs to deposit some 17 billion Euros worth at the ECB to help her banks it looks as though the ECB is about to increase the haircut on them.
So as you can see many eyes will be on Mr. Trichet at 1:30pm. One suggestion that has been mooted is that the ECB should stop relying on ratings agencies for creditworthiness analysis (good) and replace it with its own analysis (bad). So a hopeful start leads us straight into a moral hazard. Another suggestion is that the ECB should say that she would always accept Euro zone members government bonds as collateral. Maybe this would help Greece now but the danger is the sliding scale of haircuts that would be required.
In its way the concept of haircuts is gently bringing the subject of default onto the agenda for Greece. After all a haircut is a sotto voce type of default is it not? The clear implication is that the instrument is not worth its face value and in my view this is different from a price moving up or down as there is the clear implication that Greece’s debt is worth less than other nations in the eyes of the ECB. I would not shout the words from the rooftops it is more of a gentle whisper but it is there.
The International Monetary Fund
Now the IMF is physically in Greece it should take charge of events. However for this process to start its plans for austerity need to be accepted by her government. This is the price of her aid. In the short term IMF involvement would give Greece the following.
1. Cash of up to 10 billion Euros at much cheaper than market rates. So she saves some money.
2. An IMF backed plan to take to the markets which would probably settle them down as it would provide credibility and experience even if it is a faxed copy of someone else’s plan!( In case you are wondering they did do this recently)
3. Following an IMF plan other countries may make bilateral loans to Greece on better terms than she can currently get from the markets. This is complicated by the Euro zone and its grandstanding. It would have been better I think if they had said nothing and let Greece negotiate with countries individually. In the example of Latvia countries with heavy exposure for example the Scandinavian nations loaned money, this is not entirely altruism as their banks were exposed and they are protecting their investment. Of course Germany is the biggest investor in Greece but maybe on her own Greece could accept terms from other nations and continue to negotiate with Germany. The problem is that the water is now so muddy this may not be possible.
Now comes the pain as the IMF plan to have any chance of success will tighten Greece’s austerity plan further. This is a dangerous balancing act which particularly in the current climate can easily go wrong. I expect Greek GDP to shrink by 3/4% this year as it is and this will fall further if the IMF demands a further tightening.
So what happens after the IMF gets Greece through 2010?
Here is the real problem and they are 2011 and 2012. I have written before about the danger of a downward spiral for Greece where an austerity package leads to falls in economic output which leads to the austerity package not hitting its target which leads to further tightening and so on. There are already dangers of this from the plans that the current Greek government has. In my view the IMF would have to tighten further than the existing plans or face the question why are you there when nothing has changed? So let us say cuts of another 2% of GDP are imposed on Greece as a price for IMF involvement.
This would lead to a severe recession hitting Greece again but on its own it would not work. You see the competitiveness problem that Greece has would not have been addressed so we would also need a substantial fall in real wages. I hope the flaw in the plan is becoming clear falling output,rising unemployment and falling wages would begin to turn things round but would need to take place throughout 2011 and 2012 in my view and by then Greece’s economy would have shrunk considerably. It is not a happy prospect and one can imagine the union and social unrest and it is at this point that the plan troubles me and frankly looks likely to fail. However I expect the IMF under Mr Strauss- Khan to apply it.
My suggestion is that in 2011/12 there is a danger of a downward spiral into political unrest followed by default by Greece. So it would be more honest and rational for the IMF to step in and impose its usual plan but with a difference. Under a slogan of “everybody shares the pain” it should also look to a renegotiation of Greece’s existing debts where repayment of say 85% is offered. Then the plan would have a real chance of actually succeeding.