Threading The Greek Needle

By Matthew Dalton

Germany and France say they have an agreement on key principles of a new financing package for Greece. Among them: The country’s private-sector creditors will help provide some of that financing, but only if they want to.

Most importantly, Germany has agreed that Greece will not be allowed to default, satisfying the European Central Bank’s key condition for supporting a new aid package.

Here’s the problem: It’s hard to see how all this fits together, unless Germany has given up its demand for significant private-sector involvement.

The more gentle plans for private-sector contribution involve Greece’s creditors agreeing to buy new Greek bonds once their old bonds mature. But the new bonds would surely have coupons well-below the current stratospheric market yields for long-term Greek debt.

The ratings agencies have all said this is almost certain to be considered a default.

“The original promise to bondholders didn’t involve a commitment to reinvest the proceeds of those bonds at a non-market rate,” said David Riley, managing director at Fitch Ratings.

At their press conference Friday, Angela Merkel and Nicolas Sarkozy became the latest in a series of EU leaders to cite the so-called Vienna Initiative as a template for how private creditors might agree to roll over Greece’s debts.

But consider the differences, and the Vienna initiative appears more like a metaphor than an actual template for solving the Greek dilemma.

First, the initiative was mainly a commitment by Western banks to keep capital in their subsidiaries in Romania, Hungary, Serbia, Latvia and Bosnia and Herzegovina and maintain loan volumes in those countries. The banks were not asked to finance specific loans or sovereign debts at below-market rates; in fact, significant amounts of bank liquidity in these subsidiaries lay idle, showing that banks had the flexibility to decide if and whether their money should be lent.

The banks ended up buying government debt, but in large part because demand for credit from the private sector was so weak in those countries in the aftermath of the crisis.

“Given risk management considerations within banks, the rising financing needs of the government could only be partially a satisfactory response to the request for investment opportunities,” according to a European Commission paper.

For the government debt that banks did buy, there is the glaring difference that all these countries had much less debt than Greece does now. The market price of Greece’s debt shows that investors are expecting to lose part of their principal, a much more dire scenario than the brief default that would arise from agreeing to roll over the country’s debt at below-market rates

Another key difference is that the banks saw these countries as growth areas, and were loathe to shutter their operations there. But they didn’t want to be the last ones headed for the exits. It was a classic collective-action problem that could be solved through intervention by international financial institutions.

“In the Vienna Initiative there was a true strategic and financial rationale to provide the liquidity,” said Nicolas Véron, a senior fellow at the Bruegel think tank in Brussels. “I’m not sure you have the same available set of incentives in the Greece situation.”

Some large foreign banks have significant subsidiaries in Greece, such as BNP Paribas and Citigroup. But most of the country’s sovereign debt not held by Greek banks appears to be held by institutional investors across Europe as part of their investment portfolios, not because of a strategic interest in Greece.

The tough austerity plan that Greece will have to put in place to get more help won’t increase the country’s strategic appeal: What foreign business would want to invest in a country facing years of recession and anemic growth?