Look Who's Downgraded Now

Friday was another very bad day for Europe’s crisis managers. Within the space of a few hours, it was revealed that talks between Greece and its international creditors had reached a dead end and were being put on hold and that Standard & Poor’s had downgraded nine eurozone countries, including France and Austria, which formerly held AAA ratings. Both developments are alarming, but the Greek situation is the more immediately pressing.

The Institute of International Finance, whose managing director, Charles Dallara—a former high-ranking Treasury official under Ronald Reagan and George H.W. Bush who has lately made Athens his home away from home—issued a statement Friday afternoon saying that “discussions with Greece and the official sector are paused for reflection on the benefits of a voluntary approach.” The main sticking point, according to people familiar with the talks, is the level of the interest rate to be paid on the new, lower-principal bonds that creditors will get in exchange for the ones they currently hold. The Institute of International Finance had dropped its initial demand for an 8 percent rate, reduced its offer to 5 percent, and now appears open to a rate as low as 4.5 percent. Greece, the International Monetary Fund, and eurozone governments are pushing for even lower rates, going down as far as 3 percent.

The negotiations, concerning the terms on which private creditors will take a 50 percent face-value loss on their holdings of Greek government bonds, have aimed at an agreement that can be cast as voluntary, as agreed at the EU summit of October 26. Avoiding a coercive restructuring was considered crucial, both to minimize market turbulence and to prevent the additional costs that Greece would face if it forced its creditors to take losses.

However, it was also considered vital that the reduction in Greece’s overall debt burden be sufficient to make Greek debt viable post-restructuring. That is why a target of 100 percent participation was set for private-sector involvement (PSI), even though it was clear from the start that certain groups of creditors would not play ball. Friday’s announcement is an effective admission that these two goals—voluntary participation and debt viability—cannot both be met. Given the low level of participation reported, unless things change dramatically in the next few days, everything points to Greece injecting collective action clauses into those of its bonds—about 90 percent of the total in private hands—that are under Greek law. This would mean that for any given series of bonds, if a qualified majority supported the 50 percent haircut, it would also be imposed on the dissenting minority.

The consequences of such a move, both for Greece and for the whole of the eurozone, are hard to overstate. For the beleaguered Mediterranean country, entering into its fifth straight year of recession and with unemployment climbing above 18 percent, the forced haircut would lead to an outright default, which would be followed by a boa constrictor-like credit squeeze. Even if it agreed on a generous loan package with its official lenders, which would allow the state to keep paying salaries and pensions and the banks to stay afloat, Greek importers, many of whom are already denied credit by their foreign associates, would face an impossible situation. Given Greece’s sizeable trade deficit, this would mean that many basic goods, from drugs and food products to cars and washing machines, could become scarce. Added to this, one must take into account the years of legal wrangling with creditors who will seek compensation for their losses via the courts, complicating and possibly even blocking Greece’s return to the international capital markets. These creditors will not include small-scale individual bondholders, almost exclusively Greeks, who invested their savings on Greek bonds, who don’t have the money for prolonged legal battles and who will thus end up losing half their fortune because they made the mistake of lending it to their own government.

A forced restructuring will cause major aftershocks outside Greece, too. The market for credit-default swaps on Greek government debt is not particularly large, but there’s no telling if there is a systemically significant player in it who is badly exposed and will therefore need to be bailed out. The biggest worry, though, is the contagion to other troubled eurozone countries. This is where the Greek mess ties in with the loss of the AAA rating for Austria and, especially, France. Eurozone leaders have argued since at least last July and the first version of Greek PSI that Greece is a special and unique case and that all other countries in the common currency would fully repay their debts. The only problem with that was that they—above all, the Germans—refused time and again to back their words with the necessary policies, ones that would convince markets that the full financial weight of the eurozone would stand behind, say, Italy, if a liquidity crisis threatened.

Because of this, investors see what is happening in Greece not as a local tragedy but as a harbinger for what is to come in Portugal, Ireland, and possibly Italy and Spain. France and Austria being two of the six countries whose AAA ratings guaranteed the equivalent rating for the European Financial Stability Fund, their downgrade means that the EFSF will probably be next. Unless measures are taken, which would involve larger contributions from the remaining four AAA-rated eurozone countries (Germany, the Netherlands, Finland, Luxembourg), the EFSF’s firepower, nowhere near large enough to bailout Spain or Italy to begin with, will shrink further. Yet German Chancellor Angela Merkel has reacted to the news of the latest round of S&P downgrades with nary a raised eyebrow of concern, commenting that she sees no need for changes to boost the EFSF and renewing her call for a speedy implementation of the December 9 agreement for tighter fiscal discipline in the eurozone. And so the Germans continue to ignore the markets, and the markets continue to wreak havoc. How much longer can this go on?

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