Berlin — The Greek debt crisis may be turning into a European Central Bank crisis.
As the European Central Bank (ECB) continues to loan money to keep Greece afloat, the ECB’s exposure to the failing economy also grows, threatening potentially backbreaking losses if Greece declares bankruptcy. This is a looming concern as Germany lawmakers continue to balk at a bailout.
The extent of the financial assistance needed by Greece – with Spain and Portugal, both of which also saw their debt downgraded this week, now in similar positions – is placing unsustainable stress on the ECB, says Desmond Lachman, a former managing director at Salomon Smith Barney and current fellow at the American Enterprise Institute.
“What this has now become is a European Central Banking crisis,” says Mr. Lachman. “The main concern of [EU negotiators] is keeping this crisis from affecting the ECB, and whether continued default [in Spain and Portugal] would affect the bank.”
The ECB already holds tens of billions of dollars in Greek bonds. As it now stands, Greece will not be able to repay the bank for these bonds, let alone the bonds that the ECB continues to buy from Greece to keep it afloat as bailout negotiations continue. This is also the case with Spanish and Portuguese bonds, which the bank also holds.
The ECB has not commented on its exposure to these bonds. Governing Council member Axel Weber said Thursday that the impact of a Greek default would be “incalculable.”
Bailout on the Way?
European leaders were scrambling to arrange a bailout and quell market panic over Greece’s looming debt payments after Standard & Poor’s downgraded the country’s credit rating to junk this week.
EU and IMF officials say a deal will be in place by the weekend to provide Greece with tens of billions of dollars in aid to make upcoming debt payments. Time is short because the country has about $11.3 billion worth of debt due by May 19. EU Monetary Affairs Commissioner Olli Rehn said the deal would help Greece while allowing “every euro area member state and their citizens to safeguard the financial stability in Europe and globally.”
Germany, which has dragged its feet over a bailout since the depth of Greece’s problems emerged earlier this year, seemed to finally acquiesce Wednesday, though holdouts remained in parliament.
Chancellor Angela Merkel, joined by European Central Bank chief Jean-Claude Trichet and International Monetary Fund Managing Director Dominique Strauss-Kahn who both made a special trip to Berlin to raise support for a bailout, said Thursday that a bankrupt Greece would sink the value of the euro and that Germany, expected to make the largest contribution to the bailout package, would act to protect its currency. Mrs. Merkel’s comments were also meant to stop the market panic about contagion risk the Greek crisis would spread across Europe.
$160 Billion Needed
She spoke of a $60 billion aid bill, although financial analysts now estimate that Greece needs $160 billion over the next three years to remain solvent.
“The package European leaders are discussing right now is only the beginning,” says David R. Cameron, professor of political science at Yale University and director of the Yale Program in European Union Studies.
Some investors and economists suggest that Greece might do well to merely default or restructure its debt and thereby avoid taking on more debt just to pay off its current loans. This would have dire consequences for the ECB and private European banks as the largest holders of Greek debt. According to estimates from Barclays Capital, German banks hold $37 billion in Greek bonds. Without a bailout, those bonds would pay pennies on the dollar, causing tens of billions of dollars in losses for any institution that holds them.
“Germany had to give in to [the bailout] not only because of their own interests in protecting the euro, but because of private German interests as well,” says Ansgar Belke, macroeconomics research director at the German Institute for Economic Research in Berlin. “This bailout will happen if only because [Berlin needs] to protect the banks.”
Greece Must Increase Cuts
As a condition of any bailout, the IMF has asked Greece to increase taxes and cut spending, including by eliminating two months of bonus pay for public workers.
Recent strikes by public workers over pay cuts, as well as a history of government corruption and fiscal irresponsibility, have left investors with little confidence that Greece will follow through on its pledges. But Lachman says that Greece is no longer in the driver’s seat when it comes to its own fiscal policy.
“Greece can’t do anything to stop the crisis,” says Lachman. “The ball is in the European court. Europe needs to come up with the money and do everything they can to avoid Greek default.”
A second, less likely option, according to Charles Wyplosz, professor of International Economics at the Graduate Institute of International Studies in Geneva, is for Greece to restructure its debt obligations through the IMF without assistance from the European Union.
“European leaders don’t really understand the economic and fiscal implications of the actions they’re taking right now,” he said today by telephone, adding that the European response to the crisis has been reactionary and insufficient since the crisis began. “This restructuring option would leave them off the hook.”
Obstacles Remain in Germany
Even if the terms of an agreement are announced in coming days, the bailout is not a done deal. A number of obstacles – most of which come from Germany – remain.
First, Merkel must manage parliamentary approval of the deal with local elections in North Rhine Westphalia, where the bailout is unpopular with voters and Merkel’s Christian Democratic Union-Free Democratic coalition is in danger of losing parliamentary power.
“If the government loses its majority, everything that Merkel wants to do for the rest of her term has to be negotiated with and accommodate the opposition,” Yale’s Mr. Cameron said by telephone. “It’s a political complication of the first magnitude.”
Immediate political considerations aside, the German parliament might be reluctant to approve bailout funds for Greece with similar crises in Spain and Portugal looming.
“Spain, Portugal, and Greece are all seen very critically here,” says Mr. Belke of the German Institute for Economic Research. “The German population does not accept the responsibility to pay for a generous social security system elsewhere.”
Even with parliamentary approval – which Belke says is likely, despite being unpopular – the German high court could rule the bailout package unconstitutional. Belke says a number of German economists are already preparing legal challenges to the aid package on the grounds that it violates EU regulations that forbid direct economic assistance from one European nation to another – a Greek bailout would clearly violate the euro zone’s “no bailout” clause.
“The last uncertainty is the constitutional challenge,” he says.