The German parliament’s acceptance of a refurbished eurozone rescue fund makes it very likely that the package of measures agreed by the currency area’s leaders in July will be implemented. But the game has moved on, and it is a good sign that the main decision-makers are discussing what more is needed.
The answer is two things above all: to leverage the European financial stability facility up by enough weight classes to impress markets; and to exact deeper private sector sacrifices in the planned exchange offers of Greek government debt. While the former is controversial, sentiment seems to be tilting in its favour. A bigger battle is about to erupt over the latter.
The idea of “ private sector involvement” in the second Greek rescue has been riddled with a contradiction. Making private owners of the bonds in question help to make things easier for Greece is incompatible with averting a sovereign default – if “default” means anything but honouring original terms on time and in full, these are incompatible. But the goal should be another: to ease Greece’s burden while making investors no worse off in real economic terms than they are now. This is possible: the market discount on Greek bonds reveals that investors know their prospects are awful.
This discount should be captured to benefit Athens and its partners. The bond swap now in the works envisages a 21 per cent net present value loss to investors, but a lesser cut in Greece’s debt at face value. While not negligible – the stretching out of maturities is particularly helpful – this is not enough.
Before a formal offer of a bond exchange is made, terms should be toughened. Many investors would still come out ahead and would accept. Holdouts can be discouraged by putting collective action clauses into Greek law: Ireland’s use of such against bank junior bondholders is a good model.
There are two objections – both serious but less strong than they seem. Steeper haircuts would bring greater losses to banks. But most banks have claimed ad nauseam that they can weather losses on their Greek holdings. If they have lied, it is less bad to bail them out directly than via Athens.
The second objection is that investors will expect similar losses on other sovereigns and contagion to banks. But as Ireland’s falling yields show, markets can discriminate. And the worst contagion flows not from realising losses but from uncertainty over future ones. Only a lasting deal over Greece and adequate firewalls around it can cut that uncertainty short.
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