The negotiations have been tortuous. After first insisting no default by any euro-zone country would be possible, leaders agreed in July to seek a deal to cut about 10% from the face value of Greece's bonds in private hands. By October, Greece's prospects had deteriorated, and euro-zone governments and the IIF agreed to pursue a deal to cut the face value in half. Since October, Greece's economy, which is entering its fifth year of recession, has weakened further, worsening the state of its government finances. That means a bigger gap in Greece's budget that must be filled either by more debt relief or more new lending from official creditors.
How can this downward spiral end with anything other than a technical default? It can't, which is why the debt talks collapsed. The cuts necessary to bring Greek debt down to anything even remotely sustainable is much greater than the supposed 50% haircut agreed to last October. And that 50% headline number is now a source of heartburn for European politicians. Via the FT:
Charles Dallara, the IIF’s managing director, told the Financial Times on Sunday that he believed an agreement in principle needed to be completed by the end of this week if the restructuring deal was to be finalised in time for a €14.4bn Greek bond redemption due on March 20.
Though he said Greek officials were negotiating in good faith, he was critical of other eurozone negotiators, saying they were not living up to the outlines of the haircut deal reached at a tense October EU summit. “[Ms Merkel and Mr Sarkozy] and all the European heads of state said they wanted a deal with a 50 per cent [haircut] and a voluntary agreement,” Mr Dallara said. “Some of their own collaborators are not following that decision.”...
...Greek debt managers had agreed with bondholders on a coupon just below 5 per cent but creditors last week proposed a much lower interest rate.
Germany has proposed a 2-3 per cent coupon that would increase bondholders’ losses from 60 per cent to more than 80 per cent in net present value terms.
It looks like Merkel and Sarkozy are trying to pull the old bait and switch on creditors. The difference between a 60% and an 80% cut is meaningful, and sufficient to drive some debtholders, such as hedge funds that picked the stuff up on the cheap, to think they are better off to take the chance on their CDS counterparties rather than submit to a "voluntary" restructuring of the magnitude necessary to bring real relief to Greece's fiscal situation.
One has to say this about European policymakers - they sure keep it interesting.
Meanwhile, German Chancellor Angela Merkel appears to have learned nothing from the ongoing debt-deflation dynamics throughout much of Europe. Responding to the S&P downgrades, via the FT:
Ms Merkel said the downgrade made implementation of steps towards fiscal union – to be codified in an inter-governmental treaty which could be signed by the end of January – urgent. She called on leaders to resist softening up the so-called fiscal compact “here, there and everywhere” as details were hammered out.
Even after German GDP turned negative in the final quarter of last year, Merkel can find no other option than fiscal austerity. Perhaps some hope from France:
François Fillon, prime minister, at the weekend ruled out more austerity measures, saying the government’s efforts were aimed at boosting growth.
Then perhaps, maybe not:
But he also said in an interview with Journal du Dimanche, a Sunday newspaper: “We will do everything to get it [the triple A] back.”
Does France have any choice but additional austerity? What would happen politically if the core refused to embrace what it pushed upon the periphery? Spain appears ready to double-down on the austerity path, even as a slowing economy pushes the budget deficit over 8% of GDP:
Mariano Rajoy, the centre-right prime minister who took power in Spain last month, has responded to Friday’s credit downgrade from Standard & Poor’s by saying that his government will persevere with austerity and economic reforms, cutting the budget deficit, modernising labour laws and restructuring the banking sector.
Good luck with that - it has worked so well in Greece.
Bottom Line: The actions of the European Central Bank greatly eased the immediate financial pressures in the Eurozone. But the underlying problem of internal imbalances remain, and the European response is still not addressing those imbalances. Instead, the commitment to the fixed exchange rate combined with Germany's failure to recognize that their current account surplus must turn to deficit if they ever hope to be repaid promises to lock the Eurozone on the path of ongoing recession.