In the fight to keep Europe from tipping the world into another serious financial crisis, words matter. And no word matters more than "default."
If the plan by European leaders and banks to extend Greece's debt is considered a default by the world's top credit rating agencies, it could trigger a cascade of negative events – including, for a start, an insolvent banking system in Greece and a stressed one in other parts of the euro zone.
If it's not, Greece carries on as a debt-addled, bailout-dependent state, and Europe buys a little more time for countries such as Spain, Ireland and Portugal to convince investors that their fiscal programs are working, giving them access to loans at reasonable interest rates.
The stakes are high and so are the frustrations of European leaders who have been working for weeks to find a solution – even a temporary one – to Greece's impending cash crunch, only to find the credit raters putting up one more obstacle.
S&P irritated European officials on Monday by stating that current proposals to have banks and insurers roll over about €30-billion ($41.7-billion) of Greek bonds would constitute a "selective default" because Greece would have failed to meet its original obligations.
Europeans were quick to stomp on the S&P statement for fear it would spark turmoil in financial markets. The Financial Times, citing an unnamed government official, reported Tuesday that the European Central Bank (ECB) would continue to accept Greek bonds as collateral so long as at least one of the four major credit rating agencies maintained an investment-grade rating for Greece. And German Chancellor Angela Merkel signalled that she has had enough of credit agencies' arcane standards complicating the European Union's effort to avoid a financial meltdown.
The issue is collateral. The ECB is effectively underwriting Greece's banking system by allowing the country's lenders to swap Greek sovereign debt for fresh loans. The ECB, according to its rules, can do this as long as Greece maintains an investment-grade rating. A default would theoretically require the ECB to stop accepting Greek debt as collateral, which would cause a trauma for Greece's banks, and raises the prospect of woes for other banks around the world that have financial exposure to them.
The taint of default also risks complicating the effort to cajole private banks and insurers into taking part in Greece's rescue. Significant participation by the private sector is the only way voters in countries such as Germany, the Netherlands and Finland will be sold on a second bailout. But convincing financial institutions to renew their loans to Greece will be more difficult if that debt lacks an investment grade. Banks likely would have to raise capital to offset the added risk of lending to country that is essentially bankrupt, risking a backlash from shareholders.
With a debt that is set to rise to 166 per cent of gross domestic product next year, Greece is unable to pay its bills on its own. On the weekend, Greece's partners in the euro zone authorized a loan the equivalent of about $13-billion to get the country through the summer. It's widely acknowledged that further help will be needed to carry Greece over the next couple of years. Finance ministers from the euro group are scheduled to meet again on July 11 to work on a second bailout that could cost as much as €85-billion.
Many observers say it's only a matter of time before the EU, the ECB and the IMF accept the inevitable and allow a proper restructuring of Greek debt. Jacob Kirkegaard, a research fellow at the Washington-based Peterson Institute for International Economics, says this will happen within 18 to 24 months. Carl Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y., said Europe will be condemned to an outbreak of default worries every few months until a neutral party organizes a voluntary rollover of Greek debt by the private sector.
But European policy makers still wish to delay that day as long as possible – for good reason. The longer they can avoid technical defaults, the better it will be for other highly-indebted European counties like Portugal, whose credit rating was cut to junk Tuesday by Moody's Investors Service.
If Greece defaulted now, there would be a ripple effect across Europe, and probably the world. Credit markets likely would seize as investors tried to figure out which banks were most exposed to Greek debt. Speculation would increase that Ireland and Portugal would follow Greece into default, putting upward pressure on borrowing costs across Europe. That would be a blow to global economic growth.
"You are kicking the can down the road to make the broader European financial system more resilient," Mr. Kirkegaard said. "It buys them enough time to do enough to keep the appearances of a successful program going while buying time for the economy."
That means there is now political pressure on the credit agencies to bend. Ms. Merkel said Tuesday that the EU, the European Central Bank and the International Monetary Fund are better equipped to judge the adequacy of new proposals to involve banks and other financial institutions in a second bailout of Greece. "I trust, above all, the judgment of those three institutions," the German leader told reporters in Berlin, according to a report by the Associated Press.
A debt crisis primer
Greece has a sovereign debt pile of €350-billion euros ($486.5-billion), more than €30,000 for each of its 11.3 million people.
Three European countries have received emergency loans to make payments to bondholders - Greece (€110-billion, with more to come), Ireland (€85-billion) and Portugal (€78-billion).
The failure to repay principal or interest owed.
A phrase a debt rating agency is using to describe French banks' plan to, among other things, hold Greek debt for longer periods than planned (the French rollover).
A default by Greece would hurt the banks that hold its debt. It could also prompt credit markets to freeze up, as happened after Lehman's demise when banks virtually stopped lending to each other.
Staff, news services