Greece Requires Conservatorship
In our assessment, Greece should be placed into conservatorship by the European Commission. Greece's liquidity issues have morphed into a solvency crisis. Greece's challenges are fiscal, which requires a political solution. Therefore, Greece's problems cannot be resolved by the European Central Bank (ECB), although ECB policy can affect the dynamics as this crisis evolves. It is paramount to receive clarity on the political path chosen; closed-door deliberations may avoid the hastened band-aid approach employed by U.S. policy makers at the peak of the financial crisis, but are only good if it leads to substantive results.
As we see it, a variety of options are possible to address Greece's challenges:
The European Commission, in conjunction with the International Monetary Fund (IMF) and the finance ministers of eurozone countries, could provide sufficient capital for Greece's immediate financing needs. This may be the worst-case scenario, as any short-term capital injection may be very inefficient and not solve the long-term issues. It would show a lack of political leadership, seriously increasing the threat of contagion.
No agreement could be reached and Greece could fall into chaos. In that case, at least we have clarity and the markets can react accordingly. It would send a rather loud warning to Portugal. Portugal is in far better shape than Greece, but the arrogance of the political opposition in overruling the minority government to increase, rather than to cut, spending makes the country's debt vulnerable. In case of a disorderly default, we believe the ECB would provide unlimited liquidity to the banking system; the eurozone member countries would provide a backstop to their banking system.
This rather brutal approach would allow the eurozone to move on and may be preferable to any plan that does not set the framework for a long-term solution to Greece. Given the political realities, this scenario is highly unlikely, although not impossible.
A comprehensive bailout with insufficient austerity measures could be announced. Such a bailout may reduce the spreads between German and Greek bonds, but may, over the long-term, bring Germany's borrowing costs closer to that of Greece rather than the other way around. Incentives must be in place to encourage fiscal restraint. Given that Germany has taken a strong leadership position in the negotiations, we believe this outcome is unlikely.
Placing Greece into conservatorship may be the most effective way to get Greece back onto the right track. Greece's government, while working hard, is fighting an uphill battle. Greece finds itself in a predicament not all dissimilar to that of Newfoundland in the 1930's. In the case of Newfoundland, its government had to relinquish control to a commission appointed by Britain and the British government guaranteed its public debt. Similarly, Greece may have to give up sovereign rights with regard to its fiscal management as a price for support.
The European Treaty does not provide for conservatorship, making our preferred scenario an unrealistic one. However, the IMF is the one institution with the credibility and experience to impose and supervise credible austerity measures. Governments are not like investment banks: governments bleed, they don't evaporate; solutions are rarely black and white. As a result, policy makers should work hard on imposing credible and sufficient restrictions on Greece through all available means. While the European Commission may not be able to seize control, Greece is able to yield control to aspects of its finances.
Whether or not a debt restructuring (partial default) is part of any arrangement remains to be seen; in our assessment, the credibility of any announced plan will be more relevant in calming the markets; having said that, a debt restructuring would make a plan more credible in the absence of other measures to restrain Greece.
With regard to the size of any bailout, the IMF may well be willing to give a multiple of what is on the table. ECB President Trichet traveled to Germany on Wednesday to communicate the urgency of the political leadership in the eurozone to act on a comprehensive solution to Greece, saying: "to us it is extremely important that the decisions are taken extremely rapidly." It would be helpful to have an announcement within days, preferably before the next scheduled ECB meeting and press conference on May 6.
We have long argued that Greece will ultimately be seen for what it is: a struggling country, whose GDP comprises a little over 2% of eurozone GDP. It is now up to the political leadership to decide whether this will take days, weeks, months or years.