Greek Bailout Gains Could Fade Fast

10.02.2012 13:20

WSJ: Even After a Deal Is Finalized—Assuming That Happens—the Euro Zone and Athens Face Old and New Challenges
European leaders' laser-like focus on muddling through has brought the euro zone this far into 2012 without disaster.

Assuming the new bailout and debt-restructuring agreement for Greece are finally agreed on, the biggest near-term risk to the euro zone should be erased. A messy default on €14.5 billion ($19.2 billion) of Greek government bonds coming due March 20 now looks significantly less likely. A sense of moderate optimism has even suffused financial markets.
The restructuring could still be awkward—the reaction of investors to the likely strong-arming of unwilling bondholders into the restructuring has the capacity to unsettle bond markets in the weeks ahead, bond analysts say, and there are risks that national politicians in Greece and outside may balk—but the worst case appears to be off the agenda.

An agreement between the Greek government and its creditors is "essential to ensure that the euro zone can manage an orderly default in Greece and stay in its current shape. It is a huge relief that the negotiations have finally reached a conclusion," said Marie Diron, senior economic adviser to Ernst & Young.

The main game changer has been the actions of the European Central Bank and its new president, Mario Draghi. Financial-market sentiment has been shifted particularly by the ECB decision to provide three-year funding to euro-zone banks.

That action in December, to be followed by a further dose later this month, appears to have broken for now the negative feedback loop between weak banks and weak governments that undermined confidence last year.

With ECB funding keeping banks above water, anxiety about sovereign borrowers has eased—and further ammunition to boost the region's crisis funding should be forthcoming soon.

Germany secured an agreement for a fiscal pact at the end of last year that increases European Union control over euro-zone government budgets and provides for more automatic punishment of rule breakers. With that in hand, European officials say they hope German Chancellor Angela Merkel will feel she has more political space to increase her backing for weak economies.
It should allow her to signal support for Portugal and other struggling governments that are obediently swallowing their economic medicine—and to further emphasize that Greece's failure to pay its bondholders back in full is a special case.

It should also allow her, they hope, to give the nod to boosting fiscal firewalls to prevent further financial contagion. This would be done by joining the resources of the current temporary bailout fund and the permanent fund, now expected to come into being this summer. That boost could then unlock further resources through the International Monetary Fund.

There are plenty of risks to this moderately rosy scenario. The chief one is complacency. With the crisis fires no longer licking at Spain and Italy's portals, governments may use the time bought for them by Mr. Draghi to do nothing.

"I fear that the ECB's support for the banking system may be making the EU complacent," writes Sony Kapoor, managing director of Re-Define, a financial think tank. It isn't clear, he says, how and when banks will be able to wean themselves off their increasing dependence on the ECB.

Economists also argue that the new fiscal rules constitute a recipe for continued low growth across the euro zone for several years, and will prove increasingly unpalatable for governments.

But the greatest risk is still perceived to be in the country where the whole crisis started: Greece. Even publicly optimistic officials don't claim privately that the second bailout program will clear Greece from radar screens for long. With the country now entering its fifth year of recession, keeping to the hard-won austerity agreement hashed out over recent weeksis regarded as a near impossibility.

That suggests Greece will be back to the negotiating table with its official creditors in months rather than years, which—amid growing impatience among Greece's paymasters—will again raise the question of whether the country can stay in the euro zone.

In a research note this week, Willem Buiter and Ebrahim Rahbari of Citigroup raised their estimate of the chance of a Greek exit from the euro zone to 50% over the next 18 months—up from 25% to 30% in September.

Part of the reason is their view that the perceived costs of its departure from the euro to the rest of the region are moderating over time. There are signs, they argue, that sentiment in the financial markets is increasingly differentiating Greece from other struggling euro-zone members—as are policy statements from German Chancellor Angela Merkel and others. They also argue that the likelihood of policy action by the ECB and euro-zone creditor governments to support vulnerable euro-zone economies has increased over the past six months.

Says Mujtaba Rahman, a former EU official who is now an analyst with Eurasia Group in New York: "The interesting question was not whether a second program would be agreed, but what happens when it fails, as it inevitably will."

Over time, he says "the possibility of a Greek exit becomes more plausible as its costs become more negligible."

Write to Stephen Fidler