For whom the bells toll: Why the foretold Greek debt restructure will bring Spain into the mire which will, in turn, boost Ireland’s pain

Despite angry denials, the trajectory that started in Greece is heading for Madrid and carries the cumulative weight of sovereign and banking insolvency that will further immiserate Ireland.

First things first. The long awaited Greek debt restructure is around the corner. Not a moment too soon, I would add. For there is no worse fate for an economy than a  debt restructure foretold but hopelessly delayed. It is as if the whole economy is  stagnating, with investment activity below zero, sort of… waiting for Godot (only without the brilliant prose). The sooner the waiting period is over the better.

Back in May, when the Greek state was lent €110 billion for the purposes of staving off default (or perhaps because of it), some of us where suggesting that  such loans resembled petrol being thrown on the flames in the hope of… dampening them. We were dismissed as alarmists. As Schopenhauer once said, all prickly truths are first ridiculed, then fought tooth and nail and only finally they are proclaimed (by the same people who ridiculed and fought them previously) as self evident. The Greek debt restructure seems to be entering the third and final stage. Let’s see why.

Just look at the numbers: Setting aside 2011 (during which the Greek state’s debt will be refinanced by the butt end of the €110 billion loan), in the following year, in 2012, the Greek government must repay existing loans as follows: €15 billion in the first quarter, €9 billion in the second quarter, €8 billion in the third, and a mere €1 billion in the last quarter. €33 billion in total (and all this assuming that, in spite of the savage recession that is eating into the state’s tax intake, the primary deficit will be eliminated – a truly tall order). Of that €33 billion, almost €25 billion must be raised from the money markets. What money markets? The very ones that have deemed Greek bonds  non grata. Or to put it differently, all this money must be raised in a market in which most institutional investors are banned from buying bonds with the low credit rating of Greek bonds. The money will, very simply, not be raised.

So, what will happen? Can Europe allow Greek debt to be restructured unilaterally after having invested so much capital, political and economic, in preventing it? The answer, I submit, cannot be independent of what happens elsewhere. In Ireland, in Portugal and, above all else, in Spain. Now, the conventional wisdom is that Spain has been ring-fenced; that the buck stops with Portugal; that Spain’s austerity program, coupled with its attack on its banks’ troubles, will pay off; that the EU-ECB-IMF troika will not be alighting at Madrid airport. While I do not wish such a fate on my Spanish friends, I am compelled to point out that this ‘conventional wisdom’ is being peddled by the very same people who claimed back in May 2010 that the Greek ‘bail out’ was all ‘fully costed’, that Ireland was not Greece and that Portugal was no Ireland. Forgive me dear reader but the track record of such confident prognosticators leaves me unimpressed.

As Wolfgang Munchau explained in his FT article today, Spain’s banks are exposed terribly to real estate deals that have gone badly wrong. Worse still, prices have not reached their equilibrium level yet. They remain artificially high. Why? Because many developers were self-financed and could hold out in the hope that their newly built apartments and office blocks might rebound. They did not and they will not. And then the true extent of both the developers’ and their bankers’ losses will be revealed. It has not happened yet. But it will as surely as day will follow night. What exactly is at stake here? Around half a trillion euros in bad debts is the answer. Plus another €100 billion of Spanish banks’ exposure to Portuguese fast depreciating sovereign bonds. In short, enough dough to cause sufficient panic in the money markets to see Spanish spreads rise to unsustainable levels.

All this, I hasten to add, is happening against the background of increasing ECB interest rates, which accelerate Spain’s path toward insolvency. Still, there is more – when it rains bad news it pours: As the Spanish banking troubles gather momentum, those of Ireland will worsen too – at the very juncture the ECB is trying to wash its hands clean of all periphery banks. Lest we forget, while the Dublin government has borrowed around €67 billion from the EFSF at a usury interest rate of 6%, and with so many strings attached that the Irish taxpayer is hardly breathing, the Irish banks have borrowed €146 billion at a scandalous interest rate of 1% (recently pushed up to 1.25%).

Why am I arguing that the Spanish crisis will push Ireland and Portugal deeper into the mire? For the simple reason that the ECB is now determined to offload the periphery’s banks onto the EFSF. To make them borrow at 6% too from the taxpayers of the surplus countries, just like the periphery’s member-states do. This would be catastrophic, unless of course the EU changes its mind on allowing Greece et al to default (or, even better, unless the EU decides to impose a debt restructure onto the PIGS’ lenders).

Before we contemplate the future, let us look more closely at the present. What happens today when the proverbial Nick the Greek shifts money from his Athens National Bank of Greece account to a German account, in a frenzy of worries about a possible collapse of the Greek banking sector? Or when Paddy does the same, transferring his hard earned savings from the Dublin branch of, say, Anglo Irish Bank to some Dutch account? Most likely, the surplus country’s bank (i.e. the German bank or the Dutch one) will refuse to accept to effect the transfer in exchange for a right to claim the monies from the National Bank of Greece or the Angle Irish. To honour Nick’s and Paddy’s rights to transfer their funds freely within the eurozone, the Central Banks of Greece and Ireland must come into play.

How does this happen? This is how: The Anglo Irish borrows an amount equal to that which Paddy shifted to Holland from the Central Bank of Ireland. Similarly with the National Bank of Greece which borrows a sum equal to that which Nick shifted to Germany from the Central Bank of Greece. And what happens at the other end, in Germany and Holland? The banks that received Nick’s and Paddy’s money reduce their borrowings from the Bundesbank. To square things up, the Bundesbank has ended up with new claims over the Central Banks of Greece and Ireland. In effect, the more capital is transferred from the periphery to the surplus countries the more the Central Banks of the deficit countries are borrowing from the Central Banks of the surplus ones. At what interest rate? At the ECB’s 1.25%.

In this context, the Bundesbank’s loans to other Central Banks come up to almost €326 billion or 71 per cent of all such loans within the euro area. And who owes most of it? Ireland, at more than €146 billion. Greece follows with €87 billion, Portugal with €60 billion and Spain with €51.

To put it simply, once Spanish sovereign debt (under the influence of the Spanish real estate sector bad debts) begins to scale the upper echelons of the 5 to 5.5 per cent range, and Spaniards join Nick and Paddy in shifting their savings to Germany and Holland, the periphery’s Central Banks will end up owing the Bundesbank well over €500 billion. The ECB (aided and abetted by the Bundesbank – especially after Mr Trichet’s departure) will start making loud noises about the need to switch off the tap that keeps the periphery’s banks going, suggesting that they turn instead to the EFSF for much, much more expensive loans. At that point, the euro crisis will take a new, nastier turn.

Can anything be done to avert the eurosystem’s collapse? We think so. Our Modest Proposal remains, in my mind, the only rational response to a tough but ultimately solvable problem. But with one caveat. As some readers have suggested, the Modest Proposal will need a more beefed up approach to the question of the debt restructure. Especially for Greece. Well, we are working on it. Version 3.0 of the Modest Proposal should be out after the Easter break.