Disagreements on how to address
Greece's reform process boiled over this week when European Central Bank
(ECB) President Trichet walked out of a meeting. Trichet warned if Greece were to extend the maturity of
existing debt, the ECB would stop supporting Greece.
We have long argued that it is not in
Greece's interest to default at this stage because Greece needs to get its primary
deficit under control before restricting its debt. As further reforms are
implemented, the risk/reward ratio for Greece will change to potentially
favor a default to reduce its debt burden. Delaying any default benefits
Greece because any default now would impose an immediate adjustment of the
primary deficit as it may be impossible to get new loans at palatable terms.
However, if ECB deserts Greece, the
risk/reward assessment for Greece is changing. If the ECB gets too tough on
Greece, dynamics in Greece may drive political dynamics to favor a default or
even a re-introduction of the drachma.
Mind you that this would not be in
Greece's interest: a default now won't fix Greece's underlying structural
issues. Leaving the eurozone might cause an
implosion of Greece's financial system. But from Greece's point of view, if
they feel deserted by the ECB, political dynamics may favor the worst of the
bad choices at hand.
As far as the banking system in the
rest of the eurozone is concerned, we know that
central banks, including the ECB, are bad poker players. If the ECB indeed
pushes Greece over the brink though, they would provide ample support to the
rest of the banking system. It would certainly expedite the process of
raising more capital in the eurozone banking system
(some of which through national governments).
Manager, Merk Hard Currency Fund