13/05/2011: Procrastination only postpone the inevitable

Greece will default and need to restructure, as we argued already a year ago. Risks of international and financial market contagion have Eurozone leaders in a state of paralysis. Action is needed before the crisis takes its own course.
Every day brings more bad news on the debt situation on Europe's periphery. Der Spiegel, the German weekly, reported last weekend of a secret, urgent meeting among Eurozone finance ministers to discuss the Greek threat that the country would leave the Eurozone. Greek, German and other Eurozone officials denied this scenario vehemently, but had to acknowledge that a meeting took place, the agenda and results of which have not been disclosed.
Greece is in a desperate state: Its economy will shrink this year by 3%, and interest rates on its public debt are upwards of 20%. This should surprise no one, however. We at UBS Wealth Management Research have insisted for over a year that Greece was bankrupt and would need to restructure its debt with hefty haircuts. Though at the time this was not the majority view, we were nevertheless not alone, and economists have migrated towards it in consensus over the last year. Today even German officials discuss it openly.
The two main reasons why Greece is currently not allowed to default and restructure its debt are also well known: international contagion and financial market contagion. If Greece did default and restructure, market participants would very likely again question Ireland and Portugal, though these two countries have agreed to support packages. The spotlight's glare might then fall on Spain, and shadows could stretch as far as Italy, Belgium and even France.
The financial market contagion lies in the structure of Greek debt holders. Greek government debt amounts to some EUR 340bn, roughly one third of which is held by international public entities (IMF, European Monetary Union, European central banks), another third by financial intermediaries (Greek and other European banks as well as insurance companies), and the last third is with unknown holders. A Greek default with a significant haircut for debt holders could lead to a crumbling of the Greek banking system, a banking crisis in Europe and further defaults beyond the banks in a massive cascade. This appears especially likely given that holders of so much of the outstanding debt are presently unknown.
Delaying Greece's default and restructuring, buying time with piecemeal solutions to block contagion might once have been a good strategy. In our view, this was exactly the strategy pursued by the European Monetary Union until a couple of weeks ago, when the European Central Bank stopped buying European peripheral debt. Until then we considered this a technique similar to that exercised by the US Federal Reserve with its various subprime debt programs. The European Central Bank was purging the balance sheets of European financial intermediaries by replacing toxic European sovereign debt with fresh euros.But this bond-buying program has stopped, and so far nothing has replaced it. Postponing the Greek default looks more and more like procrastination. This merely amplifies the problems which will occur on the inevitable day, and is not constructive policy.