European Leaders Plan for Partial Greek Default

As Greece struggles to mend its deficit, eurozone countries debate whether to help banks in the event of a default.

As Greece’s debt is increasingly likely to be restructured, European leaders convene this weekend to discuss a plan to prevent banks that would suffer major losses because of it from going bankrupt. A coordinated recapitalization effort, as championed by the International Monetary Fund and the United States, seems unacceptable to creditworthy nations like Germany however.

American officials and the IMF urge European countries to inject public capital into the financial industry to quickly restore confidence in the euro area. The European Central Bank, which has reluctantly financed Italian and Spanish borrowing in recent months to prevent the debt crisis from reaching those countries, would guarantee government debt under their plan.

European leaders are divided on a mass bailout effort for financial institutions however and would rather ask banks to raise capital from private sources in anticipation of a Greek default. They could appeal to their national governments for support and to the European Financial Stability Facility as a last resort if their exposure to Greek sovereign bonds becomes untenable.

Economists at the Brussels think tank Bruegel estimated last year that just 20 percent of Greek debt was held by domestic banks. Another third is held by pension funds and insurance companies in other European countries.

The step-by-step approach is a concession to fiscally solvent euro nations including Finland, Germany and the Netherlands which were wary of expanding the EFSF to begin with to enable it to bail out banks.

German finance minister Wolfgang Schäuble told fellow Christian Democrats in Berlin last week that the Greek debt burden “will simply have to be reduced to such an extent as to provide Greece with a reasonable outlook.” But this cannot come exclusively at the expense of taxpayers, he added.

The eurozone’s leaders agreed to another Greek bailout in July after the €110 billion committed last year proved insufficient to steer the troubled country off the brink of bankruptcy.

Last month, it emerged that Greece had failed to miss the deficit target that it had set to qualify for the sixth, €8 billion tranche of the original aid package it needs to be able to pay public-sector salaries.

With more than €340 billion in debt, Greece is now among the least creditworthy of nations. Nearly one out of ten Greek workers is unemployed and its economy is expected to contract by as much as 5 percent this year. The lack of expansion, caused by a dramatic drop in consumer spending, is accompanied by higher taxes which are extremely detrimental to private-sector growth.

The specter of default does not appear to have engendered a particular willingness on the part of the Greek people to reform. Although subject to heavy austerity measures, including public-sector pay cuts and pension reductions, reining in the pervasive Greek state is unpopular.

Government spending accounts for almost half of the Greek economy and the state maintains ownership in airports, casinos, hotels, resorts, railways and utilities. Many of these enterprises are wholly unprofitable and need thorough reforms before they can go to market.

The agency charged with selling off state property employs less than a dozen people while local governments possess no digitalized records of what buildings and land they own.

Greece’s powerful trade unions are another obstacle as they are vehemently opposed to the planned liberalization effort to be carried out by a socialist administration. Athens has promised to net €50 billion through privatizations but consistently falls short of its short-term financial targets.

Contrary to the original aid program, the second bailout involved voluntary contributions from banks and insurance companies that had invested in Greek bonds. They were persuaded to accept rollovers on Greek debt which should buy Athens time to get its fiscal house in order.

If Greece were unable to repay all of its loans despite the attempted rescue, it would probably not renege on its obligations to other members of the euro area, thus forcing private bondholders to accept even bigger losses. Investors fear similar partial defaults could happen in countries as Italy, Portugal and Spain which are also heavily indebted and struggling to reduce their deficits.