Alan McQuaid: Avoid Greek cracks to stay at EU table

Under the second option, participants would re-invest a minimum of 90%, but preferably 100%, in new Greek government bonds with a maturity of five years and bearing interest at a rate of 5.5%.

The plan, presented to a group of bondholders in Rome last week, is heavily conditional. For a start, it must not trigger a rating agency downgrade to default or similar status on existing or new Greek government bonds. There are good reasons for avoiding the D-word.

The European central bank (ECB) has bought about €45 billion worth of Greek government bonds since last year in an effort to calm the markets. It is keen to avoid taking losses on these bonds, which could eat into its capital and force it to seek fresh funds from eurozone governments.

A full default by Greece could force such losses on the ECB but a limited, restricted default might not. As long as the Greek government is able to pay principal on its bonds, then sovereign issues may escape downgrading to full default status.

The plan must also not trigger a “credit event” as defined by the International Swaps and Derivatives Association (ISDA). The EU specifically wants to avoid an event that would trigger payouts on credit default swaps, ie, insurance contracts on Greek debt.

This is partly to avoid rewarding speculators against Greece, and partly to prevent contagion effects across the global financial system.

The guidelines of the ISDA says that changing the terms of existing bonds is a credit event, but an exchange of bonds for new ones with new terms is not.

Whether the French proposal ticks the default and credit event boxes will be a matter of negotiation and technical debate.

The key to any deal will be voluntary private sector involvement. Any solution needs to contain strong incentives for the private sector creditors to generate a meaningful contribution to debt rollover.

Greece has €124 billion of bonds maturing between now and 2014. A bail-in by the private sector could account for €30 billion-€40 billion. The incentive for the creditors will be a slightly higher coupon on the newly issued bonds.

The French plan is a near replica of the Brady bonds initiative used to bail out countries in Latin America over the past two decades.

Carlos Steneri, who orchestrated Uruguay’s debt restructuring in 2003, said recently that Greece should follow his country’s example in working with creditors to resolve its debt crisis and it should consider issuing Brady-style bonds.

He admitted, however, that there were differences in the two situations. Greece's debt-to-GDP ratio is currently about 160%, which is totally unmanageable. Uruguay’s was 80%. Greece has a solvency problem while Uruguay had a liquidity crunch.

But there are lessons to be learnt. Uruguay’s debt restructuring was widely seen as one of Latin America’s most successful, particularly in contrast to that attempted by neighbouring Argentina, which unilaterally imposed “haircuts” on bondholders in 2002.

Uruguay returned to capital markets within five months of the restructuring whereas Argentina is still frozen out almost a decade later.

The market feels an orderly restructuring of Greece’s debts, halving their value to about 80% of GDP is what’s needed to put the country back on a solid footing and allow it to return to the markets.

If Greece restructures, then the market focus will swiftly turn to Ireland and Portugal.

Ireland’s debt ratio is forecast to peak at somewhere between 110% and 120% over the next couple of years. So if 80% of GDP is seen as the sustainable debt limit, a haircut of about 30% on Irish sovereign debt would be required.

The soundings coming from the Irish government are that there is no desire to implement any haircut on sovereign paper. Its stance is that Ireland is not Greece. The battle is to convince the markets that this is true.

It is possible that the government will stick closely to its current bailout plan; that general market sentiment will improve and that the National Treasury Management Agency will be able to go back into the bond markets late next year or early in 2013 and issue debt on reasonable terms.

With 10-year yields not far off 12% at present, this is not a widely held view within the market, however.

Any Irish debt rollover or restructuring would most likely be similar in format to what is taking place with Greek debt.

Ireland’s solution, however, is more likely to be framed within the European Stability Mechanism (ESM) that becomes operational in mid-June 2013.

If Ireland does need to restructure through the ESM, then the question will be at what price.

The danger is the state will be hounded to change its economic policies once again, potentially even its cherished line in the sand: the 12.5% corporate tax rate.

Some still argue that Ireland should embrace default as an alternative, but such a move would be a disaster for Ireland and the EU. A new currency would slide dramatically, making Ireland’s debt burden even more onerous than at present and placing a severe and perhaps intolerable strain on the banks — or what is left of them.

Inflation would take off as import prices shot up and Ireland had to print money to finance its deficit. There would, of course, be a significant benefit to the Irish export sector, which cannot be underestimated, but the overall gain wouldn’t be nearly sufficient to offset the negative aspects.

Ireland would still need external finance: who would lend to it?

There are no easy options. Being in the tent with EU and IMF aid and assistance is still a much more palatable option than being outside it, looking for support.

PS: Economic statistics relating to the Irish consumer made particularly gloomy reading last week. Despite the morale boost from the visits to Ireland by Queen Elizabeth II and President Barack Obama, consumer sentiment fell in June.

It should remain fairly weak over the rest of the year as households continue to grapple with high levels of personal debt and disposable incomes shrinking from higher taxes, increasing interest rates and high unemployment.

Official retail sales figures for May were up 1.3% in the month in volume terms, but were 2.1% lower year on year. Excluding the motor trade, sales were 0.6% lower in the month and 5.1% lower year on year, the 12th consecutive such decline. To compound the misery, in the latest Live Register figures, the unemployment rate rose to 14.2% in June from 14.1% in May.

As the fear factor keeps the savings rate high, consumer spending will continue to fall.

So, personal spending on goods and services is expected to fall in real terms for the fourth year running in 2011.

Consumers matter. The export sector remains the key driver of Ireland’s economic recovery in the short term, but it won’t be enough. When imports are taken into account, net exports are equivalent only to between a fifth and a quarter of national output. The consumer still accounts for more than 50% of GDP.

If the economy is to regain significant momentum over the next few years, then weaning consumers off their savings and getting them back spending is a must.

The real poser is how to do it.

Alan McQuaid is the chief economist at Bloxham stockbrokers