Significance of the EU Gathering on May 6

The unscheduled meeting between several euro zone finance ministers, Eurogroup head Juncker, EU Monetary Affairs Commissioner Rehn, ECB President Trichet and a few other senior officials was important.  It marks the official recognition that the year-old Greek aid package is not working. This does not mean that Greece is about to exit monetary union, rather it means officials are going back to the drawing board and re-evaluating their options.  It raises the significance of next week's (May 16) summit of European finance ministers.

Drawing on my analysis of other debt crisis, I have consistently argued that Greece (and Ireland, and possibly Portugal) will have to restructure their debt.  In a recent post I argued European officials would soon have to make some difficult decisions because Greece needs more funds and it would most likely not be able to effectively tap the capital markets next year as the IMF/EU assistance program had assumed. 

Moreover, the austerity measures that Greece had taken to access the assistance had driven the country into a deep contraction.  The more the economy contracts, the lower the tax revenues fall, and the greater the counter-cyclical spending becomes.

Recently Eurostat estimated the 2010 deficit at 10.5% of GDP not the 9.4% the government had estimated and well above the 8.1% target.  Greece needs new assistance and for the first time European officials recognize this.   This is an important first step:  acknowledge the issue.  What is now under discussion is how to do it and under what terms.  Measures under discussion include pushing further out in time deficit targets, easing terms of the 80 bln euros from the EU as part of the 110 bln 2010 package, additional aid from the EFSF, bond purchases by the EFSF,voluntary restructuring of some of Greece's sovereign debt, held by private investors. 

Recall that Greece has seen the interest rate charged by the EU cut already (now around 4%) and the maturity has been extended to 7.5 years from 3 initially.  In past debt crisis, these steps to ease the repayment terms by lowering the interest rate and lengthening maturities are often the first line of defense and it rarely succeeds.  Ultimately something has been be done to reduce the overall debt level.

Officials are moving in that direction, albeit slowly.  Since early April, press reports in the German, UK, Greek and American financial press report movement toward some type of restructuring at least among some officials.  The IMF reportedly is sympathetic, and a number senior German officials, seem to recognize that a Greek restructuring will be necessary.  And some officials have even begun suggesting that a restructuring would not be an unmitigated disaster as has previously been suggested by officials.

A Greek exit monetary union remains highly unlikely, but the odds must be recognized above zero.  It is a function of a cost-benefit analysis.  The cost to Greece would be severe: deep recession, banking crisis, high inflation, a pariah to the international capital markets, and a massive destruction of living standards in Greece.   And yet as the screws tighten on Greece it is experiencing much of these conditions presently.

The press report that claimed that Greece was considering leaving the monetary union seemed to be more based on a German study for the Finance Ministry on the implications of a Greek exit.  The study seemed to suggest that it is preferable for Germany and France and the rest of EMU that Greece remains in the club than outside it.  Aside from the direct and indirect financial costs to banks, including the ECB, if Greece would to leave, it would raise the risk that others would exit and could fatally undermine the entire monetary union, if not the EU itself, which Greece apparently would  have to leave as well.

The important take away from the EU official gathering on May 6th is that the cost of Greek exit is still seen as prohibitive, which means some sort of solution within the EU framework, even if there is some innovation, is required.  This will likely allow the euro to stabilize in the foreign exchange market after falling nearly 4.25% Thurs-Fri last week.   A move above the $1.4500-50 area may be needed to raise confidence that the position-squaring correction, following Trichet's signal that the ECB would not hike rates in June, within the framework of Trichet's claim that the ECB never pre-commits.  On the downside, a break of the $1.4300 area would target the mid-April low near $1.4150.