Thursday, May 13, 2010

Greek rescue: It's the banks, stupid

The Greek rescue is more about rescuing foreign banks with exposure to Greece than about rescuing Greece itself. Foreign banks' exposure to Greece is estimated at 76 bn Euro. A Greek default would mean a loss of upto 70% or 53 bn Euro. If other countries such as Spain and Portugal were to default, banks' losses would increase.

The 750 bn Euro rescue package is intended to shock and awe. But this is hardly the 'cost' of the rescue. The cost of the rescue, assuming the guarantees in the package are all invoked, would be the difference in the market rate of interest and the rate of interest charged on the package- approximately 4%. This amounts to 30 bn Euro, which is less than what banks would lose on Greek debt alone. That's the maximum cost that taxpayers outside Greece will pick up.

As for Greece and other troubled economies, there will be huge adjustment costs. For Greece, fiscal consolidation of 11% over a three year period. Thus, the so-called rescue places the burden of adjustment overwhemlingly on Greece and other economies. Why? So that again there can be a massive bail-out of private banks using public money. The markets don't think will work because they don't think this sort of burden will be acceptable to the people of those countries.

The more sensible course would be to restructure debt and accept losses on bank exposure to government debt. Some of these losses could be made good by the governments concerned. This course would distribute losses more evenly and make for smoother adjustment.

More on this in my ET column, Why the Greek rescue won't work

2 comments: said...

I think there is a general aversion to 'accept losses'. with the 2008 mess, this was the root cause for all trouble (govt playing big brother).

the problem you will have is this: how do you know, if the toss will not turn up heads this time?

Guha Rajan said...

In the last few years, the problem has happened where the currency are strong, like USD, EURO, Pounds. These currencies are also considered as Reserve currencies of the world.

The world is turning out to be flat and hence I believe it does not matter where the product is produced but it has to be cost effective to survive in the world market. Hence, I feel developing economies will continue to grow at a much faster rate and sometime feel its good to have a weeker currency :)