US technical default would convulse markets. Nothing else is certain
AMERICA’S debt is supposedly the world’s safest, backed by trustworthy courts and an unrivalled capacity to raise taxes and print money. Yet thanks to a quirk of law, talk of default is not confined to the European side of the Atlantic.
Unlike most countries America requires two legal steps to run a deficit: one to pass budget bills, the other to borrow the money. Congress sets a ceiling on how much the country may borrow. In the past it has always raised the ceiling before the Treasury ran out of cash, doing so on 16 occasions since 1993 alone. But it often attaches conditions, and this year Republicans who control the House of Representatives are insisting on particularly onerous terms. With the debt and the deficit at their highest in 60 years, they want to see at least $2 trillion in spending cuts over ten years and no tax increases.
If a deal cannot be reached before August 2nd the Treasury says it will be forced to default. It has not specified on what: it could choose to stop paying pensioners and soldiers before it stopped paying interest on its debt. But outright default cannot be entirely ruled out. What happens if the world’s most trustworthy borrower reneges on its debt?
The possibility has not gone unnoticed. Trading in credit-default swaps (CDSs) on Treasury securities has picked up and the price of protection against default, as measured by the CDS spread, has risen (see chart). One-year protection is now almost as expensive as five-year protection. This is more often seen in distressed markets where investors are pricing in an imminent default than with otherwise healthy borrowers with long-term problems.
The illiquidity of the CDS market means it can be prone to misinterpretation. The vast Treasury market itself—for Treasury bills, Treasury bonds and other government securities—remains largely free of anxiety. America’s biggest interest payments occur on the 15th of August, November, February and May. Priya Misra, head of US rates strategy at Bank of America Merrill Lynch, says anyone who thinks America might default for several weeks this summer should sell a bond with interest due on August 15th and buy one with interest due on November 15th, which would result in the price of the first bond falling relative to the second. But, she says, neither market pricing nor the chatter of clients shows such a trend.
There is a profound muddle about what a default would entail. Firms usually get a few weeks’ grace to make a payment. Sovereigns typically do not so default would probably be declared the day the Treasury missed a payment.
Some market participants argue such a default would be quickly “cured” and be therefore merely technical. Yet history suggests that even a technical default can be costly. America’s only known instance of outright default (other than refusing to repay debts in gold in 1933) occurred in 1979 when the Treasury failed to redeem $122m of Treasury bills on time. It blamed unprecedentedly high interest from small investors, a delay in raising the debt ceiling and a word-processing-equipment failure. Although it repaid the money and a penalty to boot, a later study by Terry Zivney, now of Ball State University, and Richard Marcus of the University of Wisconsin-Milwaukee found it caused a 60-basis-point interest-rate premium on some federal debt. Today that would cost $86 billion a year or 0.6% of GDP, a hefty penalty for something so avoidable.
A default now would attract more attention, affect more debtholders and reach more deeply into the financial system. More than half of Treasury debt is held abroad, principally by foreign central banks. Such investors would be unlikely to sell overnight since they have few ready alternatives. But they would be reluctant to hold as much in the future; some, like China, are already diversifying their reserves. After Fannie Mae and Freddie Mac, two giant mortgage-financing agencies, had to be rescued by the federal government in 2008, foreigners cut their holdings of these securities and have yet to raise them again even though the firms never defaulted.
Domestic banks would not have to classify their sizeable holdings of Treasuries as non-performing if they thought the default short-lived. But they would suffer nonetheless. Currently Treasuries represent roughly 30% of the collateral that financial institutions such as investment banks use to borrow in the $4 trillion repurchase (“repo”) market. They represent another 4-5% of the $1 trillion in collateral used in the derivatives market. A default could trigger demands by lenders like money-market funds for more or different collateral.
Matthew Zames of JPMorgan Chase, writing on behalf of the securities industry in April, gave warning that this could “lead to deleveraging and a sharp drop in lending”. Money-market funds themselves hold another $338 billion of Treasuries. In the event of a default at least one would probably “break the buck” (ie, fail to give the principal back to investors), threatening “a broader run on money funds”, Mr Zames said.
No one can be sure of any of this. Money-market funds, like banks, might argue their holdings are sound if the default is brief. A suspension of new sales of bonds could constrict supply of Treasuries, pushing yields down instead of up. On the other hand America responded to the crisis of 2008 by standing behind the obligations of banks, money-market funds, and Fannie and Freddie. It could hardly do the same for a crisis caused by an inability to stand behind its own debts.
Even if Congress were to tackle turmoil by quickly lifting the debt ceiling, the stain would linger. “In the past our assumption was interest would always be paid on time,” says Steven Hess of Moody’s, a ratings agency which has cautioned that even a brief default would cost America its coveted Aaa status. “If an actual payment were missed once, might that happen again? If you thought it could, that is clearly not compatible with Aaa.” Such warnings are having an effect. On June 19th Mitch McConnell, the Republicans’ leader in the Senate, opened the way to a short-term increase in the debt ceiling, even though his counterparts in the House demurred. They may not show it but Republicans, like Democrats, are scared of default, too.
If Greece goes…
The opportunity for Europe’s leaders to avoid disaster is shrinking fast
THE European Union seems to have adopted a new rule: if a plan is not working, stick to it. Despite the thousands protesting in Athens, despite the judders in the markets, Europe’s leaders have a neat timetable to solve the euro zone’s problems. Next week Greece is likely to pass a new austerity package. It will then get the next €12 billion ($17 billion) of its first €110 billion bail-out, which it needs by mid-July. Assuming the Europeans agree on a face-saving “voluntary” participation by private creditors to please the Germans*, a second bail-out of some €100 billion will follow. This will keep the country afloat through 2013, when a permanent euro-zone bail-out fund, the European Stability Mechanism (ESM), will take effect. The euro will be saved and the world will applaud.
That is the hope that the EU’s leaders, gathering in Brussels as The Economist went to press, want to cling to. But their strategy of denial—refusing to accept that Greece cannot pay its debts—has become untenable, for three reasons.
First, the politics blocking a resolution of the euro crisis is becoming ever more toxic (see article). Greeks see no relief at the end of their agonies. People are protesting daily in Syntagma Square against austerity. The government scraped through a vote of confidence this week; the main opposition party has committed itself to voting against the austerity plan next week and a few members of the ruling Socialist party are also doubtful about it. Meanwhile, German voters are aghast at the prospect of a second Greek bail-out, which they think would merely tip more money down the plughole of a country that is incapable either of repaying its debts or of reforming itself. As the climate gets more poisonous and elections approach in France, Germany and Greece itself, the risk of a disastrous accident—anything from a disorderly default to a currency break-up—is growing.
Second, the markets are convinced that muddling through cannot work. Spreads on Greek bonds over German bunds are eight points wider than a year ago. Traders know that Greece, whose debts are equivalent to around 160% of its GDP, is insolvent. Private investors are shying away from a place where default and devaluation seem imminent, giving the economy little chance of growing. The longer restructuring is put off, the more Greek debt will be owed to official lenders, whether other EU governments or the IMF—so the more taxpayers will eventually suffer.
The third objection to denial is that fears of contagion are growing, not receding. Early hopes that Greece alone might need a bail-out were dashed when Ireland and Portugal also sought help. The euro zone has tried to draw a line around these three relatively small economies. But the jitters of recent weeks have pushed Spain and even Italy back into the markets’ sights again. The belief that big euro-zone countries could be protected from attack has been disproved. Indeed, far from fears of contagion ebbing, the talk is of a Greek default as a “Lehman moment”: like the investment bank’s bankruptcy in September 2008, it might unexpectedly bring down many others and devastate the world economy.
While the EU’s leaders are trying to deny the need for default, a rising chorus is taking the opposite line. Greece should embrace default, walk away from its debts, abandon the euro and bring back the drachma (in a similar way to Britain leaving the gold standard in 1931 or Argentina dumping its currency board in 2001).
That option would be ruinous, both for Greece and for the EU. Even if capital controls were brought in, some Greek banks would go bust. The new drachma would plummet, making Greece’s debt burden even more onerous. Inflation would take off as import prices shot up and Greece had to print money to finance its deficit. The benefit from a weaker currency would be small: Greece’s exports make up a small slice of GDP. The country would still need external finance, but who would lend to it? And the contagion risk would be bigger than from restructuring alone: if Greece left, why not Portugal or even Spain and Italy? If the euro zone were to break up it would put huge pressure on the single market.
The third way
There is an alternative, for which this newspaper has long argued: an orderly restructuring of Greece’s debts, halving their value to around 80% of GDP. It would hardly be a shock to the markets, which have long expected a default (an important difference from Lehman). The banks that still hold a big chunk of the bonds are in better shape to absorb losses today than they were last year. Even if Greece’s debts were cut in half, the net loss would still represent an absorbable proportion of most European banks’ capital.
An orderly restructuring would be risky. Doing it now would crystallise losses for banks and taxpayers across Europe. Nor would it, by itself, right Greece. The country’s economy is in deep recession and it is running a primary budget deficit (ie, before interest payments). Even if Greece restructures its debt and embraces the reforms demanded by the EU and IMF, it will need outside support for some years. That is bound to bring more fiscal-policy control from Brussels, turning the euro zone into a more politically integrated club. Even if that need not mean a superstate with its own finance ministry, the EU’s leaders have not started to explain the likely ramifications of all this to voters. But at least Greece and the markets would have a plan with a chance of working.
No matter what fictions they concoct this week, the euro zone’s leaders will sooner or later face a choice between three options: massive transfers to Greece that would infuriate other Europeans; a disorderly default that destabilises markets and threatens the European project; or an orderly debt restructuring. This last option would entail a long period of external support for Greece, greater political union and a debate about the institutions Europe would then need. But it is the best way out for Greece and the euro. That option will not be available for much longer. Europe’s leaders must grab it while they can.
Uma nova pesquisa, divulgada hoje, aponta para que 60 por cento dos alemães consideram que o país tem de ajudar a Grécia a recuperar da crise de dívida soberana em que se encontra, gostando ou não.
A maioria dos alemães, segundo parece, já percebeu.
Uma minoria de gregos, ainda não.
Os bancos ainda muito menos.