Immovable force, near unfixable debt

As Greek debt negotiations stall over the question of a writedown, the country's overnight bond auction underscores just how fragile the situation is.

European markets are rattled. European Finance Ministers have buckled and extended Greece’s budget deficit reduction plan by two years, while there is a conflict brewing between the European Union and the IMF of what to do about Greece’s public debt.

At the same time, there are growing concerns that Germany will dip into recession or something close to it as it is weighed down by the chronic weakness in its export markets and a loss of confidence as the eurozone sovereign debt problems roll on.

European Union finance ministers, the IMF and the European Commission are engaged in negotiations about the future of Greece and its almost unfixable debt problems.

The negotiations are not running smoothly. While the IMF was against extending the date for Greece to reach its target of reducing government debt to 120 per cent of GDP from 2020, EU finance ministers, driven by Germany, recognised the near impossibility of meeting that target and suggested a two-year extension to 2022.

The difference of opinion centres on whether there should be a partial debt write-off for those holding Greek bonds.

The head of the IMF, Christine Lagarde, flagged to possibility of a debt writedown, saying "all avenues in order to reduce debt on Greece are being explored and will continue to be explored in the coming days."

In an obvious case of naked self-interest, the Germans are against Greek bond holders taking any haircuts on their portfolio. This is not because a partial debt writedown is an inherently bad idea – it has merit – but rather because German institutions are the biggest holders of Greek government bonds.

If the IMF scenario of bond holders being paid something less than face value for their Greek bonds as a means of reducing Greece’s debt were to pass, a 20 per cent writedown, for example, would cut public debt from current levels of around 190 per cent of GDP to 155 per cent with the stroke of a pen. It would also leave the 2020 target of getting debt down to 120 per cent of GDP by 2020 on track.

With the German economy stalling and elections scheduled for September 2013, it is clear why German Finance Minister Wolfgang Schaeuble, in an unusually soft approach, is happy to relax to 2020 timeline for Greek debt reduction, saying it was "a little too ambitious”. He was an advocate of extending the target to 2022. On the issue of some debt forgiveness for Greece, Schaeuble returned to form saying "there's a debate about a haircut for official creditors. On that I will say… that that's legally not possible."

These negotiations are occurring with the Greek government scrambling to meet a €5 billion bond repayment on Friday, November 16. It covered only €4 billion of the €5 billion in a T-Bill auction overnight and will be forced to go back to the market to accept what were uncompetitive bids to raise the additional €1 billion.

This is not a good sign for the next T-Bill of bond auction that Greece will inevitably need. If uncompetitive bids are successful, the motivation of investors to pay too much for Greek debt will be severely dented. It is yet another sign how fragile the whole debt problem in Greece is.

While these debt problems were unfolding, in Germany the well-respected ZEW institute survey of business confidence and activity slumped to an index level of -15.7 in October, well below market expectations which were for of a small improvement to -10. Senior ZEW economist Marcus Kappler noted the concerns of many, suggesting: "Germany cannot decouple from the recessions around it. A likely scenario is that the German economy will do slightly worse than expected, but without turning into negative growth."

The signs of economic weakness from the ZEW survey complement earlier news for Germany that showed sharp falls in exports, factory orders and industrial production. Already reluctant participants in the bailout plans for other eurozone members, a recession or even protracted weakness in Germany would add to the risks of further intransigence in the long path to fixing the fiscal problems of eurozone members.

The signs of optimism that came with the ECB plan of a few months ago that it would "do whatever it takes” to hold the eurozone together, are quickly fading as the magnitude of the problems come back into focus. The latest dramas are focused on Greece. The problems could easily escalate when the focus moves back to the problems of Spain, Italy and Portugal.

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