Hamish McRae: Greeks are right to worry as loan default would hit home banks hardest of all

Economic Life: 'Debt forgiveness', widely recognised as part of the solution to a sovereign debt crisis, has not been applied to a developed country for half a century
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The Independent Online

The eurozone sovereign debt crisis has reached one of those points where opinions – be they of the various national leaders, of the European Central Bank and the International Monetary Fund, or of the European Commission, no longer matter very much. The mathematics are taking over.

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In a curious way the rioters in the streets in Athens have a greater grip on the maths than do the politicians and the bankers. They can see that the country cannot repay its debts. Ultimately the ability of any national government to service its debts is the willingness of the citizens to pay the taxes to do so. If that burden is seen as too large, default becomes inevitable.

It looks as though we have reached that stage. That does not mean that the country will declare a default over the weekend, though that is not absolutely out of the question. Nor does it mean that Greece will pull out of the euro in the near future. What it means is that not only has the first rescue of a year ago failed but the current rescue that the authorities are trying to stitch together will also fail. This is a situation that many developing countries have found themselves in over the past few decades. The expression "debt forgiveness" is widely recognised as part of the solution to a sovereign debt crisis; it is just that this has not been applied to a developed country for half a century.

We cannot see the detail of what will happen, nor indeed the timing, and certainly not the full consequences. Nevertheless there are some things that can sensibly be said. The first is that some of the lenders, maybe most, will lose money. So where are these debts?

The capital markets group of Royal Bank of Canada has just produced some estimates of where Greek sovereign debt is held, together with some estimates for the situation in Ireland and Portugal. The graphs summarise this. As you can see, the commercial banks hold 27 per cent of the debt, and the European Union, IMF, and European Central Bank between them another 30 per cent, leaving some 43 per cent held elsewhere by other investors such as fund managers, central banks and sovereign wealth funds. The total is the thick end of €350bn.

There has been a lot of talk about the blow to European banks were the country to default but, as you can see from the bar chart, though German and French banks do hold a fair slug, it is the domestic banks that would be worst hit. So a default would destabilise the country's own banking system, quite aside from all the damage it would do elsewhere. The official support, at 30 per cent of the total, has been rising fast but is "only" 30 per cent. Most of the burden of default would be carried elsewhere. Obviously if loans from some investors are protected – the ECB, for example – then other lenders will have to suffer more.

Since we cannot hope to see the detail of what will happen I don't think there is a lot of point in trying to calculate how much, for example, the British taxpayer is likely to be down the slot, except perhaps to note that the German taxpayer will be down a lot more. But it is worth observing that the Greek people will be first in line to suffer, both from any write-down of their savings and from the general disruption to the economy.

The next set of imponderables will be the knock-on impact on the other weak eurozone members, first on Ireland and Portugal but also on Spain. Ireland is interesting because it has a new government, which is seeking to renegotiate the terms under which the previous government got its bailout. The numbers are smaller, about one third of Greece's debts, at €113 billion, but they are spread in broadly similar proportions. Having failed to get much out of the European establishment, it is now seeking to change the terms of the bondholders in Anglo Irish Bank and the Irish Nationwide Building Society, reversing the policy of the previous government. (I should quickly say that the Irish Nationwide has no connection with the British Nationwide.)

This is interesting on several levels. One is the simple point that it elevates the political risk that in a democracy the decision of one government might be overthrown by its successor. That is something that does not normally enter into investors' calculations. Another is the practical point that the money in question is relatively small, equivalent to only 2 per cent of GDP, but were Ireland to change the rules it would probably increase the cost of funding for the country's other banks and perhaps eurozone banks in general. Against this, as a note from Barclays points out, if making some bondholders suffer bought political support for the austerity package as a whole, that might increase the chance of the country's fiscal strategy succeeding. So you can argue the wisdom of this proposal either way.

Stand back a moment. What is happening here in the eurozone is a revision of assessments of risk. There are risks in every kind of investment; there always have been and there always will be. The risk of lending to the British Government, or indeed the US one, is not that they won't repay the debt but rather that they will debase the currency by permitting inflation to whittle away its real value. When the eurozone was created it took away that risk, or so it was perceived, for the member states. Investors did not appreciate they were swapping one risk for another. So debt was mispriced.

That reassessment of risk has not yet settled down. There is no consensus. Unfortunately the pessimists have been proved right repeatedly and the optimists consistently wrong. Governments have been proved wrong pretty consistently too. I keep on my phone a text from the Irish authorities that the country was not seeking support from the EU and was fully funded to the middle of this year, dated only last November.

This situation will not continue for ever. There always has to be a resolution. At some stage the weak European countries will re-establish their ability to borrow, paying whatever rates satisfy lenders that there is an adequate reward for the risks they are shouldering. But we are along way from that. It could be several years before Greece is again able to borrow on the markets at an acceptable rate. Meanwhile it will be dependent on transfers from the rest of the eurozone. But money comes with terms and those terms may be unacceptable to the Greek people.

The main worry must be that risk-aversion will intensify and spread. The position of Portugal and Ireland has been made more precarious; Spain may find it increasingly hard to finance itself on the markets at an acceptable rate. The brutal truth is that governments have to pay their bills. If they cannot raise the taxes to pay those bills they have to borrow to cover the gap. And if they cannot borrow? Then they cannot pay their bills. As I say, we are not through this one yet.