The direction of the debate on Greece has pitted the International Monetary Fund, European Central Bank and all euro zone members in a vicious game of bailout responsibility hot-potato in the face of fears of debt contagion were Greece to default.
Greece currently has €372B of debt outstanding and EU forecasts put Greek 2011 GDP at 96.5% of 2010 GDP (€222B). At this rate, in 2011 Greece will have debt totaling 167.5% of GDP with a budget deficit of 9.5% of GDP.
As I see it, there are essentially two long-term solutions for Greece:
1. Public international assumption of a large chunk of Greek debt at low a interest rate and/or long term
It has begun to happen now through the bailouts, but this would essentially consist of the cooperation or piecemeal individual action of the IMF, ECB, and other euro zone parties to refinance a significant portion of outstanding Greek debt at low interest rates and/or a long terms to remove rating agency concern over remaining privately held Greek debt and allow Greece access to credit markets. As a condition to this maneuver, further austerity measures, asset sales and trade-barrier removal plans could be pushed through the Greek government.
2. Default/restructuring of all or a significant portion of existing domestically issued debt
This could range from haircuts on loan principal, term extension and/or coupon reduction. The end result would be a reduction in the outstanding amount of debt to a reasonable level. Depending on the market reaction, Greece would likely have to exit the euro to avoid its economy grinding to a halt.
As of now, interested parties of the international/European community have a strong distaste for the possibility of a Greek default/restructuring. Jean-Claude Juncker mentioned that a full bailout for Greece would be determined by the end of June and that a total restructuring had been decided against. Dominque Strauss-Kahn's favored replacement as the head of the IMF, Christine Lagarde, stands opposed to a restructuring. Christian Noyer, the governor of the Bank of France and a member of the ECB, has also been forthcoming about his belief that a Greek restructuring would spell economic disaster for Greece. Noyer's perspective likely centers around the fact that Greek banks hold approximately €50B of Greek debt and may be on the hook for some of the outstanding credit default swaps.
Because gradual bailouts and kicking the can down the road is more politically appetizing in the short-term than an organized restructuring that would likely trigger CDS contracts, my best guess is this will be the direction that is taken.
What a Bailout Would Mean to the Market
In a gradual or sudden bailout, while Greek bondholders would be extremely pleased, investor minds would immediately jump to what will happen with the other countries that comprise the PIIGS. Depending on the size of the bailout for the Greeks, bondholders in other distressed European countries might begin to fret that there would be no appetite for further bailouts.
With a bailout, the political will would have been severely tested by this point in both Greece and other member states of the EU, and the nationalism that would result might further help to tear apart the common currency at some point down the road. If the cost of the Greek bailout ultimately ended up being too high to recreate with other troubled members, there would be talk of favoritism and significant amounts of ill will for those that helped create the rescue package in the first place.
This would result in selling of euro-denominated assets and could potentially register as an inflationary red flag, depending on the amount of additional debt taken on to finance the rescue. Were the United States to at this point have a credible debt and deficit reduction plan, one would assume Treasuries to primarily gain from the outflows ... but if this were not the case, precious metals and other commodities might see inflows. Premiums on other PIIGS debt would likely rise if the rescue package was seen as too high to recreate.
Restructuring: Short-Term Pain, Long-Term Gain
While an orderly restructuring would likely be the best long-term solution for Greece, and could be relatively easily recreated with other PIIGS countries, the short-term disorder and potential to spiral out of control no doubt gives interested parties pause. As of now, with the current discount Greek bonds trade at, a principal haircut to dramatically reduce the total debt Greece has outstanding would be achievable with current bondholders recognizing little in the way of additional losses. This being said, banks carrying Greek bonds would have to book losses which might further destabilize credit markets.
Depending upon the nature of the restructuring, credit markets would likely react negatively to the event, i.e. the spread in interest rates between high-quality and low-quality debt would increase. This would likely register as a positive for Treasuries, and in the short-term a negative for riskier assets like equities.
Although the euro would likely take a greater dive in the short-term with a restructuring compared to a bailout, over time one would imagine the euro to do better under a restructuring vs. a bailout due to the limited ill will that would have been fostered between bailout recipients and those financing them. That being said, Greece and subsequent PIIGS members might have to exit the euro to allow their workforce and industry to regain competitiveness and prevent economic collapse.
Due to the likelihood of a bailout over a restructuring as the long-term solution, this would appear to be a better environment for Greek bondholders than other PIIGS bondholders. Much like how Bear Stearns got better treatment than Lehman Brothers, so will likely be the case with subsequent euro zone trouble spots after Greece.
Regardless of the outcome, as long as the United States achieves a somewhat legitimate path to a balanced budget and reduced debt overhang, future bailouts of troubled euro zone members will serve to bolster Treasuries and the dollar. In terms of the euro, I will be much more concerned about its long-term viability if the path that actually gets chosen is bailouts.