After weeks of disorderly discussions among EU members on what to do with Greece, Germany appears to have made its position clear in a letter from its Finance Minister to other EU members.

About ten days ago it appeared as if the ECB and other EU members had convinced Germany to back off from its push to get ‘burden sharing’ in Greek debt. Ideas like reprofiling or rescheduling were mentioned. Any change in contracted cash flows that leads to a reduction in the net present value (NPV) of debt is a debt restructuring, regardless of its label. Call it reprofiling, call it rescheduling, or call it a tomato, it is debt restructuring. It can be a pre-emptive restructuring that avoids default (à la Uruguay 2003), or it can be an exchange of defaulted debt for new performing debt (à la Argentina 2005). In sum, two weekends ago it appeared as if the dislocated family of European politicians had convinced its richest member to back off from its tough stance.

The letter from Mr. Schäuble appears to say the opposite. Germany seems to demand a 7-year maturity extension in exchange for more financial assistance for Greece. This looks a lot like the Uruguayan exercise of 2003, except that it is not as well coordinated and not as well structured. In 2003, the IMF made the credible threat that no debt relief would lead to the interruption of the IMF program. So debt holders participated in what was a negative NPV voluntary exchange. The success of the transaction meant Uruguay kept its IMF program and now had a better debt profile, so prices soared and debt holders were better off. So the IMF credible threat worked perfectly to coordinate a voluntary exchange that left everybody better off.

If the EU and the IMF agreed to try an Uruguay 2003 on Greece, it would most likely work. Success requires two market events: a very high level of participation in the exchange, and the yield of debt post restructuring to collapse. The latter would happen if the debt relief is large enough and the EU support triggered is also significant. The only difference with Uruguay would be the accompanying adjustment of the currency. Uruguay was a dollarized economy to a large extent, though it still had its own, which depreciated from less than UYU 15/USD at the start of 2002 to a 2003 average of about UYU 28/USD (large depreciation of UYU, which helped in the adjustment process).

The ECB rejects the plan, apparently afraid of the potential contagion. Holders of Portuguese, Irish or even Spanish debt could infer that an Uruguay 2003 can be played on them. The reason to postpone dealing with Greece is to allow the others to differentiate enough in order to minimize the contagion risk. Bond yields tell us that Spain is perceived to be different (yielding 4.6% in the 5-year tenor), while Portugal and Ireland in the 11-12% area are neither here nor there. A Greek event could push them down, and that is a gamble the German government seems willing to take, and the ECB is not[1]. Keep in mind the ECB gets a new President in September, and everything points to the Italian Draghi. Also important is the fact that the ECB is now a large holder of periphery bonds.

Whether the German approach is an effort to scare the Greek and push them to do more faster, or it can be implemented soon, it is yet unclear. If we get to an interruption of the IMF agreement only because politicians could not agree on what to do, the euro could suffer and we should expect more volality. So, in principle there are two scenarios: one where politicians and the IMF and the ECB coordinate a solution (regardless of which one it is), and one where lack of coordination leads to defaults or restructurings that are poorly planned or not planned at all. In reality there is a third scenario, in which the EU continues to postpone the inevitable, which is still a very likely one, though the IMF rules will have to be dealt with.  Though we should learn something over the next few weeks, this could be a long saga. We stay away from the euro.

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[1] The market does clearly not believe Greece makes it unscathed (yields 26% in 1-year and 17% in 5-years).