Angela Merkel Talks Tough At Davos, But Germany May Have No Option But To Pay

Germany Preaches Moral Hazard To Greece, But May Have To Pay Anyway

European leaders have gathered in Davos for the World Economic Forum, and have been talking tough on Greece, as the country's attempts to fix its broken economy appear to be failing, and as international institutions and investors intensify calls for more money to be poured into the eurozone's bailout funds.

On Thursday, the tone was stern and clear - no more pouring good money after bad.

However, the moral hazard argument that there is a point where Greece - which has slipped consistently in its attempts to reform its economy, cut its deficit and find ways to generate growth - should just be cut loose 'pour encourager les autres' has been demonstrably undermined by the panic that spread across the eurozone and led to governments being replaced in Spain, Portugal, Ireland and Italy.

The effects of the eurozone's intractable debt problem could yet claim France's president, Nicolas Sarkozy, when his country goes to the polls in the spring.

Despite the hard talk, the fortunes of the eurozone countries are yoked together,

It is Angela Merkel, however, who is in the driving seat, and there were few better candidates for the keynote slot in Davos. The German rhetoric has hardened over the past few months, to the extent that Merkel has shed her reticence in warning that Greece may fail and the eurozone may lose a member.

She has also insisted that her country will not, despite pressure from international organisations and other governments, increase its contribution to stabilisation funds or participate in any bridging loan to tide the country over should it look likely to miss one of its many repayment deadlines.

Many in the market are still holding out hope that the bitter experience of last autumn, when political paralysis, then a call by the then-Greek prime minister George Papandreou to put a vital austerity package to a referendum, saw markets wake up to the real risk of contagion. Bond yields in Spain and Italy soared. The Berlusconi government fell.

Germany needs to make a difficult calculation - rescue Greece, and offer a precedent that allows other countries leeway to ask for similar concessions, or let the country fail for the sake of principles and domestic political support.

"If you look at it in isolation, a loan to Greece where maybe they haven't followed through [with commitments], you wouldn't do the loan," Alan Higgins, chief investment officer at Coutts, told the Huffington Post UK.

"But when you're well-advised and you look at the broader picture, and the contagion, and the potential impact on French banks and the potential impact on German banks, which are exposed, as well as the global economy, then you take a different perspective."

Angela Merkel is well-advised, he added.

At Baring Asset Management, head of fixed income and currency Alan Wilde agreed. “I think Germany is prepared to play hard-ball with Greece, but the longer term solution to issue EU bonds and have more fiscal and political integration may necessitate capitulation by Germany on some current 'sacred cows'," he told the Huffington Post UK.

While the stage at Davos gave a platform for world leaders' pronouncements on the long-term vision of the eurozone and the European Union, more private - possibly more critical - talks resumed in Athens.

Charles Dallara, the managing director of the Institute of International Finance (IIF), which is representing private sector holders of Greek debt, was due to meet Greece's prime minister, Lucas Papademos, on Thursday evening.

Talks between the two parties have stalled repeatedly over the details of a debt-swap deal, which would see creditors take a "haircut" of up to 70% of the value of their bonds, taking instead longer-dated paper with a higher "coupon", or interest payment.

An initial - hard won - agreement between Greece and the IIF was batted back by European finance ministers, who have made a successful conclusion to the "Private Sector Involvement" (PSI) a condition of the release of a second bailout for the struggling country. The EU wants the coupon reduced to a level that will not too dramatically undermine Greece's efforts to reduce its debt from 160% of its gross domestic product (GDP) to 120% over the next decade.

Without that bailout, Greece will most likely default. The country has around €14.5bn of bonds maturing on March 20, and has no way of paying it back. It has no access to capital markets to roll over the debt. If the PSI cannot be agreed in time, Germany will have to make that difficult calculation - stick or twist.

Already speculation has begun to take hold that Portugal may take the example of Greece and try to negotiate a restructuring of its debt - despite assurances from the French government at the end of December's meeting of the EU that there would be no more haircuts, and that Greece would be a one-off. That promise will be tested by the PSI.

Germany's resistance to another potential solution - the ECB's printing presses - might also have to be relaxed, although, as Higgins noted, the central bank has managed to drive a considerable improvement in sentiment and liquidity through a programme of three-year loans introduced in December last year.

"This is very, very cheap funding and we had a very large take up. It's stabilised the system," Higgins said. "To give credit to Draghi, this appears to be his masterstroke."

Higgins, like the majority of analysts, believes that the PSI will ultimately be agreed. However, that merely resolves the immediate threat of default. Between that and the grand vision of European integration that Merkel spoke of in Davos, there is a long and difficult medium term, fraught with hazards and "event risks."

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