After a period of relative quiet – at least compared with last year’s drawn-out saga – Greece has found itself firmly back in the spotlight in recent weeks. European policymakers were hoping that, following the €110bn bailout package in May 2010, and the subsequent easing of the funding terms more recently, financial markets might give Greece time to get back on its feet. The Hellenic Government is busy pushing through drastic tax rises, privatisations and spending cuts to curb the deficit. The quarterly reporting cycle that was set up when the bailout was agreed – whereby Greece has to submit to inspection and review by a team from the IMF, ECB and European Commission every three months – was supposed to reassure investors that everything was on track (or act as a first shot across the bows, should the Greek Government drag its heels). All three reviews so far (another is due shortly) have indicated that the deficit reduction programme remains broadly on track, while noting major challenges that still need to be tackled.

Unfortunately, what breathing space Greece did have is now running out fast. The crisis spreading to Ireland and Portugal clearly did not help. And, with Greece no longer reliant on financial markets, secondary markets in Hellenic debt have been far more volatile than usual. But the simple fact remains that financial markets have not swallowed the line that has been pedalled by the European Commission that Greece is on track. Spreads on Greek debt continued to rise following the May bailout last year, and currently 10Y paper is trading more than 12% above German debt.

This presents a fairly major problem for policymakers, which is why markets are hoping for a strong policy announcement in the next week, or failing that by June. Up until now, European politicians have been at pains to emphasise that, even if a euro member is really in serious trouble, there is no way they will let a country default before 2013. That is when the new permanent funding mechanism (the European Stability Mechanism, or ESM) will take over from the temporary structure (the Financial Stability Fund, or FSF) that was thrown up in haste last year, after Greece’s bailout. The €750bn that the FSF can potentially call upon, with the IMF’s help, should be enough to see Europe through the next two years, even if Spain gets into trouble.

Interestingly, one point that some people miss is that the FSF is distinct from the Greek bailout package – the two are separate entities. In fact, on the FSF website the FAQ section states that ‘Greece has its own rescue package. Therefore it is not envisaged that Greece needs support by the (E)FSF’. In practice, however, this may soon have to change.

The problem is that the original Greek package was never actually designed to get Greece all the way to 2013. The financial support programme explicitly states that the Greek Government needs to start issuing long-term debt again during the first quarter of 2012. Over €30bn of Greece’s funding requirement from then until the end of 2013 Q1 is supposed to be met by Greece returning to financial markets.

With Greek 10Y yields currently hovering at around 15%, that looks highly optimistic to say the least. The idea that Greece will be able to start issuing bonds again in around seven or eight months, and will be able to live with the interest rates that the market demands, is laughable. Investors and probably even (some) politicians know this – which is why market chatter and informal reports from policymakers have cranked up several notches in recent weeks.

What will the end result be? Europeans can choose to support Greece to 2013, if they so choose – the FSF could cope with that. But there is a sense that such a move may only postpone the inevitable. With full fiscal union still firmly off the table, an eventual default now seems the only way out of this mess. (Greece leaving the euro, however, is still very unlikely.) Europeans are terrified that such a default would be their equivalent of Lehman Brothers – and if a disorderly default did ensue, the damage could be spectacular. But postponing or ignoring the problem is plain silly; it is not going to go away. Policymakers need to think seriously about how to manage an orderly restructuring of Greece’s debt mountain (a polite default). And they need to do it now.

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