Developments in European sovereign debt markets have taken a significant turn recently, and the risk that the crisis could affect financial markets has increased.

Greece’s financial condition has deteriorated.
Greece’s finances have fallen further and further off track, and recently it has become increasingly recognized that Greece will need more funding from the rest of Europe and the International Monetary Fund (IMF). However, there are questions about the terms for new funding: How much, what the Greeks will have to do to “earn” it, and whether the private sector will be asked to contribute in some way.

While a debt restructuring had always been a distinct possibility, the European Central Bank (ECB) and many European governments have sought to delay this outcome in order to give Ireland and Portugal more time to demonstrate that they remain solvent.

During May, there was a fairly open clash between the ECB — which wants no restructuring, ever, and nothing that even appears to be restructuring — and some European politicians, who believe the private sector must contribute to a solution by accepting some type of restructuring.

Germany’s position has hardened.
In early June, a letter from German Finance Minister Wolfgang Schäuble to his peers in the eurozone indicated that Germany will extend new financial aid for Greece only on terms that would likely cause a destabilizing event in financial markets.

The letter expresses that German politics simply will not allow for more German taxpayers’ money to be sent to Greece without the private sector making some kind of contribution as well. This occurs in a context of high political tensions not only in Germany, but also in Finland, Greece, Italy, and Spain, as economies stagnate and governments cut spending.

There is now a rising risk that German money will only be forthcoming in an aid package on terms that could trigger a credit default swap (CDS) on Greek debt and/or a large ratings downgrade for the countries on the eurozone periphery. A CDS protects investors from default triggered by a “credit event.” The decision about what constitutes a “credit event” remains unclear — it is not the same as the decision the ratings agencies make about a default. However, Standard & Poor’s on Monday, June 13, downgraded Greek sovereign debt to CCC, the lowest of any sovereign rating in the world.

The broader risk is that a market event will produce large-scale selling of debt — issued by nations on the periphery of the eurozone into a market in which there are no natural buyers.

Reaching a compromise has become more difficult.
Europeans have certainly been working to try to pull off some sort of compromise that would ease pressure on Greece without causing big problems for the markets. However, while still possible, a compromise has become more difficult to achieve.

One idea is a “voluntary” maturity extension on Greek debt. However, the ratings agencies have been surprisingly hawkish on this idea, and appear ready to define such a compromise as a default.

Crafting a deal that provides enough financing for Greece, satisfies the ratings agencies, and keeps Germany’s politicians happy, while not provoking the private holders of the debt issued by Europe’s peripheral nations to sell their investments (in order to avoid a similar maturity extension on their investments), would be a tall order.

The discussions deserve careful monitoring.
One reason for concern about the outcome is that the ECB has authority only over monetary policy, and its views are compromised because it has become a large holder of sovereign debt of Europe’s peripheral countries. In democracies, the people’s representatives are the superior authority, and even the ECB has stressed that the solution to the crisis lies with fiscal authorities.

For the ECB’s views to prevail, the German finance minister would need to concede. However, he has little ground to give. German politicians are fed up with unlimited and virtually unconditional transfers to countries such as Greece. They are expecting “burden sharing.” Note that this is occurring while the German economy is doing exceptionally well — German generosity is not being restrained by economic weakness.

We are likely to see continuing back-and-forth discussions between the nations of the eurozone, the ECB, and the IMF. At this stage, a compromise cannot be ruled out. However, a mistake by policymakers is also possible. Developments in recent days, and the political realities that they reflect, have increased the risk that Europe’s sovereign debt crisis will cause instability in financial markets.