I had made the big mistake to think that EU-authorities would be aware of the distinction between sovereign debt risk and country risk. Sovereign debt of Greece represents the obligations of the Greek state; no more and no less. But what happens with a sovereign country is that the moment the sovereign debt hits a crisis, the entire country hits a crisis, whether that is objectively justified or not. When Greek bonds are down-graded, all other foreign debt of Greek borrowers (particularly the foreign debt of the banking sector) is down-graded at the same time. Once there is a run on a country’s bonds, there is the same run on the country banks (sometimes the run on the banks starts before the run on the bonds). The chances of ever stopping such a run against a sovereign country are very slim (ask George Soros about the UK).
This is not so in a federal state of to US. If the State of California would find itself, once again, unable to pay all of its bills, it would not necessarily affect the Wells Fargo Bank, one of California’s largest banks. Why? Because depositors of Wells Fargo would not have to fear that the State of California could convert their deposits to a new currency and if the Wells Fargo Bank had no exposure to the State of California, markets would not see its risk affected by the state’s near-bankruptcy. So, in extreme terms, Wells Fargo might continue to be rated AAA whereas the State of California defaults.
Here is what happens in a bank when the sovereign debt of a country like Greece becomes troublesome.
The responsible board committee requests, optimally by yesterday, a report on the ENTIRE exposure to Greece, i. e. loans to the government, the public sector companies, the banks, the private sector companies, etc. If the sovereign debt of Greece is down-graded to junk status, all other debt will be down-graded as well. And when debt is down-graded to junk status, every bank in the world will immediately try to get its money back while it still can. The strategy becomes: be the first one out the door! Or, grab the cookie jar while you still can!
Moral of the story
Had the EU-authorities understood that, they would have had to ringfence the entire foreign debt of Greece and not just the sovereign debt of the state. Above all, they would have had to make sure that private banks would not cancel their loans to the Greek banking sector.
The final question
If EU-authorities did not know that, why would they not have asked those who knew?
PS: previous posts in this series: P1, P2, P3, P4, P5.