Europe Needs to Shock and Awe, but...

Various news wires are reporting leaks of the IMF/EU/ECB review of Greece. Apparently they are concluding that the implementation of the conditions for last year's aid package have ground to a halt.

They are also concluding that the Greece economy is weaker than they had previously thought. Earlier they had assumed Greece would contract 3.5% this year and now 3.8%. Next year's growth was also revised down to 0.6%, roughly half of what they had previously forecast. Weaker growth of course has a knock-on the fiscal situation.

The media leaks suggest that the Troika projects Greece's financing needs to be about 170 bln euros 2012-2014 (inclusive). Where is this going come from ? Here is where there are conflicting reports and numbers. There will be almost 60 bln from the first package that will be rolled up into Greece Aid 2.0. Officials seem to be counting on about 30 bln euros from asset sales during this period. Many private estimates claim this is too high. On the other hand, when Schauble talks about a significant role for the private sector, the purchase state assets, should be included.

Officials also seem to be assuming/hoping that the voluntary extension of maturities are worth 30 bln euros. This is also a bit tricky as the recent comments by the rating agencies have suggested. Assuming it is do-able without triggering a credit event, who would be the likely participants? Trichet should have been asked if the ECB would be one of them. The ECB is among the single largest holders of Greek bonds. The ECB had indicated in the past that it would hold those bonds it purchased until maturity. Greek pension funds are also likely candidates to extend maturities and some Greek banks, especially with the Greek bonds in the "hold to maturity" bucket may also participate.

Assuming that these components are more or less achieved, it still leaves about 55-60 bln euros in new loans from the IMF/EU/EFSF. Given the odorous nature of aid and another aid package at that, as well as moral hazard issues, it is understandable why the European officials will not want to do more than is necessary.

Yet this could be a strategic mistake. They need to leave no doubt in the market's mind that Greece will have the funds available to keep its creditors whole, through at least 2014. Some flexibility needs to be built in. If the privatization proceeds fall short or the roll-overs are too close to "distressed exchanges", is there going to be an appetite for a third package.

The other important point is that what happens to Greece is understood as the possible (likely?) course for Ireland and Portugal. A credit event in Greece would increase the risks of a credit event in the other periphery. Many of the arguments claiming the euro zone would be better off if Greece were to drop out, do not fully appreciate the contagion. If Greece were to leave the union, the risk premium on the remainder would go up not fall and there still would be the risks of a systemic financial crisis in Europe.