So, the Dow and euro are up as the latest debt crisis passes, again.
I wish it were so. We have had a stonking sell-off and I suspect it’s time for a technical bounce, with some evidence beginning to flow through that lower commodities are boosting US purchasing power, and Bernanke likely to offer QE2.5 tomorrow in the form of a sustained Fed balance sheet. Japan too is showing early signs of life. Not that I think these are enough to halt the general downward trend, but they are the anecdotes upon which a market will rally when technicals suggest it should.
However, the latest Greek issue is far from resolved.
Assuming that the Greek government survives the no confidence vote, and the Greek people remain ready to take it for the team once more, then we face serious questions over the functionality of the new bailout structure. First, to Robert Preston of the BBC:
Following last week’s agreement between Angela Merkel and Nicolas Sarkozy that any private-sector contribution to Greece’s rescue would be voluntary, not a compulsory roll-over of credit or formal write-down of the 340bn euros owed by the Greek government, there has been understandable interest in what on earth the eurozone has in mind.
These uncertainties came to a head late on Sunday night, in a conference call between the leaders of the G7 developed economies – whose main point was to brief the US and the Canadians about attempts to stabilise and quarantine the Greek financial problem.
Because US banks have the second biggest exposure of any country’s banks to the Greek economy (see my note “Eurozone woes are US woes“), Tim Geithner, the US Treasury secretary, was particularly interested in learning what France and Germany mean by “voluntary” contributions.
The response he received, according to a well-placed source, was profoundly unenlightening, I am told. “It is all incredibly vague and formless” said a source. “Goodness only knows how they will get a serious and credible proposal together by the deadline they’ve set themselves of July”.
The idea seems simple enough. As and when Greek government bonds owned by banks, pension funds, hedge funds, insurers and (presumably) the European Central Bank, among other things, mature and come up for repayment, those banks, pension funds and so on would choose to lend the repaid debt back to Greece – thus reducing the amount of money that eurozone governments and the International Monetary Fund would have to lend to Greece to prevent it reneging on its debts.
The hope would be that, in this way, additional loans from eurozone taxpayers to Greece could be reduced by (perhaps) 30bn euros.
Which is a brilliant wheeze, modelled on the so-called Vienna agreement with banks which kept the economies of eastern Europe afloat in 2008. Except for one thing: the relevant eastern European economies back then were not nearly as indebted as Greece is today.
They had a relatively short term liquidity or cash-flow problem. Greece’s woes are much more fundamental.
The point is that eastern European banks and governments had become too reliant on wholesale finance that dried up in the credit crunch. But they were not conspicuously insolvent. Which meant that international banks could roll over credit to them and be reasonably confident they would get their money back.
The FT pointedly describes this as:
One game of chicken is over in the eurozone but another is just beginning.
The first ended with Germany backing down over its demands on how private creditors should be involved in a new Greek bail-out, handing a victory of sorts to the European Central Bank and France.
But the latter duo’s preference for a so-called voluntary rollover of Greek debt means a new game of chicken will take place between bondholders and authorities.
A rollover would see investors encouraged not to cash out when their bonds mature but to buy new, longer maturing bonds.
Investors and strategists say that the outcome of this game is less likely to go the way of the European authorities.
They expect that only the banks – which are estimated to own about a quarter of Greek sovereign debt – will agree to a rollover.
“I can’t see why anybody would want to roll over a Greek bond if they had a choice,” says Gary Jenkins, head of fixed income at Evolution Securities. “I can’t see private investment funds being willing to do this. It would only be French, German and Greek banks who might do so as they would be leant on.”
He uses the example of five-year bonds maturing at the end of August to show how it makes no commercial sense to agree to a rollover.Such a five-year bond, maturing on August 20, pays a coupon of 3.9 per cent yet current secondary market prices show five-year Greek bonds trading at a yield of 19.96 per cent.
In other words, unless investors are offered new bonds at a coupon of a similar level to current yields close to 20 per cent, it makes little commercial sense to reinvest into Greek debt.
The FT goes on to describe that the only holders of Greek debt that will participate are the banks that are under pressure from regulatory reform. In short, they’ll be coerced. Which raises the stickiest of questions: what will ratings agencies see voluntary haircuts as? Fitch clarified that point nicely yesterday, according to Reuters:
Fitch Ratings said on Tuesday that it would regard a voluntary rollover of Greece’s sovereign bond maturities as a default and would cut the credit rating appropriately, keeping pressure on Athens ahead of a confidence vote in parliament.
The definitive comments weighed on the euro and underscored how much is at stake for Greece, which is struggling to implement a deeply unpopular fiscal austerity plan necessary to win the next tranche of emergency aid from the European Union and International Monetary Fund.
Fractious euro zone finance ministers are trying to patch together a second aid package for Greece, with more official loans and, for the first time, some sort of contribution by private investors who hold Greek government bonds.
“Fitch would regard such a debt exchange or voluntary debt rollover as a default event and would lead to the assignment of a default rating to Greece,” Andrew Colquhoun, head of Asia-Pacific sovereign ratings with Fitch, said at a conference in Singapore.
A month ago Fitch downgraded Greece’s credit rating three notches to “B+” and warned it could cut the rating further into junk territory. At the time, the rating agency said an extension of the maturity of existing bonds would be considered a default.
So, if default it is, we can refer to Martin Wolf, who argues today it’s preferable:
What is the case for persisting with lending ever more and, in the process, taking a larger proportion of the liabilities of the Greek government on to public sector balance sheets? I see four arguments.
The first is that the strategy conceals the state of private lenders. It is far less embarrassing to state that one is helping Greece when one is in fact helping one’s own banks. If private lenders have enough time, they can sell their loans to the public sector or write them off without capital infusions from states.
The second argument is that the strategy of delay allows other countries to get their houses in order before a Greek default and perhaps a disorderly exit from the euro. Should those events occur now, it is feared, there will be runs from sovereign debt and the banks in fragile countries, with devastating results.
The third argument is that it is possible that Greece will come good. Giving the country the maximum support makes that at least feasible.
The fourth argument is that Greece is forecast to run a primary fiscal deficit (before interest payments) of 0.9 per cent of GDP this year, by the IMF. Thus, the net transfer of resources is into the Greek public sector. So long as this is the case a default makes no sense.
These arguments are persuasive roughly in ascending order. The first argument was used to justify the policies of denial that gave Latin America its “lost decade” in the 1980s. It seemed immoral then and seems equally immoral now. Losses should be recognised and banks recapitalised. The second argument assumes that the Greek position is still a mystery. It is clear, however, that flight is already under way from other fragile jurisdictions. The third argument is not ridiculous, but such a happy outcome seems implausible, given the situation in which Greece finds itself. The last argument is right. But it is one for a brief delay, not for struggling forever.
When an outcome is inevitable, it is necessary to plan for it. In this case, that outcome seems to most informed observers inevitable. I can see little merit in having Greece default to the public sector years of agony hence rather than to the private sector soon. The best policy is to act pre-emptively. One aspect of such pre-emption would consist of acting to shore up other fragile eurozone members and financial systems more strongly than now. In at least one case, Ireland, that might require debt restructuring. This will also surely require a further move toward a eurozone-wide financial system, with matching fiscal support.
Do you see any of that planning happening? Neither do I. As Euroskeptic Nigel Farage describes today, such preparations for integration generally come at the point of a gun, even in states that share common language and culture.
Don’t get me wrong, the European commitment to the euro is very strong in my view. Eureopeans have yearned for the power of a reserve currency for a long time and won’t give it up. Which leaves two paths ahead: unexpected default at some point with crisis integration or more generous bailout terms, and more wrangling all around.
With slowing world growth and the removal of stimulus proceeding, we’re still in a “sell the rallies” phase of the cycle.
