EU Summit: Next Leg of the Greek Tragedy

Includes: DBC, ERO, EU, EWG, EWQ, FXE, UUP
by: True North

There is bound to be a lot of buzz about the EU spring summit (Mar 25th and 26th) since markets will try and decipher EU's stance on Greece and the latter's reaction to any new developments (or lack of) . It’s very important for any investor to keep track of these developments as the outcome will dramatically affect the Euro, dollar and consequently commodities. The Euro was down more than 1.3% Wednesday, I am guessing preparing for the uncertainty around the summit and on John Taylor's (CEO of FX concepts, the largest currency hedge fund) comment about the Euro heading to 1.2 against the Dollar sometime before the year's end (Link here).

So what’s this EU summit about:

Officially, it’s just a regular EU summit (as described here):

Employment, the economy and climate change are the main subjects on the agenda of the meeting of the European Council, chaired by Herman Van Rompuy, in Brussels on 25 and 26 March.

But this EU summit has garnered tremendous attention due to the recent statements by different EU leaders. So here we move to the players (the different leaders) who have spiced things up recently.

The players:

Greek PM: Mr. Papandreou is keen for the EU to announce more details of a potential aid package and is pushing EU members to use this summit as an opportunity to do so. Mind you, he is not asking for financial aid yet. He just wants the EU to spell out more details of a contingency plan and the aim of such a move is to pacify the markets before the next Greek bond auction comes due (explained below in detail).

In his own words as mentioned in this AFP article:

We are not asking for money from Germans, French, the Italians or other workers or taxpayers. What we are saying is we need strong political support in order to make these necessary reforms and make sure that we are not going to pay more than necessary in order to get these reforms enacted.

After announcing the second round of austerity measures, detailed here in the NY Time’s article, the Greek PM said: “We are now justifiably expecting E.U. solidarity, which is the other side of this agreement, Europe faces a historic responsibility.”

And he has also been talking in the press lately about going to the IMF if the EU fails to announce further details about potential aid, as he believes that these two sets of austerity measures qualify Greece for IMF aid. So at the moment, according to the PM, they are paying the price for belt tightening without any benefits coming out of such severe spending cuts.

The French and the Germans:

Germany’s Merkel has recently changed her stance and now favors a leading role for the IMF in any potential aid package for Greece possibly because of the threat of severe backlash by Germans in case they have to bailout the Greeks. The French haven’t yet acquiesced but are warming up to the idea.

The Greek tragedy:

Greece needs to refinance almost €16bn (about $21bn) worth of debt maturing between Apr 20th and the end of May. The Greek yields (and accordingly their risk) has shot up recently with their 10 year yields trading almost 300 bps (100 bps = 1%) over equivalent German Bunds. As shown in the chart below for 2H2010, Greeks yields were 100 to 200 bps above Bunds but since the beginning of 2010 they have shot up and are now 300bps above Bunds.

According to market estimates the Greeks are willing to pay 50bps above Ireland and at max 200 bps above the German Bunds. Hence, with the German Bunds 10 year yield at 3% in the market the Greeks are fine with 5-5.25% 10 year rates, but the market now prices their 10 year risk at 6.25% (almost 100bps more than what the Greeks want).

The IMF option:

Since Greece has already taken harsh measures to tighten its belt (at least in theory) it qualifies for IMF aid, which comes much cheaper. The IMF has this facility called the extended fund facility (EFF) according to which the IMF can offer credit lines to up to 10-12 times the country’s quota in the IMF.

Details about EFF: Here

Guidelines for using the funds: Here

Obviously, the IMF adds a surcharge for these additional credit lines and presently the numbers look like this:

§ For the first tranche the country pays the basic rate of about 1.25%

§ For credits above 200% of the quota there is a 100 bps surcharge

§ For credits above 300% of the quota there is a 200 bps surcharge

Hence, based on Greece’s quota they might be able to borrow close to €10n from the IMF at about 3.25% (including the surcharge) which is a lot cheaper than the prevailing 6.3% yield the market assigns to the 10 year Geek bonds. Hence all the fuss by the Greek PM about the EU stepping up to comfort the market and get the Greek yields down.

I think Greece going to the IMF is a strong possibility at this moment (I would love to hear counter arguments) since:

§ The markets are still concerned about sovereign debt issues

§ The Germans and the French are warming up to the IMF aid idea

§ IMF aid is a lot cheaper than the market rates for Greece

And think about it, finding unity in a young union with a welcome page that lists options in 23 languages is definitely going to be a very tough act of Spartan proportions.

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