Latest EU / IMF Rescue Plan Doomed by a Fatal Flaw

Includes: EWG, EWI, EWP, FXE, IGOV
by: Cliff Wachtel

On Sunday May 2nd the EU announced an expanded rescue plan for Greece after the prior 45 billion plan proved too little too late and caused borrowing costs to spiral for other troubled EU economies, which in turn threatened to set off a wave of EU sovereign defaults and a new financial crisis.

Doomed By Its Fatal Flaw; No Plan B For The Rest Of The PIIGS

Motivation behind the latest expanded rescue plan was to prove that the EU can prevent member defaults, thus lowering PIIGS nations' borrowing costs so that they could continue to afford new bond issues and avoid needing EU subsidized loans. The goal was to save the EU and the euro more than to save Greece.

Yet, per our initial understanding, the plan is silent about how the EU would deal with other members in danger of default. That means continued doubts about whether the EU has any ammunition left to help the other PIIGS nations.

That is the fatal flaw, which will keep plenty of uncertainty alive about the solvency of these countries, and THAT is what will keep their borrowing costs high and possibly rising higher if national or international conditions deteriorate.

EU: Please Clarify ASAP

The omission is understandable given the time pressure to remove fears of imminent Greek default.

OK, now get back in the conference room and address plan B for the rest of the PIIGS – FAST. Otherwise, you risk returning to the same situation within a month with problems that are many times worse. Remember:

  1. Italy needs to sell about € 30 bln of bonds in June.
  2. Spain needs to sell a similar amount in July.
  3. Both have many times the debt load of Greece and no one believes you have the ammunition to bail them out. That’s a problem because….
  4. Goldman Sachs has already recommended making bets on Spanish, Italian, and Portuguese bank failures by buying CDS on their bonds – there are already those out there with interests in seeing the crisis spread.
  5. Consider trying to cut off a crisis involving any of these before it starts. As we’ve seen, panic and exploding bond yields can sneak up on you fast!

Other Key Provisions Include

  • 110 billion ($146 billion), first payment to come before Greece's next bond redemption on May 19th.
  • The 16 Nation EU group provides 80 billion in loans to Greece at around 5%, the IMF, 30 billion.
  • Greece agrees to cut its deficit to 3% of GDP within 4 years, by the end of 2014, a year later than previously agreed, making deep additional spending cuts that in total amount to about 13% of its GDP.

Markets Not Yet Convinced

The new plan still must be approved by contributing members, especially the heretofore reluctant Germans, who contribute 28% of the EU loans. Greece needs to pass additional austerity measures, including wage freezes and tax increases. Neither is a given.

Germany hopes to get parliamentary approval by May 7th, before it faces a regional election May 9th in Westphalia. If it registers a serious protest vote, that risks shaking German resolve--again.

Greece has already seen riots, and has a 2 day strike scheduled for Tuesday and Wednesday with additional demonstrations, which can turn violent. These raise questions about whether Greece will be able to sustain the required cuts over the coming years. Funding is conditional on quarterly compliance with spending cuts. Greece's strong unions have as yet not been cooperative.

Not surprisingly, in early Monday trade, the euro and its bonds have not rallied.

Disclosure: No Positions