It appears to be assumed by all that Greece will make it through and that the US will go along with providing whatever additional IMF funding is needed. We aren’t so sure. Here’s why:
Greek CDS Hits New Intraday High- Growing Fears of Greek Debt Ballooning, Ending In Restructure?
Greece is expected to make it through the next few months, but concern about its longer term prospects, and those of the euro, are rising to the forefront of market concerns along with those of financial regulation and the health of the ongoing rally.
BBK President Axel Weber, a leading candidate to replace current ECB President Jean Claude Trichet, admitted openly what all were thinking – Greece would likely need , ahem, a bit more cash than that envisioned in the current EU/IMF package – a lot more. That casts the current plan as a mere Trojan Horse that, once it breaches the EU’s stability pact standards, will lead to a flood of money printing and new debt.
Indeed, the EU debt crisis is worsening due to rapidly fading confidence that is sending PIIGS borrowing costs beyond their reach, which in turn feeds the death spiral towards a self fulfilling prophecy of Greek default, which will likely put at least some of the rest beyond hope.
Per CMAvision.com, a few charts to consider (click on all to enlarge).
11 apr 21
Largest weekly change in credit default spreads: PIIGS block all in the top eight:
08 apr 21
Spanish and Portuguese banks lead financials in CDS market:
09 apr 21
What is Feeding The Fear?
Greece is expected to get through in the near term, but is not expected to be able to avoid default unless borrowing rates are even lower than the roughly 5% rates of the EU/IMF debt package – already a substantial discount from the market.
There are growing fears that participants in the aid plan may be throwing money down a bottomless pit. Questions include:
- Can Greek figures be trusted?
- Even if so, can Greece remain solvent on the borrowing rates it can realistically get?
- If not, is there anyone who is willing or able to offer a bailout? Even knowing that more of the PIIGS block may be waiting in line for aid?
Is It in the US's Interests to Provide Aid?
As the largest source of funding for the IMF, the role of the US in the EU debt crisis will grow with that of the IMF. As EU members delay paying up their share of aid for legitimate parliamentary approval procedures or sheer political expediency, the role of the IMF, hence the US, is likely to grow.
What Washington Must Consider
However, it is not a given that Washington should step in, even with the clear risk of global default – both for states and their large bank creditors. Though I hate to cast the US in a selfish light, but with ships of state slowly sinking, Washington will have to consider its own needs first.
1. Risk of Imminent Contagion May Not Be Worse Than Delayed Contagion
However, it is unclear that it’s in Washington’s interest to do so. Admittedly, ceasing additional IMF aid raises risk of EU and global sovereign default contagion, but given the trouble Greece alone is causing, might that not be unavoidable anyway? Washington will need to weigh which risk is greater –
- contagion now
- contagion later, but after even more money printing and debt.
The second is preferable only if there is good reason to believe that in the intervening time the problem can be minimized or solved. Key to this is for Washington to assess US exposure to an EU contagion. US bank exposure is fairly limited to the PIIGS bonds – they are mostly an EU banking problem. The question is, what is the exposure US banks have to large European banks that are themselves threatened? That is a central question for Washington policy makers.
Moreover, as colleague Graham Summers has pointed out, a likely rather severe stock market pullback would also be convenient for US bond sales. At a time when US bonds have a higher yield than some corporate bonds due to increased fears of continued US spending and need to backstop defaulting states, that’s a real consideration.
2. Political Risk
What should be quite clear, however, is that US voters will be no more enthusiastic about aiding Greece than those in Germany, and ahem, there are midterm elections coming up. The Obama administration will need to be able to make a VERY strong case to the voters for more IMF/Greece aid given America’s own parlous deficit. If Berlin can’t, how will Washington?
3. Euro’s Pain Is the Dollar’s Gain – Which May Be America’s Greatest Hope of Sustained Recovery
Beyond political motivations for abstaining from more US money printing, there are distinct economic reasons.
The euro is the only current alternative to the US dollar as world reserve currency. Being sole reserve currency really helps when you need to sell mountains of bonds. Given the amount of debt the US must sell over the coming years, why encourage the competition, especially if it’s unclear that contagion can be avoided anyway?
Also, as anyone familiar with forex markets knows, the EUR/USD pair alone accounts for about a third of all forex trade. That means that for every 3 euros bought or sold, a USD is used. Thus the two push each other in opposite directions. As the EUR falls, the USD gets a huge boost and vice versa. A falling EUR means more USD demand, and lower US borrowing costs. That helps the US recover.
A falling euro also helps keeps US mortgage rates low as investors buy dollars and T bonds in a flight to safety, and that is a VERY big deal, given that starting July the US sees a wave of resets of a magnitude not seen since the wave that created the subprime crisis, which of course metastasized into the current Great Recession. As noted above, if Washington needs to sell more bonds to pay for another bailout, the increased demand from a full blown crisis in the EU would not be the worst thing imaginable.
Conclusion: What Washington Must Weigh
In sum, against the risk of EU implosion and contraction under the weight of a wave of PIIGS state defaults (as one default sends borrowing rates for all to unaffordable levels), and possible global sovereign and banking default contagion, the US must weigh:
- Contagion and crash part II may be unavoidable anyway, so best to face it without another layer of deficit spending
- Near term benefits of a flight to safety that bolsters the USD and lowers US borrowing costs (though there is real risk that all sovereign states may see higher rates)
- Longer term benefits of a much weakened euro eliminated as competition for reserve currency status. Yes, a cheaper euro makes US goods more expensive, but given US borrowing needs and impending mortgage rate resets, keeping US borrowing costs lower is arguably the greater near term economic and political priority.
Key point – despite what markets currently think, it’s really uncertain that the EU can be saved, whereas the above advantages of keeping the US purse shut are fairly clear.
Disclosure: No Positions