Greece Bonds Under Attack Again, Schäuble Adds More Oil on the Fire

by: Erwan Mahe

In the past few days, PIGS nation markets have benefited from a little breathing room thanks to the ECB's ferocious opposition to involuntary restructuring of Greek debt susceptible to trigger a default event. The effort is aimed at preventing the contagion from spreading to other sovereign nation debt, which would not stop at countries like Ireland or Portugal, but would eventually include too big to save countries, like Spain, Italy or even France, should the existence of the euro itself come into question.

The EU, IMF and ECB hot and cold

The combined EU, IMF and ECB announcement on 3 June relieved investors, because it seemed to confirmed the early disbursement of the next loan tranche to Greece, based on progress already achieved:

  • Overall, significant progress, in particular in the area of fiscal consolidation, has been achieved during the first year of the adjustment program.
  • ... there have been encouraging signs recently, in particular a notable pick-up in exports. Unit labour costs are set to decline further, supporting the strong export dynamics, and inflation is on a declining trend.
  • The government is committed to significantly accelerate its privatization program.
  • In the financial sector ... policies are in place to ensure adequate liquidity provision for the banking system. The banking sector remains fundamentally sound .... However, the Financial Stability Fund is available as a backstop for viable banks that cannot raise capital in the private market.
  • Further progress has been made with structural reforms.
  • Building on the agreed comprehensive policy package, discussions on the financing modalities for Greece’s economic program are expected to take place over the next few weeks. Once this process is concluded and following approval of the IMF’s Executive Board and the Eurogroup, the next tranche will become available, most likely, in early July.

Vienna Initiative reassures investors

Honestly, such a joint statement from the three main bail-out plan backers fully justified the recent 5%-7% rebound on Greek short-term debt markets.

This "optimism" is largely inspired by the new Vienna Initiative, which includes a voluntary roll-over system to involve private-sector investors, as demanded by the Germans. The original Vienna Initiative (IMF Survey Magazine, Oct. 2009: "Agreement with Banks Limits Crisis in Emerging Europe," and EBRD May 2011: "Vienna Initiative –moving to a new phase") consisted of demanding that private-sector banks, at the time exposed to a very seriously affected Central Europe, to extend their loan commitments there in exchange for a government aid plan (IMF, EBRD, EIB, World Bank).

However, the situation today is different for many reasons:

  • The current bank commitments toward Greece entail government debt as opposed to loans that can be re-profiled endlessly without triggering a default procedure.
  • The banks were also involved there due to investments carried out earlier via local subsidiaries that they also committed to re-capitalising.
  • In the case of Greece, a good part of securities are held by end investors (insurance firms, pension funds) and not directly by banks.

These differences further complicate the prisoners' dilemma, which deals with co-operation problems based on game theory.

Although this Vienna initiative is no more than a smokescreen

These differences explain my position expressed during numerous discussions in recent days with clients: eventually Investors would not participate to this Vienna Initiative. It then amounts to no more than so much powder for German leaders to throw into the eyes of their voters.

On the other hand, the ECB's tacit approval of this Vienna Initiative only comforted my belief that it had little chance of success.

This smokescreen was politically necessary, given German voters' reticence to support endless and in many eyes fruitless efforts to bail out the Greeks (among others), as they remained obsessed with a moral debate, like the "Ant and the Grasshopper" fable.

In reality, we can't really blame them, since no one has shown the courage to clearly explain, with the help of statistics, the enormous advantages brought to Germany by the Eurozone's creation and by the debt surge of its peripheral nation partners, as well as the dramatic consequences that would result from aGreek default and the unpredictable fall-out from such an event. This would be particularly painful for German taxpayers, given the subsequent massive haircut on their savings, which are largely invested outside the German Nordic bloc, and the series of massive recapitalizations that would be required by their banks. But Ms. Merkel remains, for the time being, stuck in a populist message that citizens of southern countries must work as long as Germans if they want to continue receiving aid. ("Merkel Blasts Greece over Retirement Age, Vacation")

However, I see a glimmer of hope, with the recent appearance of articles in the German press, including in newspapers (Spiegel, Die Welt, Bild) that can hardly be accused of obstructing the CDU government, which point out "inconsistencies in the official line": Is Merkel Gambling Away the European Idea?

Even the FT has joined the fray, with its article Tuesday evening, "Greek debt rollover initiative gathers steam." A majority of Greek government bondholders may be prepared to voluntarily roll over the country’s debt in a move that would not spark a default.

And it all falls down!

Mr Schäuble has addressed a letter, not just to the ECB and IMF, but to all eurozone government finance ministers, in which he clearly puts forward a much more rigid German position on the need for private sector investor participation than the latest events might have led us to think: German Schaeuble’s letter on Greece to IMF, ECB, euro peers.

The publication of this letter caused a 1.5% dip in Greek bonds prices. 5-year Greek CDS have climbed to a new high (1474 bps) and all the PIGS nation spreads have worsened.

Here is a selection of quotes that put oil on the fire (emphasis mine) :

  • At the same time, without another disbursement of funds before mid-July, we face the real risk of the first unorderly default within the euro zone.
  • ... any additional financial support for Greece has to involve a fair burden sharing between taxpayers and private investors.
  • This means that any agreement on 20 June has to include a clear mandate -- given to Greece possibly together with the IMF -- to initiate the process of involving holders of Greek bonds.
  • This process has to lead to a quantified and substantial contribution of bondholders to the support effort, beyond a pure Vienna initiative approach.
  • Such a result can best be reached through a bond swap leading to a prolongation of the outstanding Greek sovereign bonds by seven years, ...

Given that credit rating agencies and the ECB have already warned that such an extension of maturities, even a "voluntary" one, would surely constitute a default event, that brings us back to square one.

But why?

His letter raises many more questions than it provides answers:

  • How will the ECB react? The latter clearly understands the stakes involved, as illustrated by Bini Smaghi'sspeech in Berlin that I examined in Monday's Thaler's Corner: Private sector involvement: From (good) theory to (bad) practice.
  • What about Germany's European partners (aside from the northern bloc), who have repeatedly opposed such a measure?
  • And the IMF, which cannot commit to a new loan tranche if the one-year financing plan is not clearly established?
  • Then there are the Greeks themselves, who have bowed to all the demands of their partners, going so far as to give up part of their sovereignty in the guise of foreign "technical aid" for the establishment of their privatisation programme?

I freely admit that I am sure of nothing, following the eleventh hour manoeuvre by the German finance minister that (almost) leaves me speechless.

However, before I leave you in a fog, check out the graphs, below, tracing the situation in which Europe finds itself today, with the publication Wednesday morning of Greek and German unemployment and industrial production statistics.

Greek and German unemployment

In view of these statistics, there is no question that Greeks are working much less than their German peers.

But first they need to find a job!

(Click to enlarge)

Greek and German industrial production

While our German cousins have nearly returned to their pre-crisis standard of living, Greece’s IP contracted 34.3%.

(Click to enlarge)

These two statistics (unemployment and industrial production) clearly illustrate the magnitude of the output gap today in Greece.

In the context of today's numerous austerity plans, this guarantees a massive deflationist bias, as reflected in the inflation figures. While inflation has historically been higher in Greece than in Germany, the disparity has been narrowing since September 2010, declining to +3.90% from +5.60% , while increasing in Germany to +2.30% from +1.30%!

If we consider core HICP inflation, which is the sole valid reference for the medium-to-long-term, the contrast is even sharper.

For the first time ever, core Greek inflation has fallen to the same level as Germany's (0% difference), which compares to a 1.80% differential since the eurozone's creation!

This historical inflation spread is surely one of the reason's for Greece's loss of competitiveness within the eurozone, so this new trend is “good news”,especially since, according to Eurostat figures, Greek salaries and related compensation contracted 4.7% in 2010, while they increased 0.80% in Germany during same period. In view of the economic data so far this year, the trend for 2011 should be even more divergent.

Since markets are effectively shunning Greece (and deposits too), this dis(de)flationist trend increases even more the need for foreign help, if we are to prevent the nightmarish scenario of runaway debt deflation.

Greek and German core CPI

In the process of internal devaluation

(Click to enlarge)

As a logical consequences of the macroeconomic factors, the Greek balance of trade deficit is disappearing before our eyes -- and not solely due to the recession and a contraction in imports.

The monthly trade deficit has fallen from €4 billion at the height of the credit bubble, in 2007-2008 when Greek-to-German interest rate spreads on 2-year debt amounted to less than 10 bps, to €2 billion recently, with a spread of 2,500 bps !

Lend when you should not, don’t when you should?

Greek balance of trade deficit

It had not been this low for a long time.

(Click to enlarge)

Incidentally, I am told that one of the budget items least affected by austerity moves in Greece is military equipment expenditures, which is no stranger to certain submarine contracts concluded with Germany. These are the submarines that cruise around Cyprus along with their Turkish rivals, who are also Nato members and candidate for admission to the European Union.

There is by the way a related €100m fraud investigation ("Greek inspectors eye German sub deal"). Even Lewis Carroll would not have been able to dream up such a story.

As you can see in this chart ("SIPRI Military Expenditure Database") in 2010 Greece was the 20th biggest military spender, way ahead of its European partners as a percentage of GDP (3.2% versus 2.5% in France and 1.4% in Germany).

Sorry to conclude on such a sour note.

Disclosure: Long 18 years OAT and 28 years BTP Zero Coupons, EDF Corp 3 Years 4.5%, Greece 1 Y and 8 Y bonds, Thaler's Corner.