EU Default Risks Grow

14- Apr-11 The blowout in Spanish risk premia on Germany’s public acknowledgement of Greek debt restructuring talks, i.e. default, this morning appears to have pushed all the right buttons. EU Economic and Monetary Affairs Commissioner Rehn stated that the risk of contagion from debt restructuring to other countries should not be underestimated and sought to directly calm market fears that private sector involvement in restructuring is not foreseen in the current EFSF framework (i.e. but it is after 2013) given the fragile situation in Europe.  He went as far as to suggests that Spain will comfortably overcome its challenges as it is building a firewall through its economic reforms and that the EU will "ring-fence" high debt countries. The comments followed similar public statements from the IMF’s Strauss-Kahn and Lipsky that Greek debt restructuring is not part of the IMF’s program (which also runs out in 2013). French Finance Minister Lagarde also came on the wires, from Washington, stating that there is no discussion on debt restructuring as far as Greece is concerned. Overall, the EU and IMF response to has been to deny Germany’s comments and push the discussion back behind closed doors.

The urgent sensitivity demonstrated by EU politicians to the risk of the solvency crisis contagion spreading to Spain may provide a psychological hedge for the markets short-term (EUR/USD back at 1.45). However this episode has also served to demonstrate the Euro zone’s systemic fragility and the considerable risk of a policy error.

The markets have been trading the risk of Greek default of some form (including debt restructuring) as a certainty for a while, but not the risk of a new EU-wide capital markets shock. Greek 5yr CDS at 1139 today imply a 61% default probability based on a 40% recovery rate, or a 94% based on an 80% recovery rate. This is up from 55% at the end of March (on the standard 40% recovery). This means that no one expects to get their investment in Greek government bonds back in full, whether restructuring happens before or after the European Stability Mechanism comes into force in 2013.

Hence Greek default is an economic certainty, not a policy choice. The policy choice only concerns the timing and on this point Germany’s decision to force the issue onto the table today is understandable – the longer it takes for Greece to default, against the backdrop of steadily deteriorating growth prospects and ever higher markets borrowing costs, the greater the losses for EU tax payers and bank lenders eventually will be, with a negative feedback to EU-wide sovereign risk.  
Yet, as we noted in our previous note, the euro has been trading contagion rather than default risk, which means that the markets did not see Greek default as a reason to expect a Euro zone break up. This has been based on two major assumptions. First, that the Euro zone can orchestrate “orderly defaults” under its permanent bailout facility, the European Stability Mechanism, whereby private sector investors will be asked to share some of the losses and only after 2013.
The second assumption, by association, was that Spain will remain insulated from the crisis in the scenario of managed default risks. Indeed, while Greek, Irish and Portuguese government yield spreads against Germany have increased this year, Spain’s credit risk premium has fallen. This, given Spain’s size and systemic importance, has effectively meant that the Euro zone’s peripheral risk premium as a whole has fallen, prompting investors to price out Euro zone breakup risk from the euro's exchange rate.

Yet, it is uncertain for how long the Euro zone can administer “orderly bailouts” in order to engineer “orderly defaults” at a later date. Greece’s dire position and the ever deepening crises in Ireland and Portugal threaten to bring Spain closer to the crisis and substantially increase the government’s costs associated with the banking system's recapitalization. The risk of a policy error looms large and euro sentiment looks fragile especially if the markets begin to worry that the ECB’s increasingly hawkish position will stamp too hard on the banking system.  European financials lost 2.3% today and we remain loyal to our long-standing argument that the ECB's unlimited liquidity provisions will not insulate Europe's banks from the capital shocks of ever falling peripheral government bond values and rising collateral costs, which ultimately leave the system more and more over-leveraged, reinforcing the negative feedback loop between sovereign and financial risk.