With the impending March 20th maturity GGBs trading at 1400% yield (or 36% of par), EURUSD trading at 1.31, and European financials (and Greek financials explicitly) all up considerably, one could be forgiven for confusion as to what is priced in and what is not. As Bank of America (BAML) noted earlier in the year, believe it or not, Greece remains a blind spot and that risks from Greece are not fully priced in. Summarizing the deep cuts that Greece is expected to make - the Troika is demanding fiscal measures of 2% of GDP in 2012 - BAML points out that while they believe a common ground can be found, the asymmetric risks of a disorderly default could weaken the EUR well below their projection of 1.25 in the first half of the year. Certainly, while Greek sovereign bond markets seem priced for inevitable default (as real cashflows still count in the credit markets), FX and equity markets seem to be jumping-the-shark of the crisis - Europe will be stronger without Greece and Fed will backstop inevitable crisis - and missing the interim crisis conditions (Lehman-moments) that will occur as tail-risk scenarios and social unrest (that LTRO seems to have assuaged for now in people's minds) could return rapidly across the entire region. With frustration growing between an impatient Troika (that faces total humiliation, moral hazard, and ugly precedents for others) and a stubborn April-election-facing political class in Greece (along with the inability of the PSI to get done for all the reasons we have discussed in the past - foreign law bonds, basis traders, hedged positions, hedge fund sovereign litigation arbs) it seems the Troika has the most to lose for now seemingly holding a gun to their own head (as once again a massive ECB intervention might be needed with all its knock-on effects on the Fed's balance sheet expansion).
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The March 20, 2012 GGB trades at EUR36.3 (or 1400% yield), down from Par less than two years ago. Default seems inevitable and whether orderly or disorderly seems irrelevant as PSI will not be achieved leaving even a 'claimed' orderly move stuck in litigation hell for months.
Bank of America: Greece on razor’s edge
The negotiations for a new program in Greece are at a crucial stage. A meeting of Prime Minister Papademos with the three political leaders of the coalition government on Sunday has failed to lead to an agreement. Another meeting is scheduled for Monday. We believe the Greek government needs to decide on the following demands by the IMF-ECB-EU Troika:
- Closure of public enterprises and organizations that do not perform a function anymore and let their staff go – a total of 15,000 employees.
- Stop the regime of permanent employment and cut wage supplements in public sector enterprises.
- Cut the minimum wage, freeze nominal wages and stop any wage increases from seniority in the private sector.
- Abolish or cut substantially the holiday salaries (13th and 14th salaries).
- Increase labor market flexibility and particularly in wage bargaining.
- Reform and cut supplementary pensions, and merge related funds.
- Include all public sector employees in the unified public compensation system, or cut by 20 percent salaries that are excluded.
- Substantial cuts in spending for pharmaceuticals.
- Cuts in defense spending.
In total, the Troika is asking for additional fiscal measures of 2 percent of GDP in 2012. Reports suggest that the Greek government has already identified measures for about half this amount and is asking to spread the adjustment over a two-year period.
The timetable is very short. Agreeing on a new program is a must for the PSI (private sector involvement in a voluntary debt restructuring scheme). To allow time for PSI participation by mid-February, an agreement should be reached as soon as possible. The final program documents can then be signed by end-February, followed by an IMF Board meeting by mid-March, just in time before the March 20 bond maturity of €14.4bn.
The negotiations with the Troika have been very challenging. Although most of the above measures are related to previous commitments, or are justified by continues fiscal slippages and failure to improve competitiveness through structural reforms, the Greek politicians appear to be trying to avoid any political cost before the April elections. The Troika has also been particularly tough and seems frustrated from continuous delays and implementation problems that threaten its credibility and could lead to moral hazard in the rest of the region, particularly after the PSI. The most controversial measures are the cuts in private sector labor costs, which intent to improve competitiveness and help the private sector adjust without further layoffs.
We still believe that a common ground can be found, but cannot ignore the highimpact risks involved – indeed, we have recently warned that Greece remains a blind spot. A disorderly default in Greece would be in nobody’s interest:
- Greece has large funding needs, both in its government and its private sector. Without market access and official funding, the required sharp adjustment would be substantially more painful than under the program and could trigger a chain of events that could lead to an exit from the Eurozone. Greece’s banking sector would collapse, in our view, as there would be no funding for its recapitalization. A bank run combined with the inability of the government to pay its obligations could lead to severe social unrest.
- As the rest of the Eurozone periphery remains fragile and is only in the beginning of its reform process, such a chaotic scenario in Greece could have systemic implications. The limited EFSF funds are likely to prove insufficient to address contagion risks.
Market implications
The elevated uncertainty in Greece suggests downward EUR pressures, in our view. We continue projecting the EUR-USD at 1.25 in the first half of this year.
Even if the Greek government reaches an agreement on Monday, social unrest is likely to follow the measures related to wage cuts. Implementation problems are likely to continue before the signing of the new program. And we believe that the PSI will reach well below the almost full participation that the Troika assumes, putting the scheme at risk. A disorderly default in Greece could weaken the EUR well below our projection.
We do not believe that the risks from Greece are fully priced in. Bond market prices suggest that a default in Greece is almost inevitable, but FX markets suggest that contagion from Greece would be contained. However, negative news from Greece continues affecting FX markets – such as the announcement of a referendum on the Euro last fall. Although the EUR could eventually be stronger without Greece, a Greek exit under crisis conditions could increase uncertainty and even lead to tail risk scenarios in the rest of the region. A massive ECB intervention may be needed, weakening the EUR.