With Dubai Temporarily Contained, All Eyes Shift To Greece

Today at 7pm, Greek Prime Minister George Papandreou will address “the economy, the productive model, the credibility of the state mechanism, the confidence of our European partners and, above all, the daily life and prospects of Greeks." The reason for this extraordinary measure (keep in mind this is Greece, not D.C., where the president provides hourly updates on the latest BLS releases) is the recent plunge in Greek stocks and government bonds, and culminating with several rating agencies either downgrading the country (Fitch) or putting it on downgrade review (S&P). Most recently, the yield on Greek 10 years hit 5.295% on concerns the country's fiscal deficit of 12.7% will makes its already extreme leverage even more unmanageable. And the biggest wildcard: the massive reliance of Greek banks on ECB repos backed by potentially soon to be much lass valuable government debt.

As a reminder here is how Greece stacks up with selected other "powder keg" countries: at 113% Debt-to-GDP, and not part of the G-7 top dog syndicate, the country will certainly be in trouble unless it finds a way to trim its staggering debtload:

Delving into the numbers is made easier compliments of a research report released by Citi, whose TARP repayment today will make the research analysts who wrote this paper much richer than they would have been otherwise.

Not surprisingly, Citi's view of the Greek fiscal debacle is not too far off the beaten path:

Greece has one of the highest government debt levels relative to GDP in the Euro Area. For 2009, the EU Commission estimates that Greece will have a government debt ratio of 113% of GDP, which is almost as high as Italy. Next year, this is estimated to rise to 125% for Greece, higher than Italy and 50% higher than the Euro Area average.

Significantly, not only does Greece have a high stock of government debt, it is expected to have a high annual fiscal deficit as well: 13% for 2009E and 12% for 2010E, according to the EU Commission. The Greek Government is projecting a fiscal deficit of 9.1% for 2010E.

The government debt to GDP estimates have increased dramatically during the course of this year for Greece: +16% for 2009E, +27% for 2010E. For the Euro Area overall, the debt to GDP ratios have risen by 6-8% during the course of this year as the impact of the economic downturn has become visible on tax revenues.

In the case of Greece, the debt to GDP estimates have risen because of changes in swap transactions and financial transactions related to social security funds affecting the 2008 debt calculations. The significant increase in the ratio in 2009 reflects the combined effect of a snowball effect and sizable stock flow adjustments.

Yet, not only is the country in a fiscal pickle, but an unstable political picture and a rather volatile population could add more sparks to the Southern Europe powder keg.

The new Greek government (PASOK-Centre left) targets a deficit for next year of 9.1% (to GDP) from 12.7% in 2009E. The deterioration in 2009E numbers came from lower revenues and higher expenses, including one-off expenditures mainly related to arrears to the hospitals' suppliers amounting at around 1.5% of GDP.

Deficit for 2010E is based on assumptions of a 1.2% GDP contraction in 2009 and 0.3% in 2010. Expenditures are planned to fall by around 1% of GDP while revenues should increase by 2%. Expenditure is projected to fall by 2.3% yoy in nominal terms in 2010 from growth of 15.9% yoy. Higher taxes are expected to deliver most of the revenues, although Greece has a weak track record of fiscal policy implementation.

The country was already under EU excessive deficit heightened supervision since April, and the country was given until January to present a viable Stability Pact to Brussels. If the plan is not considered sufficient, the situation will be monitored on a monthly basis and the country will be liable to fines if it fails to comply to its commitments.

As a result of the deteriorating Greek macro environment, CDS spreads and GGB spreads to Bunds have both widened. 5Y CDS spreads have widened to 208bps (Dec 10) from 125bps in October 1, 2009. 10Y GGB spreads to Bunds have widened to 238bps (Dec 10) from 137bps in October 1, 2009.

And an eerie deja vu from the Dubai incident are the solemn guarantees from the EU that the country will never be allowed to default. Just ask Nakheel bondholders who sold at 50 (to Pimco, thank you very much) how much credibility such claims carry.

Different officials from the European Union have raised their voices in order to support Greece. Jean-Claude Juncker, president of the Eurogroup, said on Thursday 10th December that "the budget situation in Greece is tense but the country should avoid bankruptcy".

Two weeks earlier the European economic and monetary affairs commissioner, Joaquin Almunia, stated: "Greece will never default on its sovereign debt because the country has the backing of the European Union". Almunia also stated that "They will have to pay more (for its bonds) but default risk is near zero because of the EU backing". These messages try to restitute the harm done by the Excessive Deficit Procedure report published by the EU Commission in November.

According to reports in the Greek press, the government is likely to announce in the very near future a set of new measures to address the budget deficit crisis. The measures discussed would aim to cut the expenditure but also raise revenues. On the expenditure side the government may reduce the cost of the civil service sector (salary and allowances reductions, reform of the national insurance). On revenues the government could announce an acceleration in public and semi public privatizations, and commitment to curb tax evasion.

An even bigger wildcard: Greek banks, and their exposure to risky, developing countries.

Greek banks have exposure beyond their domestic market. Most notably, NBG derives almost ~40% of its 9M09 pre-tax profits and ~30% of its loans from emerging Europe, with Turkey alone accounting for ~30% of its 9M09 pre-tax profits. For other leading Greek banks, the Balkans, Cyprus and Poland are key markets. However, NBG’s peers derive limited profits from their overseas operations (eg Alpha Bank) or make a material loss abroad (eg Eurobank EFG).

Amongst global emerging markets, emerging Europe is definitely a laggard. In 2009, based on IMF estimates, emerging Europe GDP (CEE + Turkey) is expected to decline c5%, twice as large as the Latin American contraction. In 2010, emerging Europe is expected to grow c2%, but lagging Latin America (c3%). Emerging Asia remains in a different league altogether: +5% for 2009E, +7% for 2010E.

Within emerging Europe, all the major countries are expected to register negative GDP growth in 2009, Poland aside. Romania is the worst (-8% yoy), followed closely by Hungary and Bulgaria. Emerging European growth should be anemic in 2010, with most of CEE/SEE growing at between -1% and +1%, with 2-3% economic growth expected in 2011. Only Turkey is expected to register a respectable growth rate (+4%, 2010E. +5%, 2011E).

Probably the most concerning trend is the ever increasing use by Greek banks of the European Central Bank Repo Facility. As long as this is a key short-term funding vehicle, the financial system will certainly be strained.

As set out in Figure 28/Figure 29, the Greek banks have funded a higher proportion of their assets via ECB repo operations. We understand that Greek banks tapped the ECB facility after their local interbank / repo market froze in 4Q08. Greek banks usage of ECB repo funding has declined by between a quarter (NBG, Alpha) and a half (Eurobank EFG) from their peak levels earlier this year.

Most Greek banks have used Greek government bonds as collateral for their ECB repo operations. This GGB collateral can be used for shorter-dated regular market repo operations without paying a penal rate, albeit one year funding would not be available in size as with the ECB. But the ABS-collateral repos with the ECB would be significantly more expensive if replaced in the market.

So the net cost of reducing ECB funding reliance is not clear cut for the Greek banks. NBG have pre-funded €4 billion out of their €9.5 billion ECB repo funding in the market, and if they had to reduce this further the net cost would be limited. By contrast, Piraeus in particular would face much higher funding costs to replace their ABS backed ECB borrowing – but they are probably running a negative carry on this right now.

What would happen in a government default, which would render the collateral backing up the banking system worthless, would surely prove quite unpleasant and certainly very contagious.

Yet at the end of the day, all these concerns do not prevent economist and strategists to believe that both Greece and the Eurozone are due for some major hockeystick action. One can only hope they are right, although we have yet to see even one case in which a hockeystick projection did not prove woefully myopic.