Unable to keep with the events in Europe which are now literally changing on an hourly basis? Fear not: SocGen's James Nixon has compiled the most succinct explanation for why we are where we are, and why things will get much worse, before they get even remotely better. In a nutshell, everything you know about the existing proposals is finished: what is currently on the table is "a wider strategy which includes lowering the interest rate on lending to Greece and returning to the idea of bond buybacks." Ah, yes, the Goldman proposal. However did we know we may end up precisely here. The problem with this proposal is that all bond buybacks at prices below par are, and always have been, considered by the rating agencies as immediate events of technical default. How this eliminates the ECB liquidity scramble bogeyman we have no idea. At this point we are absolutely certain that the only thing on the Eurozone and ECB's plate is to baffle everyone with steaming pile after pile of bullshit so unbelievable, that people are stunned for days, buying bankers valuable time to convert even more freshly printed paper into hard assets. In the meantime, there is no actual plan to deal with the problems of untenable debt, or at least not one that does not involve the outright monetization of debt and thus, the spurring of hyperinflation, which unfortunately is the last recourse to wipe out the tens of trillions in bad debts dispersed proratedly across Europe's insolvent banking system.
No easy way out: Europe still considering bond swap for Greece. The fault lies not with the rating agencies; rather it is the inability of European’s political leaders to agree a new financing package for Greece and the insistence of private sector involvement that has pushed Europe’s sovereign debt crisis to new highs. There is now a very real risk that contagion will engulf Italy and Spain. Germany’s Der Spiegel captures the mood when it argues that, “The fears that are turning investors against Italy are vague and are being exacerbated by the failure of euro area finance ministers to agree on a second bailout for Greece.” In the meantime, the argument over how private sector investors should be included in future bailouts is making it difficult for other higher indebted countries to borrow money in the financial markets. Where this leaves us is unclear. It continues to look as if the French proposal to roll over Greek debt has largely been abandoned, not least as it was seen as being far too generous towards the banks. Instead, Finance Ministers are reported to be giving serious consideration to the German government proposal that banks swap their existing Greek bonds for new seven-year Greek debt. Such a move appears to be part of a wider strategy which includes lowering the interest rate on lending to Greece and returning to the idea of bond buybacks. Given the discount at which Greece debt is trading, the latter continues to be an attractive strategy to impose losses on the private sector.
Despite mutterings that the Eurogroup is still exploring a voluntary arrangement, it is hard to see that there can be any common ground with the rating agencies. Although a formal debt swap and duration extension would probably not be a credit event (in the sense of triggering the CDS) it would almost certainly be treated as a “rating event” and see Greece downgraded to SD. Meanwhile, Handelsblatt reported on Monday that the ECB had contacted five financial institutions with a view to seeking advice on how to minimise contagion should Greek bonds be downgraded. In particular, according to the newspaper, the ECB is seeking advice on the refinancing and liquidity of banks, after such a downgrade.
The real problem is now contagion. If the Europeans go ahead and force through a rollover on Greek debt, the markets will rightly anticipate that Portuguese and Irish debt will receive exactly the same treatment should their existing bailout packages have to be extended. Not only does this make it increasingly unlikely that these countries will be able to return to market financing (and therefore making it more likely that Portugal and Ireland will need a new bailout), but it also injects a significant risk premium into the yields paid on Italian and Spanish debt. With Italian ten-year bond spreads heading toward 300bp, the risk is that we are fast approaching the point where neither Italy or Spain will be able to sustainably finance themselves at these levels. This naturally leads into a discussion of whether they can be financed by an enlarged EFSF. Along these lines, the German daily Die Welt reported on Monday an unnamed ECB official suggesting that the EFSF should be increased from its current €440bn to €1.5 trillion.
Should the crisis really spread as far as Italy and Belgium, then this figure is not that far wide of the mark. We estimate Spain’s total financing need over the next three years to be around €380bn; Italy’s financing need is considerably larger at €630bn while Belgium’s financing need over the next three years would be around €150bn. Including the €44bn already committed to Ireland and Portugal, and potentially a further €85bn for Greece, the EFSF would need to be roughly doubled to just over €850bn (assuming the IMF would be prepared to provide one third of the official financing). Without the IMF, whose participation cannot be guaranteed, the EFSF would have to be expanded to €1.3 trillion. In order to maximise the lending capacity of the EFSF, this would mean the AAA-rated countries would have to guarantee 172% of the lending which would potentially imply a contingent liability of between 25-45% of GDP – depending on whether the IMF were involved or not. Such numbers are huge and must raise serious questions as to whether practically the EFSF could be adequately dimensioned to cover the financing needs of Italy, Spain and Belgium.
Where this leaves us is unclear. The ECB have made it very clear what the established policy response should be, namely the best practice is to fund countries undertaking fiscal adjustment subject to strict oversight. By continuing to seek “substantial” and “voluntary” private sector involvement, Europe’s political leaders look prepared to break with that global doctrine and override the ECB. Meanwhile, the failure of the strategy of pursuing ever greater austerity is plain for all to see with the latest Greek fiscal numbers suggesting that the public deficit had widened to €12.8bn in the first six months of the year compared to a program target of €10.3bn. Public sector spending was up 8.8% y/y, principally due to higher interest payments and payment of arrears to hospitals. Net revenues dropped 8.3% which the finance ministry attributed to the deeper than expected recession. This would appear to vindicate the Troika’s May assessment that “there is a distinct risk that the performance criterion on primary balance for end June has been missed.” To close the gap, and attempt to bring the program back on track, the Greek government recently announced additional deficit cutting measures amounting to almost 3% of GDP in 2011 at the request of the Troika.